Healthy operating performance, long term trend positive
Tata Consultancy Services (TCS) reported healthy Q2FY21 results that were above our estimates. The company reported 4.8% QoQ growth in dollar revenues (in constant currency terms), above our estimate of 2.6% QoQ growth. The growth was broad based across geographies and verticals. Margins increased 260 bps mainly due to an improvement in gross margins and lower SG&A expenses. The TCS board has approved a buyback of | 16,000 crore to buy back ~5.33 crore shares at | 3,000/share. The company has also declared an interim dividend of | 12/share (the record date is October 15, 2020 while payment date is November 3, 2020).
IT sector at cusp of multi-year technology transformation cycle
TCS believes it is in the first phase of a multi-year technology transformation phase. In the current phase, enterprises are building a cloud-based foundation that will serve as a resilient, secure and scalable digital core. In subsequent phases, enterprises will see new age technologies developed around cloud to lead to new business models and differentiated customer experiences. TCS’ investments in building deep expertise on these platforms, in research & innovation and in industry-specific solutions will make it a key beneficiary of this secular demand growth in coming years. Going forward, global digital technologies are expected to witness robust growth (CAGR of ~20% CAGR in the next five years) while TCS is expected to be a key beneficiary of this trend. Hence, although we expect the company to report a marginal decline in FY21E revenues, we expect TCS to witness double digit revenue growth over a longer horizon.
Cost efficiency to drive margins
The company has seen healthy margin growth in Q2FY21 led by improving revenue growth and cost rationalisation. Going forward, we expect TCS to witness a healthy margin trajectory led by cost rationalisation, improving growth in high margin digital technologies, benefits of lower attrition and operating leverage benefit. Hence, we expect the company to witness 80 bps YoY increase in EBIT margins in FY21E followed by another 80 bps YoY and 30 bps YoY increase in FY22E and FY23E, respectively.
Valuation & Outlook
Going forward, global digital technologies are expected to witness robust growth (~20% CAGR in next five years) led by robust growth in cloud, customer experience and robust growth in cloud native technologies. TCS is expected to be a key beneficiary of this trend leading to double-digit revenue growth over a sustainable period. This, coupled with industry leading growth & solutions, better capital allocation, stable management and higher revenue growth trajectory than witnessed in the past warrant a multiple re-rating for the company. Hence, we now assign 28x P/E to the company’s FY23E EPS. Based on this, we arrive at a target price of | 3300/share and upgrade the stock from HOLD to BUY.
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