Tata Consultancy Services - Steady state growth / margins are yet to be seen! - ICICI Securities

Segments like regional markets (+7.3% QoQ, CC), manufacturing (+7.1%) and communications (+5.5%), which did not fully recover in Sep'20, led Q3 growth. Near- term growth (H1CY21) will be optically strong, courtesy - 1) low base effect (prior 2 years), and 2) ramp-up of captive / large deals. However, as focus shifts from 'recovery' to 'growth', steady-state growth (Sep-21++) will be the key monitorable. Sustainability of utilisation and offshore effort, seemingly at their peaks, is a big ask. Reversal of some Covid-led savings, large deal ramp-ups and weaker USD can upset street expectation of further margin expansion. Despite decelerating growth and stable return ratios, near-zero interest rates / liquidity led to expanding multiples over FY10-FY20. As highlighted in our thematic report, Covid gave a further impetus to valuations v/s business case of the sector. However, this time, both the pace and quantum of TCS' multiple expansion (~45%, LTM) is unprecedented and alarming - both on absolute and relative basis. In conjunction with earlier highlighted sector risks (thematic, Outlook2021), we downgrade the stock to ADD (from Buy).

- Stronger-than-expected revenue growth and margins. Revenue growth (4.1% QoQ, CC) was ahead of our expectation (3% QoQ). While growth was broad-based across geographies, the beat was driven by robust expansion in non-core geographies like India (+18.1% QoQ) and MEA (+6.7% QoQ). As we highlighted in our preview, the theme of residual recovery played out during Dec'20. Segments like regional markets (+7.3%), manufacturing (+7.1%) and communications & media (+5.5%), which did not fully recover in Sep'20, delivered strong growth during Dec'20. Despite a sturdy base, Life Sciences & Healthcare (+5.2%) continued to shine possibly led by Covid-related ad hoc work. Factors like budget flush, large deal ramp ups seem to have helped too.

The bigger surprise is in the reported ~40bps QoQ expansion in EBIT margin, despite salary hikes. While the hikes impacted margins by ~160bps, it was more than offset by utilisation / productivity improvements and offshore shift during the quarter.

- Healthy deal-win momentum; near-term outlook strong. Large-deal TCV remained healthy (US$6.8bn ex-Postbank vs US$6.1bn in Sep'20 ex-Phoenix). Management hinted at an aspiration for delivering double-digit growth and EBIT margins in the range of 26-28% over CY21/FY22. Optically strong growth in both Q4FY21 and FY22 is a given, aided by 1) ramp-up of recent captive takeovers / other large deals, and 2) low base effect (both FY21 & FY20). Nevertheless, it should be noted that revenue CAGR (CC) over FY19-FY22E (more reliable reflection of growth over this horizon) would still be ~6.5% -- lower than historical and even FY19 levels.

- Sustainable metrics / risks will be the key going ahead. Investor focus so far has been largely anchored to cyclical 'recovery' from the Covid troughs. IT sector, in general, and TCS, have shown phenomenal resilience on this count over H2CY20. As the focus shifts to sustainable metrics, growth rates in Sep-21 and beyond will be the key thing to watch out for (without Covid distortion in base).

Many of the one-time margin tailwinds that TCS witnessed in FY21 (e.g. absence of travel, marketing events, facility expenses and offshore shift, etc.) will likely reverse from Sep-21 and beyond. New margin headwinds could emerge too (e.g. weaker USD, captive integrations, large deal ramp-ups, etc.). Post the recent takeover of US Senate control by Democrats, potential risk of rise in corporate taxes cannot be ruled out. Subject to the quantum of rise, consensus estimates up to ~12% impact on corporate profitability in the US. Accordingly, we see a risk for downstream players like Indian IT companies including TCS.

- Multiples rerated too much and too fast. Above risks assume further importance in the context of a recent sharp run-up in the valuations. As highlighted in our Oct'20 thematic, expanding multiples of TCS (the broader markets in general) over the last decade surprised the value-conscious investors from time to time. This was despite the sharp growth deceleration and largely stable return ratios. Prolonged period of near-zero interest rates, high liquidity, increased trend of buybacks, and reduction in taxation were the major contributing factors.

This trend accentuated post-Covid with another round of liquidity entering into the market. To some extent, higher than market rerating was understandable for IT sector given its relatively better resilience and business continuity. However, we are alarmed by the pace and magnitude of TCS' rerating, both of which are unprecedented (45%, LTM). As we rebase our exchange rate assumptions and rethink our expected margin trajectory, our earnings estimates over FY22-23E witness 1-5% downward revisions (contrary to consensus). On our revised estimates, stock is trading at 31x FY22E EPS (v/s historical average of 19x).

While the decade in the run-up to Covid had seen TCS' stock trading at an average ~10% premium to NIFTY, the stock is currently trading at ~42% premium. Likewise, the stock now trades at a premium to Big Tech stocks where consensus' revenue growth expectations are relatively higher (e.g. Facebook, Alphabet). In that context, we stay cautious on the valuations especially since we don't expect any material growth acceleration (vs pre-Covid) in the steady-state post Covid. Post our re-initiation of coverage with a BUY rating in Oct'20, the stock was up ~15%. We see any potential rally on back of this result to be a good profit booking opportunity. Downgrade to ADD.

Shares of TATA CONSULTANCY SERVICES LTD. was last trading in BSE at Rs.3175.05 as compared to the previous close of Rs. 3120.35. The total number of shares traded during the day was 253600 in over 18332 trades.

The stock hit an intraday high of Rs. 3224 and intraday low of 3147.45. The net turnover during the day was Rs. 804977931.

Source : Equity Bulls

Keywords