Statutory Warning: This report may cause a reaction, and acting on it can be injurious to your wealth.
Note: This StockTalk analysis has been written by Nishanth Muralidhar.
Tata Consultancy Services (TCS) is one of India’s leading IT services companies, with the backing of one of the most valuable brands of India – the Tata Group. It is India’s biggest IT service company by employee headcount, as well as the biggest by revenues currently. TCS was also the first IT company in India to achieve revenues of US$ 10 billion.
TCS provides IT services like application development and maintenance, business process outsourcing, application testing, business intelligence, consulting, Enterprise Resource Planning software, and Remote Management Services to a wide variety of clients across North America, Europe, Australasia, Scandinavia, SouthEast Asia, Africa, South America, the Middle East and India. The company also has a BPO arm which is the second biggest in India according to a Dataquest survey.
Let’s take a closer look at the business model of TCS. The company, like most other Indian IT service companies, follows a offshore-onsite model.
What this means is that when TCS wins an application maintenance contract from a North American Bank, it sends some of its employees (mostly from India, on work permits) to gain knowledge on the software systems of the bank for a period of say six months. After having gained sufficient knowledge, some of the employees would stay on while others leave back to set up an offshore team for the client.
So the onsite employees interact with the client and assign tasks to the offshore team, whereby the offshore team completes them in India and delivers them to the onsite team. Given the time difference between India and the west, a project is worked on for all 24 hours of the day, first 12 hours in the west and the next 12 in India. So, for clients, the work gets done faster and at a much cheaper rate than having to hire employees themselves.
Now what are the advantages of this model? As observed, work goes on for 24 hours ensuring faster completion of the tasks, and the client gets work done at a much cheaper rate without having to hire expensive employees. For TCS, it incurs most of its expenses in rupees (as salaries and other costs for offshore employees are borne in India) and revenues are billed in dollars. As the billing rate is very different for onsite and offshore employees (onsite employees are typically paid in dollars), TCS derives most of its revenues by exploiting the low-cost offshore arbitrage model.
So with a offshore/onsite ratio of say 70/30, TCS make good profits on every project. As more work comes offshore, the more advantageous it is in terms of costs for the client and revenues for TCS.
TCS has a very wide variety of service offerings, whereby it can position itself to win multiple contracts from the same client and offer a complete range of solutions for the client’s IT needs, ensuring a predictable stream of revenue from the client. IT application development and maintenance contracts are typically long term, as there is a somewhat long gestation period for the vendor company (TCS) to learn the applications and start working successfully.
Many clients include financial services companies and retailers, clients who typically don’t like disruptions in their business operations by frequent IT vendor shifts. So once TCS is entrenched in a particular client, it takes some good amount of force (lower bidding/problems caused by TCS employees/big mistakes in work done) to get them dislodged.
TCS, as well as other Indian IT services companies, usually work on two types of contracts – Fixed Price and Time and Material.
In fixed price contracts, the client and TCS would agree on the sum to be paid for a certain amount of work. Then it is left to TCS’s discretion to decide how many employees would work on the project, the onsite-offshore ratio, utilization etc. So TCS pulls the profitability levers on Fixed Price contracts as per its business needs.
Time and Material contract is where the client requests for a variable number of people to work on the projects and pays them for the hours worked. As the revenue stream from these types of contracts is inherently unpredictable, TCS prefers to have a higher proportion of fixed price contracts.
Another less-discussed advantage of TCS, compared to other IT services companies, is the company’s ability to obtain and execute a variety of projects across various geographies and client spectrum. TCS served Indian governmental bodies, both Central and State, before others started looking at the opportunities there. It also started offices in South America long before others started realizing Latin American potential. TCS had also established accounts in Europe and Scandinavia before other companies like Cognizant started addressing the markets there.
What do the numbers tell?
Let’s now look at the financial performance factors of TCS.
Sales, EPS and Profit Growth: Sales, EPS and profit growth for TCS for the past 5 years stand at a compounded rate of 22.5%, 22.6% and 24% respectively. These are healthy growth rates compared to the industry average.
As per estimates from Gartner, global IT spending is expected to reach US$ 3.8 trillion in 2013 and as per Nasscom, Indian IT sector is estimated to grow at 11% in the coming year. As TCS has crossed US$ 10 billion in revenues recently, there is a huge addressable market still and the company is also having one of the strongest deal pipelines in the industry, indicating a rich pool of opportunities yet to come.
Moat: As explained above, TCS does not have a strong differentiating factor (like any Indian IT services company) and usually wins contracts based on being the lowest-cost provider and wins repeat business based on established relationships and performance. As this is usually the model adopted by other IT services companies as well, there is no distinguishing factor for the presence of a moat.
However, as TCS has a very wide variety of service offerings and clients across various geographies, the diversity of its revenue streams ensures a predictable flow of earnings. The percentage of repeat business over the last 5 years has been 90%, indicating good client satisfaction.
Return on Capital Employed: TCS’s average return on capital employed for the last 10 years stands at a solid 61.9% , which is higher than even it’s close competitor Infosys and highest among all its peers. This is an outstanding indicator for an investor as it shows TCS’s capability to generate good returns from the business.
Balance Sheet Strength: TCS has a solid balance sheet, with negligible debt and a lot of cash and investments on the books (Rs 7,400 crore as of FY12 Annual Report)
Dividend History: TCS, being from the Tata stable, has a history of rewarding shareholders and has had a very healthy dividend payout ratio of 37% between FY08 and FY12,which is a good sign. Cold hard cash is hard to conjure up, unlike earnings and positive news announcements.
Free Cash Flow Generation: TCS’s FCF shows a positive trend over the past 8 years with a growth rate of 13.7%, which is a confidence boosting sign for investors. Unlike earnings,which are susceptible to accounting manipulations, increasing and positive FCF speaks volumes for the financial strength of a company.
Management Profile: TCS, being from one of the most reputed brand groups in India, boasts of having a seasoned management team of high pedigree and professionalism. The company is a market leader in the Indian software space and that is due in no small part to the capabilities of its senior management.
TCS, as explained above, follows a low cost arbitrage model for low-end work and really does not have much revenue from innovation and high knowledge work. As per the company’s FY12 annual report, Application Development and Maintenance (low end spectrum of IT services) accounted for 44% of total revenue and innovative and high end work (Asset Leverage solutions and Consulting) contributed only 6%.
In my opinion, this is the biggest risk that TCS faces and one that it will be forced to address sooner than they like. If TCS has to move up the outsourcing ladder, it will have to move on from the low hanging fruit of low-end work and take up more consulting and high-end knowledge work. As per the annual report, the company has strategies to combat these issues, but it will take time to reflect in number.
The low-cost offshoring advantage will disappear over tim , as India gets more and more expensive and standard of living and salaries go higher over a period of 10 years or so.
The next risks are the political implications of outsourcing. There are currently a lot of controversies associated with outsourcing, namely the H1B work visa program being abused by the Indian IT biggies amidst high unemployment in America.
As per the FY12 annual report, around 50% of TCS’s revenues comes from North America, posing a significant impact from the visa issue. The recent backlash in Canada and Australia over the visa programs for technology workers is also a case in point (TCS is involved in both these cases).
All over the Western world, there is a growing push against the visa programs for technology workers, as evidenced by the Immigration Bill currently in the US Senate and other measures adopted by Western countries. There are a number of measures that TCS can adopt to offset the impacts, such as moving work offshore, having more local workforce in the countries of their clients, having more subcontracting workers at onsite, having delivery centres located in the client countries or near by (giving rise to the term called ‘near-shoring’; Mexico and Latin American countries are used for nearshoring). But the associated costs with these options are significant enough that TCS has not adopted it in a very big way. All said and done, this does pose a significant risk to the current business model.
A third risk is employee attrition ,revenues and expenses associated with employee linearity. TCS being a big employer naturally will face some attrition, but the crucial risk is of people with specialised knowledge leaving the company.But I dont see this as a significant risk as this is something every company faces and takes measures to minimise impacts. A bigger risk in my opinion,is that TCS has relied on increasing headcount to increase its revenues by way of more billable resources.Current employee expenses is 56% of revenue (Source:Annual Report FY12).But as offshoring gains maturity and more higher end work gets addressed, TCS should start looking at getting more revenues irrespective of employee count by ways of innovative solutions and products ,as adding more and more employees to generate profits is not a sustainable method in the long run.
P.S.: I don’t count currency risk as a major one for TCS, as the company earns its revenue in a variety of currencies and also incurs its expenses in a variety of currencies. Also, it follows hedging and other financial strategies to combat currency volatility, so currency appreciation and depreciation gets evened out in the longer run. All the above risks are faced by other Indian IT service companies as well and are not specific to TCS.
Now we come to the tricky part. As many investing gurus have pointed out, equity valuation forecasting is more art than science. We have established that TCS is a good business, with sound financials, an impressive track record and a reasonable visibility of earnings and revenues for at least the next 10-15 years. Now let’s look at the price we would like to pay for TCS’s stock.
As far as possible, I like to use simple methods and inputs for forecasting prices, because as complexity rises, chances of error increases. The three methods I have used to value TCS are DCF, EPS Growth Valuation and PE growth valuation.
DCF Valuation: The assumptions I’ve making here are 12% growth for the first 5 years and 8% growth for the next 5. The 3 year median FCF is Rs 50 billion. No. of shares outstanding is 1,957 million. Net debt is negative Rs 57 billion. Terminal growth rate is kept at 0% (ultra-conservative) and discount rate is 12%. Based on these inputs, the intrinsic value comes to Rs 449.
EPS Growth Valuation: The 5-year median EPS growth rate for TCS is 25.6%. Assuming a very conservative rate of earnings growth, I have assumed growth rate as half for the last 5-year number, or around 13%. I have used this rate to forecast EPS 10 years from now.
Current 3-year median EPS is Rs 53 .Forecasting 10 years into the future, I get a estimated EPS of Rs 177. Taking a 10-year median P/E ratio of 25x, I get a 10-year price estimate of Rs 4,425. At the current price of Rs 1,538, this translates into an average annual return of around 11%. If I take dividends into account, again at a conservative rate of Rs 10 per share, total returns would come to Rs 4,525, or an average annual return of around 11.3%.
PE Ratio Valuation: Taking a 3-year median EPS of Rs 53 and a 10-year median P/E of 25, we get an intrinsic value of Rs 1,325 per share.
Based on these three valuations and taking a margin of safety of 30%, I get a comfortable buying price of Rs 1,100 per share for TCS.
Do these valuations take into account the very serious risks that face TCS today? I would say the Immigration Bill in US and the move of the IT world from the low cost hub that is India, are potential game changers.
I’m not saying that TCS’s management is not cognizant of these risks and not taking strategies to combat these issues, but I do not believe that the market is factoring these risks into TCS’s current valuations. There exists a substantial downside to TCS’s market valuation, which only is factoring in the positive news of the rupee depreciation.
So logic compels me to wait until there is a much more sensible price level for a good company such as TCS. My study of the IT sector compels me to believe that TCS is the strongest bet among large Indian IT companies. When the market wakes up to the risks TCS is facing, that’s when we should swoop down and buy this business.
In the words of Howard Marks – “No asset is so good so as to give any price for it and no asset is so bad as that it can’t give a profit when purchased at the right price.”
Disclaimer: Readers are advised to do their own independent assessment before taking any decision. You can expect some errors or forward looking statements, so do your own research as well.