TCS: Buy

Investment with a one-two year horizon can be considered in the Tata Consultancy Services (TCS) stock considering its strong business fundamentals and availability at valuations that appear to capture its growth prospects.

 

IT stocks have taken a beating over the last few months on the back of the appreciating rupee and fears of the US sub-prime crisis affecting their Banking Financial Services Insurance (BFSI) clientele. This has resulted in the top-tier IT stocks being available at a discount to their historical valuations.

 

TCS has hedged about $2.5 billion — nearly 55 per cent of its revenues — at about Rs 41 to the dollar, partially mitigating the effect of the appreciating rupee. Also, compared to the 7 per cent appreciation in the April-June quarter, the rupee has traded in a narrow band of Rs 39.5-40.5 for most part of the second quarter. This may reduce the impact of currency fluctuation on the sequential numbers.

 

In any case, geographic de-risking is already working for the company, with increased presence in Europe, South America and the Asia-Pacific. TCS' direct exposure to mortgage clients is less than one per cent of its revenues and may not pose a serious threat to its business.

 

At the current market price (Rs 1070), the stock trades at about 25 times its trailing twelve-month earnings.

 

This is at a discount to Infosys, which is significant, because TCS may deliver the growth levels that this valuation demands and has weathered the rupee appreciation better. Wage hikes of 12-15 per cent were effected last quarter and should not be a burden on margins for the remaining three quarters of this year.
Business prospects

 

New SBU gives greater focus: TCS has recently carved out a Strategic Business Unit (SBU) for its financial products (TCS BaNCS) division, with a separate management team. This has helped TCS focus on deals with large financial institutions, stock exchanges and insurance companies.

 

TCS BaNCS has functional modules to cater to a wide variety of BFSI clientele. The product conforms to international settlement and banking standards, thus making way for seamless integration with minimal customisation. To cite a few examples, HDFC Bank has implemented the product for its treasury operations; New Zealand stock exchange has taken the market infrastructure module; General Insurance Corporation has implemented its insurance module.

 

Where application development or maintenance or routine IT services are required, the regular BFSI vertical would come to the fore. The modularity of the product may appeal to large clients, given the potential for quick implementation. This demarcation enables greater focus and targeted client mining, evident from the fact that the State Bank of India and Bank of China are now on the list of clients which would be implementing the product. The products business offers high margins and, hence, increased profitability.

 

Offshored consulting: Consulting, which is a high-value service, tends to be high-cost revenue for IT vendors, as most consulting work is carried out onsite. TCS, leveraging on its 'global network delivery model', is now deriving one-fourth of its consulting revenues from services delivered offshore, which creates a low-cost structure. This strategy, if expanded in scale, would significantly increase margins for the company. The company has indicated that it is looking to move in that direction.

 

Synergy with CMC: In chasing deals that are systems integration intensive, TCS has a synergistic advantage from the expertise of its subsidiary, CMC. This is especially significant in infrastructure management services, a fast-growing-high-revenue service where CMC has vast experience in implementing IT products across a wide range of international vendors.

 

The other advantage that CMC brings is strong domestic presence and a sizeable government clientele. TCS may be well-placed to tap this segment as various government utilities increase their IT spends.

 

High fixed price billing: TCS derives over 40 per cent of its revenues from fixed price billing, the highest among top-tier Indian IT players. Of the two key methods of billing, fixed price contracts are done on the basis of proportion of work completed, while time and material billing is based on resources deployed in the project, often on a per hour basis. The ability to price a contract on fixed billing requires a clear ability to forecast the timelines, resources and expertise required to complete a project. This can help predict cash flows and formulate a suitable hedging strategy. Increasingly, international clients are demanding such a pattern from Indian vendors.
Cost optimisation levers

 

Recruitment strategy: With growing difficulty in finding talented manpower (read engineers), TCS has begun to recruit science graduates, a strategy which other IT companies too are implementing, though on a smaller scale.

 

With a program called 'Ignite', these graduates will be imparted a seven-month training to put them live on projects. As many as 500 graduates have been recruited and TCS plans to increase this to 2,000 within this financial year. This move could address the double-whammy of attrition and wage inflation for the company.

 

Geographic de-risking: Non-North-American clientele (Europe, MEA, and Asia Pacific) contribute nearly 48 per cent of the company's revenues. This may help TCS diversify its currency exposures and, thereby, reduce the exposure to the dollar.

 

Healthy repeat business: TCS has a repeat business percentage of over 96 per cent, which is further evidence of improving quality of service delivery.

 

A high repeat business percentage may also help reduce sales expenditure to mine new clients. This is in addition to the fact that for five of its six $100 million-plus clients, it is offering the almost the entire gamut of IT and BPO services. This ensures optimal deployment of resources and a more sustainable revenue stream.
Risks

 

As TCS goes in pursuit of large size deals, it may have to face international competition from players such as IBM and Accenture who are integrated to a greater degree. This may also impose a strain on margins. Vendor rationalisation by large clients in the US and elsewhere may mean a reduced pie for TCS. Utilisation levels are close to 80 per cent; increasing this for greater volume-driven growth may pose a challenge.