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Healthy topline beat to assuage growth concern; outlook strong

Share buyback on expected lines

* TCS reported 3QFY22 revenue of USD6.52b, up 4.0% QoQ in constant currency (CC) – above our estimate of 3.2% QoQ growth. 3Q topline was driven by Communication, Technology and Regional markets, while Manufacturing and Retail verticals dragged down growth.

* EBIT margin contracted 60bp QoQ to 25.0%, 100bp lower than our estimate of 26.0%, as TCS augmented its employee intake (all-time high at 28k), along with a spike in sub-contracting cost. Net profit stood at INR97.7b, up 1.5% QoQ, which was below our estimate due to the miss on operating margin.

* TCS’s 3Q deal wins remained stable at USD7.6b, with no mega deal (similar to 2Q). We view the stability in deal wins in the absence of mega deals as positive. This also implies a higher annual contract value (ACV) that should support near-term growth.

* We are encouraged by the company’s robust topline growth in a seasonally weaker quarter. We expect this performance to alleviate the concerns on its growth potential and the likely drag from growing share of smaller deals in the market. Management commentary on demand environment continues to remain strong, with a high visibility on Cloud-led spending over the next 2-3 years. We are factoring in FY23E revenue growth of 15% YoY in CC.

* While 3QFY22 margins dipped QoQ, management indicated that TCS should start absorbing the cost as fresher intake will help rightsize their pyramid and better new-deals pricing will flow through to revenues. We expect EBIT margin to improve gradually – 50bp over the next two years. This should help TCS deliver a strong PAT growth of 19% YoY next year.

* LTM attrition again rose 340bp QoQ to 15.3%, though it indicated that attrition has peaked out and should start normalizing going forward. This suggests supply-side crunch in the industry is now easing. We see the current supply-side challenges to normalize over the next two quarters.

* The company reported an OCF/PAT of 111% and FCF/PAT of 102% on good working capital management, indicating the ability to generate strong cash flow. TCS’ 9MFY22 Revenue/EBIT/PAT grew 17.5%/16.7%/22.7% YoY in USD.

* We have marginally lowered our FY22E EPS by 2%, but maintained for FY23E/FY24E EPS. We expect 13.9%/16.0% USD revenue/INR EPS CAGR over FY22-24. Our TP of INR4,250, implies 30x FY24E EPS, with a 10% upside potential. We maintain our BUY rating on the stock.

3Q performance was a mixed bag – better topline but margin miss

* In 3QFY22, TCS’ revenue (CC) grew 4.0% QoQ, INR EBIT grew 9.4% YoY, and INR PAT rose 12.3% YoY.

* The company’s revenue of USD6.52b rose 4.0% QoQ in CC and was above our estimate of 3.2% QoQ growth; reported growth in USD was +3.0% QoQ

* Strong growth was seen in Communication, Technology and Regional markets, while Manufacturing and Retail verticals dragged down growth

* EBIT margin at 25.0% dipped 60bp QoQ, 100bp lower than our estimates.

* TCS added a record 28k employees and its sub-contracting cost rose 7% QoQ

* TCS reported total contract value (TCV) of USD7.6b, which was flat QoQ

* The company reported an LTM attrition rate of 15.3% (+340bp QoQ)

* TCS’ net profit of INR97.7b rose 1.5% QoQ, which was below our estimate due to the miss on operating margin

* TCS announced share buyback worth INR180b (1.08% of paid up equity) at INR4,500/share (17% upside to today’s close) through a tender route.

* Net cash from operations dipped 9% YoY to INR108.53b (i.e. 111% of net income). Free cash flow declined 11% YoY to INR99.4b (i.e. 101% of net income).

* Total cash and investments stood at INR670b at end-3QFY22.

* TCS announced a dividend of INR7/share.

Key highlights from the management commentary

* Deal TCV: The company reported a TCV of USD7.6b, of which USD2.9b and USD1b were in BFSI and Retail, respectively. North America posted a TCV of USD4.2b in 3QFY22. TCS’ ACV is likely to be better as its TCV comprised relatively smaller deals with the absence of any mega “$1b” deal wins. The management is witnessing a strong deal pipeline (of small and large deals) buoyed by robust industry demand.

* Cloud: Management reiterated that cloud will drive the growth. TCS enjoys strong partnership with each hyperscaler. The company has witnessed ample Horizon 1 deals and the management believes these deals will fuel short-term growth. TCS is also anticipating Horizon 2 opportunities. The management further indicated that demand from Horizon 3 deals would not be bound by time and will have long-term growth implications.

* Margins Operating margin stood at 25% in 3QFY22, down 60bp QoQ . There was a 50bp impact from backfilling and 60bp was from discretionary non-manpower expenses. These were, however, partially offset by favorable FX and lower SG&A. Management is perceiving a slight uptick in pricing and is confident to capitalize on it. However, TCS expects to maintain pricing for longer-term contracts. Management further indicated that reducing dependence on subcontractors, as attrition stabilizes gradually, will be one of the key levers to support margins.

Valuation and view – Growth to underpin valuation

* IT Services has entered into a technology upcycle, with Cloud migration and Digital transformation-led deals coming into the market.

* Given TCS’ size, capabilities, and portfolio stretch, it is rightly positioned to leverage the anticipated industry growth.

* TCS has consistently maintained its market leadership position and shown bestin-class execution. This renders the company with ample room to maintain its industry-leading margin and demonstrate the superior return ratios.

* We maintain our positive stance on TCS, given its strong growth outlook. Our TP of INR4,250 implies 30x FY24E EPS, with a 10% upside potential. Maintain BUY.

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