Please Share:: 
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
The time is now
FY12-13 should be a crucial investment phase for TCS and peers
5-10 non-linear initiatives need to pay off for meaningful impact
Expanding scale and cloud computing threats to existing model
LT investors need to watch IP moves, need relevant disclosures
The “non-linear” story
We believe FY12-13 could be a crucial
period for Indian IT companies to step up
investments in “non-linear” initiatives
(those that de-link revenue and headcount
growth). Tata Consultancy Services’
(TCS) recently launched IT-as-a-service
for SMEs, iON, is a promising start and
comes with publicly announced financial
targets. Yet, our calculations show that
even if the targets (USD1b in revenue, 26-
27% EBIT margin in five years) are met,
iON could contribute only about 5% each
to TCS’s revenue and EBIT by FY16. For
revenue to be more meaningfully nonlinear,
we believe TCS – and its peers – will need to invest more now to
ensure such initiatives pay off eventually.
Why bother now?
1) Indian players such as TCS are close to matching their much larger
(by revenue) global peers with their employee bases. Even though
offshoring remains a strong industry trend, it is reasonable to expect that
increasing scale could lead to falling growth rates after FY12-13 and derate
valuation multiples. 2) We believe cloud computing could become a
disruptive force, and as several CTOs have agreed with us, it can be an
opportunity only if Indian companies evolve their offerings. In a world that
could move towards standardised solutions, Indian players face the risk
of losing out peripheral applications business, which will need to be
replaced by IP. 3) Offshoring could weaken as a trend if cloud computing
serves the purpose of bringing down costs through standardisation.
Margin gains need to be invested in IP
After a sustained period of margin gains, TCS is now taking what it calls
a more “evolved” view of its EBIT margin target. From here on, its sees
27% as an ideal EBIT margin, with anything achieved above to be
ploughed back into its non-linear initiatives (Exhibit 5). We believe other
companies will have to adopt similar strategy, and so a flat margin
scenario looks a best case for the sector for the next few years.
Investors need to track IP moves closely
We believe long-term investors will need to keep close track of IP
investments through FY12-13, and companies would need to support that
with more relevant disclosures. Our one-year view on stocks, however, is
based more on near-term demand and how companies are positioned to
capture it. At current prices, we prefer Infosys (INFO IN, BUY, TP:
INR3,800, CP: INR3,173) and Wipro (WPRO IN, BUY, TP: INR550, CP:
INR463.5) to TCS among the large-caps we cover. But we retain BUY on
TCS for the likelihood of a positive FY12 revenue surprise given its edge
in hiring faster than peers.
The Risk Experts
• Our starting point for this page is a recognition of the
macro factors that can have a significant impact on stockprice
performance, sometimes independently of bottom-up
factors.
• With our Risk Expert page, we identify the key macro risks
that can impact stock performance.
• This analysis enhances the fundamental work laid out in
the rest of this report, giving investors yet another resource
to use in their decision-making process.
The “non-linear” story
After our recent industry meetings, we believe FY12-13 could be a crucial period for the
Indian IT companies to invest in “non-linear” initiatives (those that de-link revenue and
headcount growth). TCS’s recently launched IT-as-a-Service for SMEs, iON, looks a
promising start to us given it is backed by publicly announced financials targets (USD1b
revenue, EBIT margin to match the corporate average of 26-27% within five years). Yet,
our quick calculations show that even if these targets are achieved, iON could
contribute only about 5% each to the company’s revenue and EBIT by FY16. Clearly,
for revenue to be more meaningfully non-linear over the next decade, TCS – and
indeed its peers – will need many more such initiatives to pay off, and related
investments need to happen in the near term, in our view.
We believe the investments need to be either in the form of M&A or in in-house IP
generation and marketing, which should eventually generate new revenue or make
existing revenue less headcount-based. For their part, clients have been turning
increasingly willing to transfer project control to Indian vendors in recent years. This can
be seen from an industry-wide increase in fixed-price projects over time and material
projects. A natural extrapolation of this trend would be that clients may also be willing to
accept more vendor IP over the next few years.
Why bother now?
1) Large Indian players such as TCS are close to matching their much larger (by
revenue) global peers in terms of employee base. Even though offshoring remains a
strong industry trend, it is reasonable to expect that increasing scale could lead to
falling growth rates after FY12-13 and de-rate valuation multiples, as a result.
For the purpose of simulation, we have previously highlighted (Don't fix it if it ain't
broken, 28 February 2011) that if current productivity levels continue, large-cap Indian
IT players may reach employee counts of over a million each by 2020-22 if they are to
achieve 20% revenue CAGR over the period. Such scale could pose organisational
challenges yet unthinkable.
2) We believe cloud computing could be an upcoming disruptive industry force, and
while we have previously highlighted it as an opportunity for Indian IT players (Cloud
computing conundrums, dated 5 November 2010), that view was contingent upon
Indian companies evolving their service offerings to capitalise on potential
opportunities. In a world that could move towards standardised solutions because of
cloud computing, however, it is likely that Indian players could lose out the peripheral
applications business, which would need to be replaced by IP revenue - a view which
CTOs of Indian companies we interviewed agreed with.
3) More significantly, offshoring as a trend could lose some of its sheen if cloud
computing serves the purpose of bringing down IT services costs through
standardisation. It is therefore important, in our view, that Indian companies rethink their
strategy to sustain their competitive advantage.
Margin gains need to be invested in IP
TCS is targeting 10% of incremental revenue (i.e. about 2% of total revenue) to come
from non-linear initiatives (excluding products) by 4QFY12. The company has now
taken what it calls a more “evolved” view of its EBIT margin target, given its margin
improvement programme (cost rationalisation, offshore revenue shift, and higher
utilisations) is coming to an end. From here on, its sees 27% as an ideal EBIT margin,
with anything achieved above to be ploughed back into its non-linear initiatives. We
believe other companies will have to adopt similar strategy, and therefore a flat margin
scenario looks a best case for the sector for the next few years.
Which revenue is truly non-linear?
It is important to note that non-linearity does not necessarily come from new pricing
models, because in effect, alternative pricing without the use of tools (IP, open source
technology, code libraries) or a platform is merely a way to capitalise on existing project
inefficiencies and is therefore not a sustainable productivity improvement tool.
Investors need to track IP moves closely
In our view, a one-year view on stocks will largely not require taking a call on the
ongoing non-linear initiatives given their still minimal revenue contribution. But we
believe investors will need to keep close track of these investments through FY12-13,
and companies would need to support that with more relevant disclosures.
With a 12-month view, at current prices, we prefer Infosys and Wipro to TCS among the
large caps we cover. But we retain BUY on TCS and see a place for it in portfolios. 1)
TCS continues to give the clearest message on demand among its peers; 2) even
though its margins may not improve from the current level, TCS’s recent edge over
peers has been its ability to hire faster, and there is little still to rule out such a repeat in
FY12, and hence the possibility of a top-line surprise.
We tweak our estimates marginally to factor in the 3Q results, management’s recent
indication that 4Q could see 3-4% USD revenue growth q-q and 100-125bp lower q-q
EBIT margins, and higher guided tax rates in FY13. Retain BUY with a DCF-based TP
of INR1,300.00.
