tcs: maintain neutral

17 July 2014

1QFY15 Results Update | Sector: Technology

TCS

Ashish Chopra ([email protected]); +91 22 3982 5424

Siddharth Vora ([email protected]); +91 22 3982 5585

BSE SENSEX S&P CNX CMP: INR2,381 TP: INR2,600 Neutral 25,561 7,640

Bloomberg TCS IN

Equity Shares (m) 1,958.7

M.Cap. (INR b) / (USD b) 4,703.6/78.2

52-Week Range (INR) 2,493/1,645

1, 6, 12 Rel. Per (%) 4/-14/14

Financials & Valuation (INR Billion)

Y/E Mar 2015E 2016E 2017E

Sales 954.8 1,099.2 1,234.4

EBITDA 278.1 315.8 342.6

PAT 216.4 249.8 275.4

EPS (INR) 110.5 127.5 140.6

EPS Gr. (%) 13.2 15.4 10.3

BV/Sh. (INR) 357.9 436.2 527.7

RoE (%) 34.5 32.1 29.2

P/E (x) 21.6 18.7 16.9

EV/EBITDA (x) 15.7 13.6 12.2

Div. yield (%) 1.6 1.8 1.8

1QFY15 in line: TCS’ 1QFY15 revenue grew 5.5% QoQ to USD3.6b (and 4.8% QoQ CC), in line with estimate. EBITDA margin declined 210bp QoQ to 28.8%, v/s estimate of 29.2%. EBIT margin (26.3%) was lower than est. (27.6%) due to a one-time depreciation charge. Yet PAT was INR50.6b (-4.5% QoQ), v/s est. of INR49.5b, due to higher other income (INR8.15b v/s est. of INR4.9b).

Broad-based nature of growth continues to impress: With the exception of Insurance and Middle East, 1QFY15 revenue grew strongly across segments, including India. Among Services, Consulting has lagged in recent quarters.

See limited room for margin expansion, going forward: In the past 10 quarters, TCS’ utilization, including trainees, has increased by 850bp. 2Q will witness headwinds from the merger of Japanese entity, which as per our estimate will impact by ~65bp. Also, there will be a slight impact from promotions that will be effective in 2Q for the company. Hence, we expect EBIT margin closer to 27% at current currency levels at the higher end.

Revenue from Japanese merger may be below estimate: We estimated USD375m revenue in FY15 from the merger of TCS’ Japanese subsidiary and Mitsubishi, which may be lower on account of significant swing in the Japanese yen in recent quarters.

Rich valuations keep us Neutral: Higher 1Q depreciation and slightly lesser revenue from the Japanese merger drive 1.3% cut in our FY15E EPS. Our outlook for FY16 remains intact. At 18.7% USD revenue CAGR over FY14-16E, we expect TCS to continue leading the industry growth with excellent execution. At 19x FY15E and 17x FY16E EPS, we remain Neutral on the stock. We would treat any corrections as an entry opportunity.

Investors are advised to refer through disclosures made at the end of the Research Report.

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TCS

Revenue in line, led by strong volume growth TCS’ 1QFY15 revenue grew 5.5% QoQ to USD3,694m, in line with our estimate of

USD3,696m. In constant currency, revenues grew 4.8% QoQ, in line with our estimate of 5% QoQ. Revenue traction during the quarter was led by strong volume growth of 5.7% QoQ, v/s our estimate of 5.2% volume growth. In rupee terms, revenues were INR221.1b, +2.6% QoQ, in line with our estimate of 2.4% QoQ growth.

USD revenue growth of 5.5% QoQ was in line

Source: Company, MOSL

Revenues from India geography grew 5.2% QoQ to ~INR14b. The break-up of INR revenue growth during the quarter is: [1] Volume growth: +5.66%, Onsite mix shift: +0.18%, [3] Realization: -1.09% and [4] Currency movements: -2.15%

1QFY15: INR revenue growth impacts

Percentage

Volume 5.66 Realization -1.09 Currency -2.15 Effort Mix +0.18 QoQ revenue growth (%) +2.60

Source: Company, MOSL EBITDA in line; EBIT margin impacted by one-time deprecation charge EBITDA margin declined 210bp QoQ 28.8%, only marginally below our estimate

29.2%. Gross profit margin declined 170bp QoQ to 46.3%, v/s our estimate of 46.6%. SGA was 17.5%, +40bp QoQ (in line)

EBIT margin was impacted by one-time depreciation charge, EBITDA and SGA in line


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TCS

EBIT margin was 26.3%, below our estimate of 27.6%, primarily due to higher depreciation (2.5% of revenues v/s 1.7% in 4Q and our normalized estimate of 1.3%). This includes ~INR1.7b relating to property, plant and equipment with nil remaining useful life as of April 1, 2014 and does not affect future periods.

The break-up of EBIT margin during the quarter stands as follows: [1] Wage hikes: (-219bp), [2] INR appreciation: (-73bp), Depreciation: (-79bp) and [4] Utilization and other efficiencies: (+87bp)

EBIT margin below estimate due to one-time depreciation charge Factor Impact (bp) Wage hikes -219 INR appreciation -73 Depreciation -79 Utilization and other efficiencies 87 Total -284


PAT, despite lower EBIT, was 50.6b, down 4.5% QoQ, above our estimate of

INR49.5b. This was due to higher other income at INR8.15b, v/s estimate of INR4.9b.

Little room for further margin expansion While part of the margin decline in 1QFY15 is on account of one-time depreciation charge, we see little room for the margins to trend significantly above the 27% mark at current currency levels. In the last 10 quarters, TCS’ utilization including trainees has increased by 850bp and utilization excluding trainees has expanded by 470bp. 2Q again, will witness headwind from merger of the Japanese entity, which as per our analysis will be ~65bp headwind, offsetting the normalized depreciation. Secondly, there will be slight impact, even if not significant, coming from promotions that become effective in 2Q for the company. Our EBIT margin estimates for FY15E/FY16E are 27.2%/27.1%. Utilization has picked up significantly, leaving little room for further uptick


Segmental: Broad based with the exception of Insurance, Middle East Growth at TCS continued to remain broad-based in 1QFY15, with the exception

of BFSI. BFSI grew 2.5% QoQ, but while BFS grew close to company average, Insurance was sluggish during the quarter. Smaller verticals grew significantly above company average, and even large vertical like Retail, grew 7.8%.

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TCS

BFSI underperformed due to Insurance

Verticals Contr. to

overall rev (%) QoQ Gr. (%)

Contr. to incr rev (%)

4 Quarter CQGR

BFSI 41.7 2.5 19.7 3.1 Mfg 8.6 5.5 8.6 4.6 Telecom 9.4 6.6 11.2 3.4 LS & Healthcare 6.3 8.9 10.0 7.5 Retail & Distr 13.8 7.8 19.3 3.6 Transportation 3.6 8.5 5.4 5.4 Energy and Utilities 3.9 8.2 5.7 5.3 Media & Entmnt 2.7 9.5 4.5 10.7 Hi-Tech 5.5 9.4 9.2 3.9 Others 4.5 7.9 6.3 2.3


Middle East was the only slow growing region in 1QFY15, with the exception of

which, revenue growth was distributed across regions. Larger geographies like US, UK, Continental Europe grew close to company average.

Barring Middle East, growth was broad based across geographies

Geographies Contr. to

overall rev (%) QoQ Gr. (%)

Contr. to incr rev (%)

4 Quarter CQGR

North America 52.2 5.5 52.2 3.0 Latin America 2.2 5.5 2.2 1.7 UK 17.7 4.9 15.9 5.0 Continental Europe 12.0 4.6 10.2 9.1 India 6.3 7.2 8.1 (0.8) APAC 7.6 8.3 11.3 6.5 MEA 2.0 0.4 0.2 2.7


Among Services, sequential growth was led by IMS, followed by testing and

Enterprise solutions. Engineering Services, Consulting and Products lagged. Consulting has been the underperforming service over the last 4 quarters now.

IMS, Testing and Enterprise Solutions led growth among services

Services Contr. to

overall rev (%) QoQ

Gr. (%) Contr. to

incr rev (%) 4 Quarter

CQGR

ADM 40.8 4.9 37.1 3.0 Engg Services 4.5 (1.1) (1.0) 2.8 IMS 12.6 10.7 23.6 5.4 EAS 15.9 6.8 19.6 5.3 Consulting 3.2 (0.7) (0.5) 1.6 Products 2.5 1.4 0.7 3.9 Testing 8.6 8.0 12.3 5.5 BPO 11.9 3.7 8.2 3.9


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TCS

Takeaways from Management commentary Demand environment: Demand environment remains strong and TCS continues

to feel pretty good about it, as there are no negative surprises to report. The three themes of Simplification, Digital and Risk management / compliance continue to play out. Digital will only continue to throw up more opportunities.

Revenues from Japanese merger may be lower: We estimated USD375m revenues to be added on to TCS’ top-line over three quarters in FY15 from merger with TCS’ Japanese subsidiary and Mitsubishi. However, TCS cited that the revenues from the merger may be lower than expected on account of significant swing in the Japanese yen in recent quarters.

Margin levers going forward: If all headwinds don’t play out in the same quarter, TCS will be able to operate in 26-28% EBIT margin band. If INR volatility is in check, then appreciation of the Rupee will not be a problem. Geography mix, pyramid, Fixed price contracts, offshoring – all these are managed prudently to deliver on the margins. Soft investments are calibrated looking at the opportunities, when profitability exceeds the targeted band.

Not reading much into growth from India: Revenues from India grew 4% QoQ. However, TCS refrained from citing the trend as secular, and remains watchful on the trends in the territory. The good part was that revenue growth in Services from India was even higher, as equipment revenues declined QoQ.

Insurance growth to remain muted: BFSI grew below company-average during the quarter. However, the growth in BFS was robust, but insurance was sluggish during the quarter. While TCS expects Insurance to return to growth going forward, the growth number is expected to remain muted.

Large deals and pipeline: TCS signed 7 large deals during the quarter, 2 in Retail and one each in Hi-tech, BFS, Insurance and Life Sciences. It is currently in active discussion in at least 8 large deals, spread across industries.

Hiring outlook: TCS had a gross addition of 15,817 employees in 1Q and the company remains on track towards hiring 55,000 employees in FY15. It extended offers to 25,000 campus graduates and 3,000 of them joined in 1Q.

Pricing stable: Realization rate continues to move QoQ in accordance with the business mix. However, there is no discernable trend of any secular weakness in the pricing environment.

Change in estimates and valuation view 1Q reported EBIT margin fell below estimate due to one-time depreciation

charge of ~INR1.7b on assets with ‘nil’ useful life. That, along with slightly lesser revenue expectation from the Japanese merger, drives our 1.3% cut in FY15E earnings. Our outlook for FY16E remains intact.

Over the past four years, TCS has led the incremental revenues as well as operating profits not just domestically, but also in the global arena (compared to peers multiple times its size); and its market cap is second only to IBM. At 18.7% USD revenue CAGR over FY14-16E, we expect TCS to continue leading the industry growth with excellent execution. At 19x FY15E and 17x FY16E EPS, we remain Neutral on valuations. We would treat any corrections as an entry opportunity.

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TCS

Change in estimates

Revised Earlier Change

FY15E FY16E FY15E FY16E FY15E FY16E INR/USD 59.2 58.0 59.2 58.0 0.1% 0.0% USD Revenue - m 16,130 18,952 16,180 18,956 -0.3% 0.0% USD revenue growth (%) 20.0 17.5 20.4 17.2 -37bp 34bp EBIT Margin (%) 27.2 27.1 28.3 27.6 -114bp -49bp EPS - INR 110.5 127.5 111.9 128.2 -1.3% -0.5%


Other result highlights Utilization excluding trainees at 85.3%,+150bp QoQ (in line). Headcount addition at 4,967 (net) to 305,431 employees (v/s estimate of 10,385

additions). Gross headcount addition was 15,817. LTM attrition was 12%, compared to 11.3% in the previous quarter. Revenue proportion from onsite increased 10bp QoQ to 47.1%. Revenue contribution from Fixed Price contracts increased 10bp QoQ to 52.5%. TCS won 7 large deals during the quarter.

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TCS

Story in charts

TCS continues to lead industry growth..


… but India headwinds cripple outperformance


Revenue growth finally getting delinked to headcount..


..as competitive intensity gradually pulls down pricing


Operating at peak efficiency, reflected in utilization..


..Expect margins to settle lower and EPS to lag rev. growth


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TCS

Operating Metrics 1QFY13 2QFY13 3QFY13 4QFY13 1QFY14 2QFY14 3QFY14 4QFY14 1QFY15 Service Lines (%)

ADM 43.4 43.1 42.4 42.4 42.3 41.7 41.4 41.0 40.8 Engineering and Industrial Services 4.6 4.6 4.7 4.6 4.7 4.7 4.6 4.8 4.5 Infrastructure Services 10.6 11.4 11.7 12.1 11.9 11.8 12.0 12.0 12.6 Enterprise Solutions 15.2 14.9 15.1 15.5 15.1 15.4 15.7 15.7 15.9 Global Consulting 2.8 3.0 3.2 3.1 3.5 3.3 3.4 3.4 3.2 Asset Leverage Solutions 2.8 2.7 2.8 2.5 2.5 2.7 2.3 2.6 2.5 Assurance Services 7.6 7.7 7.7 7.8 8.1 8.5 8.5 8.4 8.6 BPO 13.0 12.6 12.4 12.0 11.9 11.9 12.1 12.1 11.9

Industry Verticals (%)

BFSI 43.0 42.8 43.0 43.5 43.0 43.1 42.7 42.9 41.7 Manufacturing 7.9 8.2 8.5 8.5 8.4 8.4 8.8 8.6 8.6 Telecom 10.3 10.3 9.5 9.3 9.6 9.3 9.6 9.3 9.4 Life Sciences & Healthcare 5.3 5.2 5.2 5.1 5.5 5.7 5.9 6.1 6.3 Retail & Distribution 13.2 13.4 13.4 13.4 14.0 13.9 13.8 13.5 13.8 Transportation 3.7 3.6 3.6 3.4 3.4 3.4 3.5 3.5 3.6 Energy and Utilities 3.6 3.6 3.8 3.8 3.7 3.8 3.8 3.8 3.9 Media & Entertainment 2.2 2.2 2.1 2.1 2.1 2.2 2.3 2.6 2.7 Hi-Tech 6.0 5.9 5.8 5.7 5.5 5.4 5.3 5.3 5.5 Others 4.8 4.8 5.1 5.2 4.8 4.8 4.3 4.4 4.5

Geographies (%)

America 53.5 52.8 52.6 53.2 54.1 53.2 52.7 52.2 52.2 UK 17.0 17.1 17.5 16.8 17.0 17.3 17.5 17.8 17.7 Rest of Europe 9.6 9.5 9.1 9.4 9.9 11.2 11.6 12.1 12.0 Europe 26.6 26.6 26.6 26.2 26.9 28.5 29.1 29.9 29.7 India 7.1 7.5 7.6 8.8 7.6 6.9 6.3 6.2 6.3 APAC 7.4 7.6 7.5 7.3 6.9 7.1 7.4 7.4 7.6 Latin America 3.3 3.4 3.6 2.4 2.4 2.3 2.3 2.2 2.2 MEA 2.1 2.1 2.1 2.1 2.1 2.0 2.2 2.1 2.0 Others 19.9 20.6 20.8 20.6 19.0 18.3 18.2 17.9 18.1

Revenue Mix (%)

Offshore 50.5 49.1 49.4 48.3 48.5 48.1 47.8 47.4 47.2 Onsite 44.7 45.8 45.6 46.5 46.3 46.5 46.8 47.0 47.1 GDC 4.8 5.1 5.0 5.2 5.2 5.4 5.4 5.6 5.7

Utilization (%)

Excluding Trainees 81.3 81.6 81.7 82.0 82.7 83.4 84.3 83.8 85.3 Including Trainees 72.3 72.8 72.1 72.2 72.5 75.0 77.5 77.9 79.8


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TCS

Operating Metrics QoQ growth (%) 1QFY13 2QFY13 3QFY13 4QFY13 1QFY14 2QFY14 3QFY14 4QFY14 1QFY15 Service Lines

ADM 0.7 3.8 1.7 3.1 3.9 3.9 2.3 0.9 4.9 Engineering and Industrial Services 3.0 4.6 5.6 0.9 6.4 5.4 0.8 6.3 -1.1 Infrastructure Services 5.0 12.5 6.1 6.7 2.4 4.6 4.8 1.9 10.7 Enterprise Solutions 3.0 2.5 4.7 5.9 1.4 7.5 5.0 1.9 6.8 Global Consulting 6.8 12.0 10.2 -0.1 17.5 -0.6 6.1 1.9 -0.7 Asset Leverage Solutions -26.0 0.8 7.2 -7.9 4.1 13.9 -12.2 15.2 1.4 Assurance Services 7.3 5.9 3.3 4.5 8.1 10.7 3.0 0.7 8.0 BPO 16.5 1.3 1.7 -0.2 3.2 5.4 4.8 1.9 3.7

Industry Verticals

BFSI 5.0 4.1 3.8 4.3 2.9 5.7 2.1 2.4 2.5 Manufacturing 3.0 8.5 7.1 3.1 2.9 5.4 7.9 -0.4 5.5 Telecom 6.1 4.6 -4.7 1.0 7.5 2.1 6.4 -1.3 6.6 Life Sciences & Healthcare 3.0 2.6 3.3 1.1 12.3 9.3 6.6 5.3 8.9 Retail & Distribution 8.8 6.2 3.3 3.1 8.8 4.7 2.3 -0.3 7.8 Transportation 3.0 1.7 3.3 -2.6 4.1 5.4 6.1 1.9 8.5 Energy and Utilities -2.4 4.6 9.1 3.1 1.4 8.3 3.0 1.9 8.2 Media & Entertainment 3.0 4.6 -1.4 3.1 4.1 10.5 7.7 15.2 9.5 Hi-Tech 3.0 2.8 1.6 1.3 0.4 3.5 1.1 1.9 9.4 Others -22.7 4.6 9.8 5.1 -3.9 5.4 -7.7 4.3 7.9

Geographies

America 2.8 3.2 2.9 4.3 5.9 3.7 2.1 0.9 5.5 UK 15.2 5.2 5.8 -1.0 5.3 7.3 4.2 3.6 4.9 Rest of Europe 0.9 3.5 -1.0 6.5 9.6 19.3 6.7 6.3 4.6 Europe 9.6 4.6 3.3 1.6 6.9 11.7 5.2 4.7 4.8 India -13.9 10.5 4.7 19.4 -10.1 -4.3 -5.9 0.3 7.2 APAC -1.0 7.4 2.0 0.4 -1.6 8.5 7.4 1.9 8.3 Latin America 9.7 7.7 9.4 -31.2 4.1 1.1 3.0 -2.5 5.5 MEA 3.0 4.6 3.3 3.1 4.1 0.4 13.3 -2.7 0.4 Others -4.2 8.2 4.3 2.1 -4.0 1.6 2.5 0.2 6.6

Offshore 5.0 1.2 3.9 -0.5 5.9 5.4 3.0 1.1 4.9 Onsite 3.4 6.7 2.8 3.8 5.0 6.7 4.4 2.4 5.6 GDC 11.6 10.6 1.2 5.8 5.5 10.3 3.7 5.8 7.2 Overall International business 4.6 4.1 3.2 1.8 5.5 6.3 3.7 2.0 5.4 Domestic Business -13.9 10.5 4.6 19.6 -10.1 -4.4 -5.8 0.4 6.9


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TCS

TCS: an investment profile Company description TCS is the largest IT services company in India, with (LTM) revenue of over USD~13.4b. It employs over 305,000 people and provides IT and BPO services to over 1,000 global clients. It is one of the preferred IT vendors for most Fortune 500/Global 1,000 companies. Key investment arguments TCS’ outlook on FY15 revenue growth remains

extremely positive, defying any concerns of growth slowdown compared to FY14.

Traction has been broad-based; and both BFSI and Telecom are expected to contribute significantly to growth going forward.

One of the largest players in IMS, a key growth driver for the industry.

Key investment risks Continued pricing decline akin to FY13 could lead to

prolonged pain on the bottom line, despite offset coming from improvement in volume growth.

Appreciation in INR could hamper profitability. Slowdown in BFSI, Telecom and Hi Tech which

contribute more than 50% of the revenues.

Recent developments 7 deals were signed in emerging digital

transformation technologies. 7 large deals signed across verticals in 1QFY15. Valuation and view We expect TCS to report revenue CAGR of 18.7% and

EPS CAGR of 14.3% over FY14-16. The stock trades at 18.7x FY15E and 16.9x FY16E EPS.

Maintain Neutral.

Sector view With strengthening demand in the US and large deals

traction in traditional services in Europe, industry growth in FY15 should be better than FY14.

Digital technologies/SMAC may not be a needle mover right now but are increasingly seeing traction and can potentially drive downstream opportunity.

We see better risk-reward in Tier-I v/s Tier-II. Currency is a key risk to valuations, and Tier-II has a

higher sensitivity to the same v/s Tier-I

Comparative valuations TCS INFO WPRO

P/E (x) FY15E 21.6 15.6 15.4

FY16E 18.7 14.3 13.7

P/BV (x) FY15E 6.7 3.6 3.2

FY16E 5.5 3.1 2.8

EV/Sales (x) FY15E 4.6 2.9 2.5

FY16E 3.9 2.5 2.2

EV/EBITDA (x) FY15E 15.7 10.3 10.6

FY16E 13.6 9.0 9.4

EPS: MOSL forecast v/s consensus (INR) MOSL

Forecast Consensus Forecast

Variation (%)

FY15 110.5 110.7 -0.1

FY16 127.5 127.0 0.4% Target price and recommendation

Current Price (INR)

Target Price (INR)

Upside (%)

Reco

2,381 2,600 9.2 Neutral

Shareholding pattern (%) Mar-14 Dec-13 Mar-13

Promoter 73.9 73.9 74.0

DII 5.4 5.3 5.4

FII 16.1 16.3 16.1

Others 4.6 4.5 4.5

Note: FII Includes depository receipts

Stock performance (1-year)

17 July 2014 11

TCS

Financials and valuations

17 July 2014 12

TCS

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This report is intended for distribution only to "Major Institutional Investors" as defined by Rule 15a-6(b)(4) of the Exchange Act and interpretations thereof by SEC (henceforth referred to as "major institutional investors"). This document must not be acted on or relied on by persons who are not major institutional investors. Any investment or investment activity to which this document relates is only available to major institutional investors and will be engaged in only with major institutional investors. In reliance on the exemption from registration provided by Rule 15a-6 of the U.S. Securities Exchange Act of 1934, as amended (the "Exchange Act") and interpretations thereof by the U.S. Securities and Exchange Commission ("SEC") in order to conduct business with Institutional Investors based in the U.S., MOSL has entered into a chaperoning agreement with a U.S. registered broker-dealer, Motilal Oswal Securities International Private Limited. ("MOSIPL"). Any business interaction pursuant to this report will have to be executed within the provisions of this chaperoning agreement.

The Research Analysts contributing to the report may not be registered /qualified as research analyst with FINRA. Such research analyst may not be associated persons of the U.S. registered broker-dealer, MOSIPL, and therefore, may not be subject to NASD rule 2711 and NYSE Rule 472 restrictions on communication with a subject company, public appearances and trading securities held by a research analyst account.

For Singapore Motilal Oswal Capital Markets Singapore Pte Limited is acting as an exempt financial advisor under section 23(1)(f) of the Financial Advisers Act(FAA) read with regulation 17(1)(d) of the Financial Advisors Regulations and is a subsidiary of Motilal Oswal Securities Limited in India. This research is distributed in Singapore by Motilal Oswal Capital Markets Singapore Pte Limited and it is only directed in Singapore to accredited investors, as defined in the Financial Advisers Regulations and the Securities and Futures Act (Chapter 289), as amended from time to time. In respect of any matter arising from or in connection with the research you could contact the following representatives of Motilal Oswal Capital Markets Singapore Pte Limited: Anosh Koppikar Kadambari Balachandran Email:[email protected] Email : [email protected] Contact(+65)68189232 Contact: (+65) 68189233 / 65249115 Office Address:21 (Suite 31),16 Collyer Quay,Singapore 04931

Motilal Oswal Securities Ltd

Motilal Oswal Tower, Level 9, Sayani Road, Prabhadevi, Mumbai 400 025 Phone: +91 22 3982 5500 E-mail: [email protected]

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