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Inexpensive valuation with elevated operational risk

Margin to undershoot expectations

* TECHM’s 3QFY21 USD revenue growth of 2.8% QoQ CC came in ahead of our expectation as it continued to benefit from strong demand in its BPO business (+11% QoQ), which accounted for half of incremental growth in the second consequent quarter. Performance in the Communications vertical improved with 3.6% QoQ CC growth, while Enterprise was up 2.6%.

* New deal wins rose marginally to USD455m, although TECHM continued to see a record high deal pipeline, including in 5G Network services.

* We were surprised by the 170bp QoQ EBIT margin expansion in 3Q as it was on top of ~400bp increase in 2QFY21. TECHM achieved it through stretching its utilization (+200bp) to a record high of 87% along with a ~2% reduction in employees.

* While we expect TECHM to deliver double-digit revenue growth in FY22E, helped by healthy order book and improving demand environment, it should continue to lag its peers (FY22E USD growth of 13% v/s ~18% YoY for INFO) as the initial ramp up in 5G would be in the smaller Network Services space.

* While TECHM’s margin performance has been excellent, we see elevated risk on account of the stretched supply-side position. It should have a high impact from expected tightening of industry talent supply in CY21-22 due to less aggressive talent interventions v/s peers who have proactively given variable pay and a full wage hike.

* As the business is running at elevated operational levers (utilization, employee expenses, etc.), we expect some normalization in EBITDA margin from 4QFY21. We upgrade our FY21E/FY22E/FY23E EPS estimate by 11%/7%/10% as we consider strong margin beat during 3QFY21 and factor it in for our FY22E/FY23E margins. Our TP implies 16x FY23E EPS. Remain Neutral.

Strong operational performance; big beat on margin

* Revenue declined 3.3% YoY in 3QFY21 (in line). EBIT increased 30% YoY v/s our estimate of 13%. PAT grew 14% v/s our expectation of a 5% decline.

* In dollar terms, revenue grew 3.4% QoQ to USD1,309m, which is marginally ahead of our estimate of USD1,294m.

* This implies a CC revenue growth of 2.8% QoQ.

* In CC terms, Communications had a strong quarter, up 3.6% QoQ, while Enterprises grew 2.6%.

* Among verticals, growth was led by Retail, Transportation, and Logistics at 8.4% QoQ. Communication/Manufacturing saw strong growth at +4.4%/+4.2% QoQ. TMT remained flat sequentially after posting strong growth in the previous two quarters.

* BPO (11% of revenue) again drove 50% of the growth, while IT Services was up 2.5% QoQ.

* EBIT margin stood at 15.9%, up +170bp QoQ and 190bp above our estimate. Historically, the quarter sees high utilization (87%) and attrition (12%), however both improved by 200bp.

* PAT was up 23% QoQ and 14% YoY to INR13.1b.

* Total TCV stood at USD455m, of which USD352m/USD104m was in Enterprise/Communications.

* FCF stood at USD226m, implying a FCF-to-PAT ratio of 127.2%.

* DSO at 97 days was the lowest in four years.

* Headcount of software professionals declined by 778 QoQ to 68,734. BPO headcount too fell by 1,630 in 3QFY21 to 46,832. Overall headcount decreased by 2,357 QoQ to 121,901.

* LTM attrition was the lowest at 12%.

Key highlights from the management commentary

* Net new deal wins in 3QFY21 stood at USD455m and is expected to improve going forward. The Communications segment saw temporary postponements. However, the management expects strong growth in deals wins and deals to ramp up.

* A large part of margin expansion was on account of offshoring and other operational metrics (80bp). The balance is due to operating leverage. Utilization levels are expected to normalize going forward. The management intends to offer standard wage hikes over the next couple of quarters starting from 4QFY21.

* 5G has more than a double-digit share in the Network business, which is driving growth in Telecom. The management is seeing 5G Networks within Enterprises.

Valuation and view – A further re-rating would require a pick-up in revenue

* TECHM’s high exposure to the Communications vertical remains a potential opportunity as a broader 5G rollout can lead to a new spending cycle in this space. However, significant traction from the same isn’t visible yet.

* While EBITDA margin has seen a very strong improvement, the management has maintained their 15% guidance band (although with an upside bias). For normalization of EBITDA margin, it would need to invest back in the business (utilization, employee wage hikes, etc.) after keeping a tight leash on the same during 9MFY21.

* We expect TECHM to deliver double-digit growth in FY22. However, the extent of the same is likely to be lower than its peers. We expect some normalization in margin, which would lead to a lower P/E multiple. We value the stock at 16x FY23E EPS, a 40% discount to our target P/E for TCS. Remain Neutral.

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