Equity Research Report: TCS

TCS may scale 4000 levels by FY23 on higher revenue and better EBITDA margin in the coming days

TCS is one of the largest Indian MNC IT service and consulting companies, having its HQ in Mumbai. TCS is part of the Tata Group and operates in 149 locations across 46 countries. As of July’22, TCS has around 600K employees globally. Like all other major Indian IT service companies, TCS is also an export-heavy company; almost 95% of its revenue comes from outside India; over 50% of revenue comes from North America, while around 32% generates from continental Europe. U.K. is also a large market for TCS, contributing alone 16% of its overall revenue.

TCS’ software/service is mainly dominated by BFSI (Banks, Financial Services, and Insurance), retail & consumer business (including CPG, travel, and hospitality), communication, media & technology, trading & distribution, and life science & healthcare. IT services: consulting and engineering services, solutions and systems integration, management applications development, outsourcing services, etc. Also, the sale of IT equipment and software licenses is a small part of the TCS business.

Key management:

Board Members:

Key Shareholders: Tata Sons (promoters)

Like all other major IT outsourcing companies, TCS scrip was also under huge pressure in Q4FY22 and lost over -13% primarily on the concern of an imminent recession on both sides of the Atlantic (U.S.-Europe) amid lingering Russia-Ukraine/NATO war/proxy war, geopolitical tensions, subsequent economic sanctions, supply chain disruptions of key commodities, resultant elevated inflation, and faster central bank tightening. The market is concerned that if the economy slows down significantly, then big U.S. and European corporates may cut their IT spending, which will eventually affect Indian outsourcing IT service companies like TCS. The same is almost true for other TCS peers like Infy, Wipro, HCL Tech etc, whose major revenues come from U.S. and Europe.

TCS is now emphasizing reskilling; upskilling, innovations (R&D), and adapting itself to the changing world post-COVID. Like all big tech companies, TCS is also a prime beneficiary of the COVID lockdown-led digital world (WFH) and part & parcel of the ‘K’-shaped economic recovery in the COVID world, unlike the consumer-facing service industry. But post-COVID, there will be less appeal to such a digital theme, although in some areas, WFH may be a permanent feature for better productivity.

Traditionally, TCS as well as other big Indian IT outsourcing companies are very conservative in guidance. Almost all of them also issued a virtual guidance warning in Q4FY22 amid higher operating expenses after COVID related to travel and out-of-pocket expenses as WFH is not mandatory now; some employees may have to report to the office and also meet clients face-to-face.

TCS tumbled over -10% after a subdued and below-expected Q1FY23 report card, making a 16-month low around 2953.05 in mid-July.

Highlights of Q1FY23 report card: TCS (Consolidated)

·         Operating revenue Rs.52.758B vs 50.591B sequentially (+4.28%) and 45.411B yearly (+16.8%)

·         Operating expense Rs.39.342B vs 36.746B (+7.06%) and 32.748B yearly (+20.14%)

·         EBITDA Rs.13.416B vs 13.845B sequentially (-3.10%) and 12.663B (+5.95%)

·         Net interest paid Rs.0.199B vs 0.245B sequentially (-18.78%) and 0.146B yearly (+36.30%)

·         Core operating profit (EBTDA=EBITDA-INTT) Rs.13.217B vs 13.600B sequentially (-2.82%) and 12.517 (+5.59%)

·         Equity share capital Rs.0.366B vs 0.366B sequentially (unchanged) and Rs.0.370B yearly (-1.08%)

·         Core operating EPS (EBTDA/Share) Rs.36.11 vs 37.16 sequentially (-2.82%) and 33.83 yearly (+6.75%)

·         EBITDA margin 25.43% vs 27.37% sequentially (-194 bps) and 27.89% yearly (-246 bps)

·         EBTDA margin 25.05% vs 26.88% sequentially (-183 bps) and 27.56% yearly (-251 bps)

·         Constant Currency (CC) revenue growth +15.5% yearly (y/y); +10.2% in dollar terms

·         Net headcount addition of 14136; cumulative workforce strength: 606311

·         North America +19.1% in CC led by retail (+25.1% in CC)

·         Cumulative order book at $8.2B; book to bill 1.2

·         New clients added: 9 for $100M+ and 19 for $50M+

·         Operating margin (USD/INR) at 23.1% vs 25.0% sequentially and 25.5% yearly

Overall, due to higher operating costs, core operating EPS declined sequentially with a lower EBITDA/EBTDA margin, both sequentially and yearly. Subsequently, TCS slumped after the Q1FY23 report card.

Highlights of management commentaries and Q&A (analyst concall):

·         Remains vigilant due to macro-level uncertainties (chorus of recession/stagflation on both sides of the Atlantic)

·         The company is actively implementing the strategy of getting closer to clients so that the overall operation would be nimbler in a dynamic environment

·         Remains confident about tech spending by clients despite some macro headwinds

·         Stress on in-person meetings (as pandemic has now turned into endemic)

·         Higher operating costs due to higher employee expenses (annual salary increase @5-8% on an average and gradually normalizing travel costs impacted -1.5% in operating margin

·         Operating margin was also affected due to lingering supply side challenges such as higher subcontractor usage and backfilling expenses

·         The company is confident of protecting its margin going forward

·         Industries: Growth was led by Retail and CPG (25.1%); Communications & Media (+19.6%); Manufacturing vertical (+16.4%) and Technology & Services (+16.4%); BFSI grew +13.9% while Life Sciences and Healthcare grew +11.9% (Y/Y in CC)

·         Markets: Among major markets, North America led with +19.1% growth; Continental Europe grew +12.1 and UK grew +12.6%. In emerging markets, India grew +20.8%; APC grew +6.2%; Latin America grew +21.6%; and Middle East & Africa grew 3.2% (Y/Y in CC)

·         Services: There was strong, broad-based demand across the different services, led by Cloud, Consulting & Service Integration, Cognitive Business Operations, and Enterprise Application Services. Key themes driving G&T demand in Q1 were customer experience, cloud transformation, and sustainability

·         More and more clients looking to leverage next-generation technologies to create leaner, agile, resilient, and efficient operations with the intent to plow back the savings into the business transformation initiatives. TCS have been big beneficiaries of this trend

·         Growing incidence of multi services integrated deals; By bringing multiple elements of the operation stack, such as business processes, applications, databases, operating systems, and underlying infrastructure, all within the scope of a single service provider, clients are not only able to drive greater accountability, but also take up more holistic transformation programs

·         An adjunct to these two trends is that clients are looking to reduce complexity by bringing down the number of service providers they work with to a few select partners who possess the right innovation capabilities and can scale. TCS won several large deals in Q1 which were vendor consolidation exercises

·         The company is confident of a strong Q2FY23 amid a strong order book and good prospects

·         No seen any technology spending budget cuts or any deferments; clients are continuing investment in techs to stay competitive, although they are vigilant about overall macro levels

·          Present book-to-bill ratio of 1.2 is quite strong despite some softening from previous quarters; the company remains vigilant on conversion about prospects to actual deal closure

·         TCS is constantly evolving on the twin-engine strategy of cost & optimization and growth & transformation to deal with both recession and expansion

·         Wage increase and attrition-related higher costs impacted EBITDA margin in Q1FY23; going forward higher attrition-related HR costs may continue to impact operating margin for at least a few more months (Q2)

·         Despite some economic slowdown, clients are emphasizing on technology revolution or spending to stay competitive/relevant

·         Subcontractor expenses were around 9.7% of revenue in Q1 against normal/current 7%; looking ahead the company is expecting it at the current 7% levels to stabilize if the need for subcontractors arises

·         The company has created an adequate strength of reserve bench to deal with any sudden surge in demand

·         The company is targeting to hire 40K fresher in FY23 after hiring 100K in FY22

·         No major headwinds in the U.K. market despite some slowdown in revenue

·         The operating margin is expected to improve above +25% in the coming quarters

·         U.S. clients are more confident about the overall economy than U.K. clients, but no material difference in tech spending, and the company is ready to deal with both sides of the equation (recession and expansion)

·         Subcontracting is here to stay because of sudden supply disruption in local markets, whereas reserve bench is for immediate capture of demand

·         As attrition comes down, utilization levels will move up

·         Overall revenue growth of +12% in the whole of Europe is still a healthy number considering the mixed macro environment (chorus of recession)

·         Operating margin should improve in FY23 due to the resolution of supply side and attrition issues amid a holistic employee rewards program

·         The company has a robust deal in the pipeline; no major change in pricing

·         The company does not believe in a hire & fire policy

Finally, TCS CEO & MD Gopinathan said in his concluding remarks:

“It has been a good start to the year with 15.5% growth in constant currency, and with all our industry verticals showing good growth. Our order book and the pipeline are also very strong, giving us good visibility for the next few months. Our margin dipped this quarter due to salary increases and supply-side related costs. But we stay confident in our ability to bring it back to a preferred range over time.

On the people front, we continue to hire across all our markets and added over 14,000 employees on a net basis in Q1. Our attrition continues to be elevated at 19.7% in IT services on an LTM basis. This will probably peak next quarter and will start tapering out.”

Valuation: Rs.3942 by FY23 and Rs.4730-5676 by FY24-25

TCS reported a core operating EPS of Rs.142.82 in FY22 against 124.08 in FY21 and 109.83 in FY20. Now considering various pros & cons, current & past run rates, and FY23 guidance provided by the company (15% revenue growth and 26% operating margin in CC), TCS may report at least 15% growth in core operating EPS in FY23 and subsequent 20% average CAGR in FY24-26. This will translate to a projected core operating EPS of around Rs.164.25-197.09-236.51-283.82 from FY23-26. Now assuming an average core operating PE of 20, the fair valuation of TCS may be around Rs.3285-3942-4730-5676 by FY23-26. As the market always discounts at least one year's earnings in advance, TCS may scale 3942 by FY23 and 4730-5676 by FY24 and FY25.

TCS is a key beneficiary of higher tech/digital transformation spending on growth & transformation (G&T) initiatives. Despite the chorus of the synchronized recession on both sides of the Atlantic (U.S.-Europe), TCS is cautiously confident about demand and ongoing technology spending by big corporates as they have to stay competitive and relevant. For example, on 27^th July, TCS signed a multi-year, multi-million dollar deal with British retail giant Marks & Spencer (M&S) to transform the HR operations; M&S is also a decade-old client of TCS. Now TCS is expecting around $1B in revenue from the retail sector of continental Europe.

TCS does not see any softness in demand/new prospects or delay in the decision-making process by big corporates despite the uncertain macro environment and the chorus of synchronized global recession/stagflation amid adverse geopolitical situation (Russia-Ukraine/NATO), economic sanctions, elevated inflation, and faster tightening by Fed, ECB, BOE and all other top G10 central banks.

Rising investments in areas from cloud computing to cyber security and digital transformation by various corporates during the COVID pandemic have propped up demand for the $195 billion Indian IT industry. However, the demand has also led to severe attrition among employees and margins have suffered due to higher employee costs like wage hikes and additional travel and visa costs (after COVID). Thus managing employees; i.e. attrition is now a massive challenge for Indian IT service companies like TCS.  

For TCS, the operating margin should improve in H2FY23 amid normalization of salary hikes, moderation in attrition, and better pricing. This coupled with higher USDINR may support all IT service exporter earnings including TCS in FY23. TCS is also aiming to double its revenue in the next few years on a sustainable basis and partnering with various big corporates in U.S. and Europe for their digital transformation journey.

Technical outlook: TCS

Looking ahead, whatever may be the narrative, technically TCS now has to sustain above 3450-3490 for a further rally; otherwise sustaining below 3435-3355, TCS may correct again as per the above table.

TCS P&L analysis: Consolidated

TCS: Consolidated cash flow

TCS: Consolidated B/S

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