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Equity Research Report: TCS -Q4FY23

TCS is one of the big beneficiaries of digital transformation by global corporates to optimize cost, and business processes and stay ahead of the competition

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Company Overview, Business Model & Competitors:

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. 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. Almost 55% of the revenue of TCS comes in USD, 13.50% in GBP, 11.00% in EUR, and 20.50% in other currencies.

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 CPG business. The main business competitors of TCS are Infy, Wipro, HCL Tech, Cognizant, L&T Mind Tree, Tech Mahindra, Mphasis, Oracle, etc.

Like all other major IT outsourcing companies, TCS scrip was also under huge pressure in 2022 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.

Key management:

Gopinathan is exiting and present BFSI head Krithivasan to take over as CEO & MD from 1^st June’23

Board Members:

Key Shareholders: Tata Sons (promoters)

Highlights of Q4FY23 report card: TCS (Consolidated-INR 100 Cr. =1B)

·         Operating revenue Rs.591.62B vs 582.29B sequentially (+1.60%) and 505.91B yearly (+16.94%)

·         Operating expense Rs.433.88B vs 426.76B vs sequentially (+1.67%) and 367.46B yearly (+18.08%)

·         EBITDA Rs.157.74B vs 155.53B sequentially (+1.42%) and 138.45B (+13.93%)

·         Net interest paid Rs.2.72B vs 1.60B sequentially (+70.00%) and 2.45B yearly (+11.02%)

·  Core operating profit (EBTDA=EBITDA-INTT) Rs.155.02B vs 153.93B sequentially (+0.71%) and 136.00B (+13.99%)

·         Equity share capital Rs.3.66B vs 3.66B sequentially (unchanged) and Rs.3.66B yearly (unchanged)

·         Core operating EPS (EBTDA/Share) Rs.42.36 vs 42.06 sequentially (+0.71%) and 37.16 yearly (+13.99%)

·         EBTDA margin 26.20% vs 26.44% sequentially (-23 bps) and 26.88% yearly (-68 bps)

·         EBITDA margin 26.66% vs 26.71% sequentially (-5 bps) and 27.37% yearly (-70 bps)

·         Interest/EBITDA ratio 1.72% vs 1.03% sequentially (+70 bps) and1.77% yearly (-5 bps)

·         Constant Currency (CC) and USD revenue growth +10.7% (y/y)

·         Revenue growths in AEs led by the U.K. +17%; North America +9.6%; continental Europe +8.4%

·         Revenue growths in EMs led by Latin America at +15.15; India at 13.4%; Middle East & Africa at +11.3% and APC at +7.5%

·         Growth in Q4 was led by Retail and CPG (+13%) and Life Sciences and Healthcare (+12.3%)

·         Other verticals grew in the single digits; Technology & Services grew 9.2%, BFSI grew 9.1%, Manufacturing grew 9.1% and Communications & Media grew 5.3%

·         TCV (Total Contract Value) at $10B with an all-time high number of large deals

·         Net addition of 821 employees

Highlights of FY23 report card: TCS (Consolidated-INR 100 Cr. =1B)

·         Operating revenue Rs.2254.58B vs 1917.54B (+17.58%)

·         Operating expense Rs.1661.99B vs 1386.97B (+19.83%)

·         EBITDA Rs.592.59B vs 530.57B (+11.69%)

·         Net interest paid Rs.7.79B vs 7.84 (-0.64%)

·         Core operating profit (EBTDA=EBITDA-INTT) Rs.584.80B vs 522.73 (+11.87%)

·         Equity share capital Rs.3.66B vs 3.66B (unchanged)

·         Core operating EPS (EBTDA/Share) Rs.159.78 (FY23) vs 142.82 (FY22; +11.87%) vs 124.08 (FY21; +15.11%)

·         EBTDA margin 25.94% vs 27.26% (-132 bps)

·         EBITDA margin 26.28% vs 27.67% (-139 bps)

·         Interest/EBITDA ratio 1.31% vs 1.48% (-16 bps)

·         Constant Currency (CC) revenue growth +13.7%; +8.6% in USD terms

·         TCV /Order Book $34.1B

·         Client metrics: 100M (60; +2); 50M (133; +13); $20M (291; +23); $10M (461; +22); $1M (1241; +59)

·         Net addition of 22600 employees; total headcount 614795

·         IT service attrition (LTM) 20.1%

·         On a full-year basis, among major markets, North America grew 15.3%, the UK grew 15% and Continental Europe grew 11%

·         In emerging markets, Latin America grew 17.3%, India grew 14.6%, Middle-East & Africa grew 7.8% while Asia Pacific (APC) grew 7.6%

·         On a full-year basis, growth was led by Retail and CPG (+19.7%) and Communications & Media (+14%).

·         All other verticals showed growth in a narrow band around the company average. Technology & Services grew 13.7%, Life Sciences and Healthcare grew 13.3%, Manufacturing grew 13%, and BFSI grew 11.8%

·         In a challenging environment, clients carefully calibrated spending, prioritizing cost optimization, vendor consolidation and automation initiatives.

·         In-flight technology transformation initiatives continued to be funded but with the expectation of earlier and higher ROI

·         Growth was led by Cloud, Cyber Security, Enterprise Application services; Cognitive Business Operations, and IoT & Digital Engineering

Highlights of the investor presentation, management commentaries, and Q&A (analyst concall): Q4FY23

·         EBITDA margin was flat sequentially, while down by over -1.2% yearly despite the benefit of FX and other cost-cutting efficiencies as sub-contractor/on-site and travel costs increased after COVID reopening

·         The effective income tax rate increased from around 24% in FY19 to 25.7% in FY23 as more facilities are coming out of SEZ tax benefit

·         Continues to focus on employee/fresher skilling, re-skilling as per evolving/changing tech/business situation

·         LTM attrition is reducing gradually despite unprecedented churn in prior quarters

·         Growing global economic uncertainty/macro headwinds is pushing more customers/companies to accelerate efficiencies through automation led by AI/ML (digital tech)

·         Overall clients are cautious about discretionary tech spending amid macro headwinds and banking crisis on both sides of the Atlantic (U.S.-Europe) and deferring non-critical projects, which has affected Q4 revenue also to some extent

·         But at the same time, clients are perusing cost optimization or strategically important projects (like the transformation of operating models) to stay ahead of the curve, which is also supporting TCV/order book and subsequent revenue growths

·          In BFSI, despite some softness in discretionary spending in North America, clients continued to push ahead with cloud migration, operations transformations, and other strategic G&T initiatives to improve overall business and efficiencies including early detection of any fraud and NPA/stressed assets

·         FY23 order book was around $34.1B, similar to FY22

·         But the FY23 order book is less lumpy and has more deals in the $50 million to $100 million TCV range, which means the company can build up an equally large order book without as many mega deals in the mix

·         This implies faster revenue conversion compared to last year's order book and gives better visibility into growth next year

·         Management was expecting softness in Q4 in the BFSI sector, which was already in play in Q3; but overall softness in BFSI discretionary spending was less than expected despite the recent banking crisis in U.S.-Europe

·         But the recent banking crisis and subsequent concern of a synchronized global recession has also affected discretionary tech spending for other segments like retail, manufacturing, etc

·         As the overall order book for FY23 is quite big with a higher mix of smaller deals ($50-100M), the conversion time from TCV to actual revenue will be quicker and the effective revenue could also be higher in FY24

·         But the management is refraining from providing any specific guidance for Q1FY24 because of underlying uncertainty amid lingering macro-headwinds; clients are still looking at their priorities for discretionary tech spending

·         Although the short-term outlook is still uncertain, the management is quite confident about a stronger and better outlook for medium to long term

·         TCS is not providing any guidance for Q1, Q2 or even Q3, Q4F (FY24) because of underlying uncertainty

·         TCS continues to be close to clients and engaged in the decision-making process of clients

·         Although the higher mix of small/midsize deals should translate into faster revenue in FY24, some transformation/discretionary projects may be also delayed or even canceled due to lingering macro headwinds or deterioration of the same

·         A change in top leadership (exit of CEO Gopinathan) doesn’t mean a change in company business strategy, because every strategy is a result of collective leadership decision and the present leadership team is also the part & parcel of the company for so many years a good understanding

·         Thus there will be no drastic change in company policy/business strategy, although there may be some tweaks based on the market situation, client centricity and employee empathy

·         TCS is working on generative AI tech (like ChatGPT) for some time and has done some pilot projects internally; such tech (AI/ML) has great potential for innovation and the potential to fundamentally change the way that companies like TCS deliver software to clients; a significant part of it may be automated, can get generated

·         Fundamentally, TCS is a tools-driven organization and developed MasterCraft™ decades ago, which is a software that generates software

·         TCS is now quite excited with the opportunity of delivering a generative AI tool that also generates software to stay relevant to clients' expectations

·         Big banks are a net beneficiary of the recent regional banking crisis in the U.S. in terms of deposit/customers shifts, which in turn could result in more M&As and discretionary tech spending-positive for big IT service providers like TCS

·         Q4Y23 operating cost was boosted by higher cost of onsite manpower (sub-contractors) and increased local hiring; the management is taking required corrective steps for FY24

·         Presently U.K. market looks more upbeat than the rest of Europe and the U.S. and TCS is the number one Indian IT service provider in Britain-active in both PSU, Private as-well-as PPP projects, many of which are strategically important/complex, not just on competitive pricing policy/operating margin angle

·         The U.S. market is much more mature and dynamic and thus less predicted than the U.K.

·         TCS is making sure to participate on both sides of the Atlantic (U.S.-Europe/U.K.) simultaneously even in any challenging macro-economic scenario

·         In Europe, the deal/TCV pace gathered momentum in Q4 contrary to earlier trends/perceptions as sentiment improved due to no winter recession, no severe energy crisis (NG prices fall drastically), and the reopening of China (from zero COVID policy); thus there was a deluge of small size ($50M) deals in Europe in Jan-Mar’23 quarter (it’s also the budget quarter) led by previously pending deals

·         The TCV flow in the U.S. was also robust in the U.S. and at a record high

·         Mid-Feb’23 banking crisis/panic resulted in postponement in some discretionary  projects, affecting revenue to some extent, but there was no large-scale project cancellation or any significant slowdown in deal flow, but the management is cautiously optimistic and watching closely the outlook for the next few quarters

·         Delaying or cancellation of some discretionary projects also affected the EBITDA margin overall (apart from higher onsite costs)

·         TCS does not provide any guidance about conversion of TCV (Total Contract Value) into ACV (Actual Contract Value); i.e. order book conversion into actual revenue, but expecting faster/higher ACV in FY24 backed by higher smaller/midsize deals ($50-100M) executed in FY23; large value deal such as $500M may take higher time for actual conversion into revenue

·         Central European BFSI is more complex than the U.S. as far as discretionary tech spending is concerned, but Nordics and Benelux are quite upbeat (in Europe)

·         The reliance on contingent labor (contractual worker/sub-contractor/freelancer) has significantly increased, mainly because of the various travel restrictions and supply side challenges in the local market (including work-visa issues) coupled with the high demand for specific skill

·         TCS is structurally and systematically moving to go back to its more preferred operating model, which is about 5% to 8% of the onsite workforce being contingent labor (traditional model) to ensure the quality of service and customer satisfaction

·         Most of the segments within CPG are performing well with travel & hospitality outperforming, while retail underperforming in North America

·         IT service industry is much more disciplined in terms of pricing than the product industry; i.e. there is limited scope for discounting and undercutting any competitor pricing; there is also an issue of incremental deal

Finally, outgoing TCS CEO Gopinathan said in his concluding remarks:

“We are pleased with our FY23 performance, growing at 17.6% in rupee terms and 13.7% in constant currency terms. The steadily deteriorating macro environment has meant decelerating the second half. Our Q4 revenue growth was 16.9 in rupee terms and 10.7 in constant currency. However, we have had a very strong order book with an all-time high number of large deals. Our operating margin in Q4 was flat sequentially at 24.5%, and our net margin was at 19.3%. On the people front, LTM attrition in IT services further fell to 20.1%.”

Fair Valuation: TCS

The present fair value of TCS may be around 3284 and TCS may scale Rs.3737 by FY24, Rs.4265 by FY25, and Rs.4882 by FY27

Overall, TCS delivered a slightly disappointed report card in Q4FY23 amid lingering global macro-headwinds coupled with the sudden eruption of the banking crisis on both sides of the Atlantic (led by the U.S. regional/small banking crisis). TCS reported FY23 core operating EPS around 159.78 vs 142.82 in FY22 and our previous estimate of 162.82. In any way, TCS clocked a growth of around +11.87% in FY23 vs +15.11% in FY22. TCS reported a core operating EPS of Rs.142.82 in FY22 against 124.08 in FY21 and 109.83 in FY20.

TCS and also other big Indian IT service companies (exporters) are big beneficiaries of digital transformation by big global corporates to stay ahead of the competition and inflation curve (higher input costs). Indian IT exporters are also benefitting from the weak Rupee despite some cross-currency headwinds and higher employee & travel expenses (post-COVID).

Now considering various pros & cons, current & past run rates, and standard 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 FY24 and subsequent 20% average CAGR in FY25-27. This will translate to a projected core operating EPS of around Rs.183.75-220.50-264.60-317.52 from FY24-27. Further, if we consider BVPS/PB (Book Value/share) and OCFS (Operating Cash Flow/share) valuation metrics along with traditional EPS/PE, then the average valuation of TCS may be around Rs.3284-3737-4265-4882 for FY: 24-27. As the financial market usually discounts 1Y projected earnings in advance, the present fair value of TCS maybe around 3284 and TCS may scale Rs.3737 by FY24, Rs.4265 by FY25, and Rs.4882 by FY27.

Conclusions:

TCS is a key beneficiary of higher tech/digital transformation spending on enterprise 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. TCS does not see any meaningful 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 small banking crisis.

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 huge challenge for Indian IT service companies like TCS. But the hybrid model of work should also optimize operating costs and improve productivity/employee satisfaction; i.e. will eventually reduce attrition.

For TCS, the operating margin should improve in FY24 amid the 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 FY24. 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. TCS has a strong, debt-free, and cash-rich company. Looking ahead it can grow multifold through various organic and inorganic expansions and also growing digitalization theme in India (both at government and private levels). It also seems that TCS has no regional/small U.S. banks as clients or the overall exposure may not be much significant.

Overall, TCS is a major beneficiary of global inflation/macro headwinds as companies are now embarking on cost-cutting/optimization by adopting greater automation and digital and cloud adaption. The market was skeptical about TCS’ performance amid the synchronized economic slowdown in U.S. and Europe, TCS’s primary market. TCS said although there are some concerns about discretionary long-term high-tech spending, most companies are now upgrading their techs for cost optimization and to stay ahead of the curve/competitors.

Global techs such as Meta, Amazon, Microsoft, Alphabet (Google), and Tesla jumped on hopes of better earnings after mass layoffs. Various other big techs are also laying-off ‘unnecessary’ employees in masses to cope with the muted operating revenue as COVID-era digital spending growth fumbled after the pandemic has turned into endemic coupled with overall slowing economic activity amid higher inflation (cost of living) and higher borrowing costs. The discretionary digital spending is being affected, resulting in muted fresh digital capex. But techs are recovering now in hopes of cost optimization amid mass layoffs. Here in India, big IT firms such as TCS, INFY, and Wipro are also in the process of employee cost optimization in a prudent and calibrated manner without creating a panic.

Impact of Fed rate action on Techs:

Fed was already behind the inflation curve from early 2021 when the economy opens fully after the 2020 COVID disruption. Fed should have started to normalize its ultra-loose monetary policy in early 2021 rather than starting the process (telegraphing about QE ending and potential rate hikes) in late 2021. In the process, Fed created synchronized global inflation/stagflation as almost all major G20 central banks usually follow Fed policy action for currency (USD) and bond yield differential.

Now (till the banking crisis emerged in 2^nd week of Feb’23), seeing inflation out of control, both Fed and ECB were engaged in ultra-hawkish jawboning to tighten monetary/financial conditions, resulting in a rapid increase in bond yields and HTM (bond portfolio) loss of mid-size U.S. regional banks, who are not so much efficient to manage interest rate increase in an efficient/professional way.

Fed is itself now suffering from huge MTM loss (unrealized) as it’s offering trillions of dollars at higher reverse repo rates to banks; Big U.S. banks are major beneficiaries of higher reverse repo rates (risk-free return) from Fed. But small/mid-sized U.S. regional banks like SVB have a significant mismatch between asset and liability, resulting in the current failure.

Fed is now going to pause after one or two more hikes as it believes banks, especially smaller ones will tighten lending norms, which will eventually tighten financial conditions more and consumer demand thereby, helping lower inflation. For the last year, Fed was too occupied with jawboning to control the market and may not have focused adequately on bank supervision/regulation; especially for vulnerable small/mid-size U.S. regional banks. Here is also Fed was far behind the curve, nearly inviting another 2008-type GFC.

But, as the immediate concern of financial stability eases, Fed may go for their planned rate hikes in a calibrated manner to ensure price and financial stability as well as credibility. Fed may go for calibrated +25 bps rate hike on 3^rd May, and may also be 14^th June for a terminal rate of 5.25-5.50% and then pause. Fed will ensure financial stability with liquidity tools and price stability with interest tools as unlike during 2008-10, core inflation is still substantially higher than the +2% targets.

In a way, now the May hike of +25 bps by the Fed is almost certain while there is a question mark for June. But there will be no rate cuts at least till mid-2024 contrary to market expectations. After mid-2024, Fed may begin talking about rate cuts (just ahead of the Nov’24 U.S. Presidential election) to boost Wall Street (risk trade) and also to ensure lower bond yields to rescue U.S. regional banks and itself. Fed has to also ensure lower borrowing costs for the U.S. government as well as businesses and households.

As per Fed’s estimates, U.S. core PCE inflation may be around +2.5% and the unemployment rate 4.6% by Dec’24. Thus from mid-2024, Fed may jawbone/prepare the market (by providing forward guidance) for a series of possible rate cuts to keep the real rate of interest at 0% or +0.50% and to bring the unemployment rate back to around 3.5% (maximum employment), while ensuring price stability (core inflation) around +2.0%. Fed has to cut rates by 2025 adequately so that it can find itself in MTM positive (profitable) position to transfer funds (share of profit) to treasury and the world’s largest/most important central bank remains solvent.

Bottom line:

If Fed indeed goes for a pause/pivot after May-June’23 and prepares the market gradually for any rate cuts from mid-2024 itself, U.S./global bond yields (borrowing costs) will slump, which will be positive for Wall Street including all Indian IT service providers like TCS in FY: 25-27 and core operating EPS may grow around +20% CAGR from present rate 12-15%.

Technical view:

Looking ahead, whatever may be the narrative, technically, TCS now has to sustain over 3070 for a further rally to 3170/3275*-3400/3575*-3750/3850-3975/4050* and 4090/4125 in the coming days (bullish case scenario). On the flip side, sustaining below 3050, TCS may further fall to 3000*-2930/2900*-2800/2770-2340/2100 and 2000/1895-1775/1435 in the coming days (bear case scenario). Investors may accumulate TCS from around 3100/3070 and 3000/2900.

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