| Making the right Japanese connection | Neutral Price: Rs2,222.90 17 Apr 2014 Price Target: Rs2,400.00 PT End Date: 31 Mar 2015 | |
TCS has announced a key merger in Japan, which, we estimate, will boost TCS’s Japan revenues by USD~375 million in FY15. This should help TCS penetrate the notoriously difficult IT market in Japan. From this arrangement with Mitsubishi’s 100%-owned IT division (details below), we expect outsized benefits to flow to TCS over time, stemming from it being able to penetrate the marquee client base with its full services model. Offshore vendors, in general, have had very little to show for their efforts in Japan, because Japan is culturally very strong/different. It is certainly not a lack of opportunity, because at USD106 billion, i.e. 11%+ of global IT services spending, Japan is the second-largest IT services market in the world (after the US). However, Japan accounts for less than 1% of revenues for large Indian IT players. This deal should help TCS overcome this culture-based penetration deficit that characterizes the Japan market. It also provides access to local talent as Mitsubishi has about 1,600 associates in Japan. In addition, we believe the valuation for the deal is compellingly cheap for TCS. Thus, we regard this merger as a good opportunity for TCS. We note that TCS clarifies that its indication that FY15 will likely be a better year for revenue growth than FY14 excludes the revenue benefits of this transaction (USD 375 million in FY15E).
· TCS leads the industry in prising open newer/less-penetrated markets (such as Continental Europe, Latin America) and new-generation offerings (digital). This transaction is a further step in cementing its leadership, in our view. That said, we believe outsized returns from Japan will likely emerge over the medium to long term (going beyond nearer-term improved margins from greater offshoring of existing engagements and optimizing local SG&A).
· The Deal: TCS has announced the creation of a new strategic entity in Japan with the merger of TCS Japan Ltd., IT Frontier Corporation (ITF – Mitsubishi Corporation’s 100% IT services subsidiary) and Nippon TCS Solution Center Ltd. (NTSC – a JV between TCS and Mitsubishi). TCS will hold a 51% equity stake in the new entity, providing the company full operating control of the merged entity. This deal provides TCS the scale, market access (Mitsubishi has deep relationships with large Japanese corporations), talent and softer aspects (appreciation of cultural norms of operating in Japan) to penetrate the relatively difficult Japanese market. The company expects/plans to close the deal by Jun-14; hence, it will consolidate the business for three quarters in FY15. We are not consolidating the deal in our numbers/estimates for the time being, and will do so once the transaction is consummated.
· More details about the merger. The new entity had combined revenues of about USD600 mn last year including USD~104 mn from TCS Japan & NTSC and USD500 mn from ITF. The combined entity will have 2,400 employees in Japan including 1,600 employees from IT Frontier (i.e. Mitsubishi). The merged entity has clients in Manufacturing, Hitech, Financial Services and Retail verticals. Mitsubishi (alone) accounts for about USD 250 mn of total IT Frontier revenues. TCS has the option to increase its stake in the new entity.
· Consideration seems quite reasonable. TCS will have a 51% stake in the merged entity, for which the company will pay USD50 mn in cash to Mitsubishi other than letting go of a 49% stake in the erstwhile TCS Japan and NTSC. The combined/merged entity has been valued at USD300 mn. TCS Japan (along with the JV) has been valued at about USD100 mn i.e. at about 1x sales (given its higher profitability and operational metrics), while we estimate that IT Frontier (Mitsubishi’s business) has been valued at 0.4x sales (USD200 mn for USD500 mn sales). Hence, TCS will pay USD50 mn in cash and USD~50 mn by way of stake (in TCS Japan & NTSC) to Mitsubishi for a 50% stake (i.e. USD100 mn consideration) in the erstwhile ITF. Looking at potential margins and earnings trajectory boost from cross-selling and offshoring, the buy seems compellingly cheap, in our view.
· TCS’s JV with Mitsubishi provides operational comfort. In Feb-12, TCS and Mitsubishi entered into a JV to establish a near shore delivery center in Japan. The two companies have been working together for more than two years, providing operational comfort. We believe the history of collaborative operations will provide comfort to the new entity.
· TCS has a proven track record in strategic initiatives. By and large, TCS’s inorganic initiatives in the past have been fairly successful at meeting their specific, well-targeted intent (e.g. Pearl for building out a BPO platform strategy, eServe for end-to-end back-office process management in BFS, Comicrom to penetrate Latin America, buying out non-TCS stake in its foreign JVs after initial comfort with the new market(s) is established).
· Investment view: We find TCS’s valuations a tad punchy for the near term, hence our 'Neutral' rating. We think TCS is still a core holding for longer-term, strategic portfolios as compounding gains of consistent outperformance multiply over a longer time-frame. The math of compounding tends to get under-appreciated, in our view. Longer the time-frame, the greater the compounding gains.
Investment Thesis
TCS consistently delivers industry-leading growth with best-in-class margins. The company has unmatched full-service positioning, with a specific focus on “bread-and-butter” service lines, such as ADM, testing and infrastructure management, which constitute more than 70% of total IT Services spending. Moreover, TCS is proactive in playing in relatively less addressed and new markets/themes, such as Latin America and SMB (small and medium-sized businesses), to drive revenue growth. Notably, TCS has admirably managed both clients and employees, as revenue growth and attrition remain the best in the industry. TCS’s versatile business model is likely to help the company gain market share if industry growth is not as solid as we expect. However, valuations look a tad punchy currently, in our view.
Valuation
We retain our Neutral rating on TCS with a Mar-15 price target of Rs2,400. Our PT is based on a one-year forward P/E multiple of 19x, a 15% premium to Infosys’s target multiple of 16.5x. TCS has exhibited a better revenue growth profile than Infosys over the past several quarters; top-line growth has been accompanied by significantly better profitability, which we believe justifies the premium. Our exchange rate assumption is Rs60/US$ for the next two years (FY15 and FY16).
Risks to Rating and Price Target
Upside risks: Better pricing and volume growth relative to expectations and a faster-than-expected recovery in Europe provide upside risk to our EPS estimates and, hence, price target.
Downside risks: Weakness in the demand environment, no cyclical strength in FY15, as expected, rupee appreciation against the US$, an adverse immigration bill and an increase in supply-side pressures (higher attrition or wage increases) provide downside risk to our EPS estimates and, hence, price target.
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