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3Q beat led by faster-than-expected demand uptick

Blockbuster performance in a seasonally weak quarter

* Tata Consultancy Services (TCS) reported revenue growth of 4.1% QoQ CC in 3Q (v/s est. 2.3% QoQ CC). This is the best QoQ growth posted by the company since FY11 in a seasonally weak 3Q – it was led by broad-based delivery across sectors and regions. Moreover, TCS improved its EBIT margin to 26.6% (+40bp QoQ; +100bp v/s our estimate) despite absorbing the full impact of a wage hike (160bps impact). Deal wins (ex-Postbank at ~USD0.5b) were USD6.8b, down QoQ on tough comps, but were up 13% from Q3 FY20.

* TCS reported OCF/PAT of 137% and FCF/PAT of 122%, boasting a strong performance on working capital. It exited Q3 with cash of INR654bn.

* This strong 3Q growth in TCS, in our opinion, indicates both a strong tech spending environment and the ability to capture an outsized share of cloud migration spend. In our view, the TCS management’s strong commentary on enterprise demand, especially on cloud, implies a positive outlook for peers as well. TCS also highlighted conversion of large deal pipeline to orders in 3Q, which we expect would be echoed across the sector in 3Q.

* We expect TCS to be relatively better positioned (v/s the sector) to leverage the large deals coming into the market. Backed by strong deal wins in 9MFY21 and continued momentum in cloud and data deals, we expect TCS to deliver a ~16% USD growth CAGR over FY21–23E

* We upgrade our EPS estimates by 3–6% for FY21/FY22/FY23E, primarily led by revenue/margin beat during the quarter. While we continue to be positive on the company, we remain Neutral given the elevated multiples. The stock currently trades at ~25x FY23E EPS.

Beat on revenue and margins

* CC revenue was up 4.1% QoQ, above our estimate of 2.3% QoQ CC. On a reported basis, it delivered +0.4% YoY CC / +5.1% QoQ topline growth.

* Overall TCV of deals won during the quarter was high at USD6.8b (does not include large deal win from Postbank in Germany), compared with USD6.4b in 3QFY20.

* The EBIT margin came in at 26.6% (est. 25.6%), up 40bp QoQ and 160bp YoY.

* PAT grew 7.2% YoY to INR87b (a 1.4% beat), largely on account of an operational beat. This was partially offset by higher ETR at 25.4% v/s our estimate of 23.5%.

* Growth was broad-based across verticals such as Manufacturing (+7.1% QoQ CC), BFSI (+2% QoQ CC), Life Sciences and Healthcare (+5.2% QoQ CC), Communications & Media (+5.5% QoQ CC), and Retail and CPG (+3.1% QoQ CC).

* On a YoY, constant-currency basis, Life Sciences and Healthcare continued to grow in the double digits at 18.2%. BFSI (+2.4%) and Technology & Services (+2.4%) also moved into the positive territory, while other verticals remain in the negative territory on a YoY basis.

* North America was flat QoQ, while the majority of growth was led by Continental Europe (+3.6% YoY CC) and India (+4.1% YoY CC).

* In Services, growth in the quarter was led by Cloud Services, Analytics & Insights, Cognitive Business Operations, loT, and Quality Engineering & Transformation Platform Services.

* Strong headcount additions were seen in 3Q – net additions of 15,271 QoQ to 469,261. Attrition stood at an all-time low of 7.6%. Currently, only 3.4% of the workforce has resumed going to the offices.

Key highlights from management commentary

* The company reported deal wins of USD6.8b (BFSI – USD2.6b; Retail – USD0.9b). Apart from two large deals announced, the company closed many large/medium deals during the quarter.

* Enterprises are leveraging with new-gen technology to enter new markets, gain new revenue streams, or enhance customer experience.

* The management understands the cloud opportunity as a three-stage strategy comprising 1) migration to the cloud, 2) application development and maintenance on the cloud, and 3) platform and ecosystem integration. This makes cloud a key growth driver for the multi-year growth cycle.

* 3Q saw the full impact of wage hikes (given from 1st October 2020). The impact of 160bps was offset by continued operational efficiency, strong revenue growth, and the effects of currency movement.

* Attrition stood at an all-time low of 7.6%. However, the management expects this to go up as the work cycle normalizes.

* With regard to subcontractor expenses, TCS is proactively prioritizing investments toward building skills and organic talent within the organization; however, it would continue to use subcontractors as and when the need arises.

* The company reported a cash flow conversion rate of 137% (OCF to net income).

Valuation and view – rich multiples justified!

* We believe IT Services has entered into a technology upcycle, led by cloud- and data-driven deals coming onto the market

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

* Additionally, TCS has consistently maintained its market leadership and shown best-in-class execution. This gives the company continued room to increase its margins, along with demonstrating industry-leading return ratios.

* We increase our EPS estimate for FY21/FY22/FY23E by 3%/4%/6% on account of a strong beat in 3Q.

* Our TP implies 25x FY23E EPS on our revised estimates.

* While we remain positive on the company, we remain Neutral given the rich multiples.

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