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Structural levers intact; growth to support valuations

* IT services companies should see acceleration in structural growth over the medium term as corporates embark on a multi-year cloud-led upgrade cycle. This shift in the business model should lead to a substantial increase (5% revenue v/s 3% historically) in the tech budgets of enterprise clients, adding 5–6% incremental growth for the industry.

* In our view, TCS is among the best positioned companies to benefit from this structural spending uptick, and hence are upgrading the stock to Buy rating.

* We expect TCS to benefit from the sustained growth given its 1) strong organic capabilities, 2) diverse vertical and geographic presence, 3) deal win momentum, and 4) strong headcount additions.

* With the industry seeing supply-side challenges, TCS has been the industry bellwether in managing these challenges over multiple business cycles. We see this as a key factor for TCS to be able to post sustainable growth.

* While TCS has delivered good returns in the last year (up 30%, in line with the Nifty), it has underperformed its Tier 1 peers (by 30%, on average) as well as its Tier 2 IT services peers (20% valuation discount for the first time in history). We expect this underperformance to reverse as peer growth starts to normalize owing to the base effect as well as the impact of increased aggression from TCS to increase its market share.

* We expect TCS to benefit from demand tailwinds and deliver a ~14% revenue CAGR over FY21–24E, ~650bp higher than that seen over FY15–20. Growth could improve further as a greater acceptance of offshoring and inorganic opportunities from captive monetization could trigger incremental market share gains.

* Growth in the cloud would anchor this phase of technology spending, which would see a mid to high teen growth rate. Along with continued double-digit growth in digital services, this should more than compensate for the decline in traditional services.

* While the current sector valuation is ahead of historical levels, the strong growth environment and increased visibility should more than justify it. We see current valuations at 26x FY24E as reasonable given its 1) sustained growth, 2) industry-high margins and return ratio profile, and 3) strong track record of supply-side management.

* We have taken up our FY22-23 estimates by 1-2% and are introducing FY24 estimates in this report. We are also rolling forward our target multiple to FY24E, leading to new target price of INR4,220 on 30x our FY24 EPS. We upgrade TCS to Buy with 17% upside from current level.

Technology spends to grow faster; expect TCS to see 14% CAGR

* COVID-19 has structurally accelerated the growth profile of the IT Services industry as corporates are embarking on a multi-year upgrade cycle.

* Enterprise technology budgets should increase to 5% of revenue by CY30 (from 3%). This should add 5–6% of incremental growth from normalized growth levels based on the global corporate performance.

* This is also reflected in the commentaries of industry advisors such as Gartner. It expects IT services spending to see a 9.1% CAGR over CY20–25E (v/s a history of 3–5% over the last decade).

Cloud migration a multi-year theme

* We are seeing cloud usher in a new cycle of technology spending – similar in potential to the ERP wave of the 2000s – creating significant growth opportunities for IT services companies. Cloud adoption/migration is a USD300– 350b opportunity for IT services providers.

* Within cloud infrastructure, hybrid and multi-cloud would continue to gain scale, providing large opportunities for IT services providers on increased complexities. We believe cloud migration and adjacent services would be the key growth contributors to the growth performance of Indian IT services.

* TCS’ management sees increased technology intensity from enterprise customers and expects the demand momentum to continue over the medium term. Cloud adoption is at the initial stages, with only 20–30% of workloads having been moved to the cloud.

* Given TCS’ strong organic capabilities and diversified vertical and geographical presence, it stands to be one of the key beneficiaries of the cloud migration demand.

Margins to remain range-bound despite supply-side pressure

* While IT services companies have ramped up hiring, we expect attrition to remain elevated in 2HFY22 and stabilize gradually in FY23E. Moreover, we see the current intensity of supply-side challenges as transient and expect normalization over the medium term. TCS is the industry bellwether in managing supply-side challenges.

* TCS’ LTM attrition is trending at 11.9% (an industry low). Moreover, the company has had strong net additions, including those of ~43k freshers in 1HFY22. On the other hand, the management has indicated the number of supply-side challenges would remain high for the next 2–3 quarters before normalizing.

* Despite the shortage of key skills leading to increased costs, we expect the company to have sufficient levers around 1) increasing offshoring, 2) cost optimization, and 3) operating leverage to keep margins range-bound.

Valuation and view

* IT Services has entered a technology upcycle, with cloud migration and digital transformation led deals coming to the market. Given TCS’ size, capability, and portfolio stretch, it is rightly positioned to leverage the expected industry growth.

* The company has consistently maintained its market leadership and shown bestin-class execution. This gives the company continued room to maintain its industry-leading margins and demonstrate industry-leading return ratios.

* We are turning positive on the company given the strong growth potential. Our TP of INR4,220 implies 30x FY24E EPS. We upgrade our rating to Buy.

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