Buy On Dips

Tata Consultancy Services (TCS), a part of Tata group, is an information technology (IT) services, consulting and business solutions company. It offers a consulting-led, integrated portfolio of IT, business process outsourcing (BPO), infrastructure, and engineering services. The company derives 53.4 per cent of its revenue from North America, 15.5 per cent from the UK, and 2.2 per cent from the Middle East and Africa (MEA). At 43.5 per cent, the Banking, Financial Services and Insurance (BFSI) sector is the largest contributor to its revenue. Next come retail and distribution (12.1 per cent) and telecom (10.7 per cent). The contributions of other sectors such as manufacturing, life sciences and healthcare, travel and hospitality, energy and utilities are in single digit.

Sectoral outlook
World-wide spending on technology and related products and services is estimated to have crossed US $1.6 trillion in 2010, a growth of 4.0 per cent over 2009. Growth was driven by emerging verticals and emerging geographies in addition to USA. According to NASSCOM, spending on IT services is expected to increase from US $566 billion in 2009 to US $684 billion by 2014 at a compounded annual growth rate (CAGR) of 3.9 per cent. Offshoring of IT services is expected to grow from US $31.1 billion in 2009 to US $42.8 billion in 2014 at a CAGR of 6.6 per cent.

Strengths
Resilient performer. TCS’s performance in terms of both volume and dollar growth has remained strong. In Q1FY12 it posted a quarter-on-quarter (q-o-q) revenue growth of 7.5 per cent (in US$ terms), primarily owing to volume growth. The company reported another quarter of strong volume growth in Q2FY12. In the September quarter, it posted a q-o-q revenue growth of 7.7 per cent (in rupee terms), driven by both volume growth of 6.25 and the positive impact of exchange-rate movement, which added 2.49 per cent to its revenue growth. Pricing, however, had a negative impact of around 1 per cent on its topline. Revenue growth occurred in all regions except India and Latin America. North America grew at 8.8 per cent and UK at 10.3 per cent q-o-q.
Large deals to pay off. Ten large deals were signed during the second quarter. Five came from North America, four from UK and Europe, and one from Latin America. These large deals in key markets indicate that growth is likely to remain robust despite the slowdown-related concerns about the US and the sovereign debt crisis in Europe.
Moreover, the deal pipeline remains strong across all verticals. The company won two large deals in the telecom vertical. It also won major deals in banking, financial services, telecom and pharma. Such deals are expected to support growth in the near term. Management has indicated that it is currently chasing 10 large deals.
On a hiring spree. TCS has been on a hiring spree since the second half of FY10. In Q2FY12 it added a whopping 20,349 gross employees and 12,580 net employees, taking its total employee base to 2,14,770. However, this hiring spree and wage hikes to existing employees prevented the company’s operating margin from expanding in Q2FY12.
Huge cash pile. The company has huge cash holdings of Rs 7,378.1 crore (end of FY11). Its cash holdings have grown at a CAGR of 82 per cent over the last three years. This huge war chest gives TCS the option of growing through acquisitions. The company’s free cash flow stood at Rs 10,202.4 crore in FY11.
More profitable than peers. If one were to compare TCS with peers such as HCL Technologies, Wipro and Infosys, it scores over them all in terms of profitability. Both its return on capital employed (RoCE) and return on net worth (RoNW) are better than those of its peers. TCS has delivered a five-year average RoCE of around 50 per cent and RoNW of 45 per cent. At the end of FY11, its RoCE stood at 50.16 per cent and RoNW at 43.89 per cent. Its FY11 RoCE was 12.25 percentage points higher than that of Infosys; 26.7 percentage points higher than that of Wipro; and 29.12 percentage points higher than that of HCL Technologies. Similarly, when we compare RoNW, TCS’s return on net worth was 16.2 percentage points higher than that of Infosys; 18.93 percentage higher than that of Wipro; and 20.81 percentage points higher than that of HCL Technologies.
Comfortable margins. Over the last five years, TCS has registered an average operating profit margin of 28.5 per cent, and net profit margin of 22.4 per cent. For FY11 its operating profit margin stood at 31.5 per cent and net profit margin stood at 24.6 per cent. Over the last five years, these figures have improved by 2.84 percentage points and 1.85 percentage points respectively.

Concerns
Hedging losses. TCS has a much larger percentage of its revenues hedged (80 per cent) than its peers (except Wipro). This limits its gains in case the rupee depreciates (the hedging is meant to guard against appreciation of the rupee). Among its peer group, foreign exchange hedging as a percentage of revenue stands at around 40 per cent for Infosys and at around 30 per cent for HCL Technologies.
In Q2FY12 TCS posted a significant hedging loss of Rs 80 crore, but its accumulated hedging losses are as high as Rs 530 crore. According a recent report from HSBC Securities, this is likely to hit the company’s bottomline over the next two-three quarters.
If the rupee appreciates beyond certain levels, or there are other adverse cross-currency movements, these could also potentially hit the company’s financials.
A slower-than-anticipated recovery in pricing and adverse regulations are other areas of concern.

Can TCS keep its leadership?
Earnings call raises concerns. In the past five quarters, TCS has outperformed Infosys on revenue growth while closing the margin gap. However, in Q2FY12, its revenue growth converged with that of Infosys, while the latter expanded its margins vis-a-vis TCS. Moreover, while Infosys’s management has indicated that it will grow strongly in the second half of FY12, that of TCS has indicated that growth could be weaker in the second half than in the first owing to seasonal factors. Analysts at Barclays Capital are of the opinion this could signal that Infosys might reclaim the industry leader’s position.
Valuation premium at risk. TCS has been trading at a premium to Infosys. From a 30 per cent discount during the sub-prime crisis, TCS traded at a premium valuation (in terms of PE) of over 15 per cent in the last quarter. In October (till October 17, 2011), the premium ranged between 2-9 per cent. TCS is currently trading at a premium of 3 per cent over Infosys.
Now, with Infosys apparently back on the growth path after a long organisational restructuring, the question arises: will TCS’s premium shrink further or will it stay at these levels? Analysts at HSBC believe that the probability of the premium shrinking further over the next three months is high. According to them, Infosys could report a stronger Q3 than TCS, both in terms of revenue growth and EBITDA margin.
Moreover, SAP has reduced the discount on its licence sale and has seen an improvement in large-size enterprise resource planning (ERP) deals. This is important as Indian IT companies provide downstream implementation and support services to SAP customers. Therefore, stronger licence sales by SAP are a positive for Indian IT companies. Infosys, which derives around 25 per cent of its revenue from EAS (enterprise application services) than TCS (11.1 per cent) will benefit more from this development.

Valuation
TCS is currently trading at a price-to-earnings (P/E) ratio of 22. It is trading below its five-year median P/E of 25.61. Based on a five-year CAGR of 22.79 per cent in earnings per share (trailing twelve-month), its price-to-earnings to growth (PEG) ratio stands at 0.96.
TCS has succeeded in maintaining strong performance in Q2, beating its rivals both in terms of volume and dollar growth. However, currency movements limited its growth in rupee terms. Large hiring and the bagging of a number of new deals suggest robust growth ahead. The only concern relates to an economic slowdown in its key markets. The company holds reasonable growth prospects but is currently trading at high valuations. Accumulate on dips.