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TCS/INFY FY21 AR analysis: A year of Digital acceleration

Structural demand led by Cloud remains a key tailwind

* Analysis of the FY21 annual reports of TCS and Infosys highlight two big industry trends: 1) need for across the board Digital transformation as enterprises move towards contactless business, and 2) rapid adoption of Digital technologies by companies forcing a re-examination of their cost structures, increase business resilience, and agility.

* These changes will be driven by adoption of Cloud-first solutions to create a seamless experience across public, private, and hybrid Cloud, and across the PaaS, SaaS, and IaaS landscapes.

* Companies see this technology shift as the start of a multi-year technology upgradation cycle, which should open up newer opportunities for technologydriven differentiation.

* TCS said it is entering FY22 with a strong growth momentum and much better visibility of future growth than last fiscal, powered by a strong order book built up over FY21 and a robust deal pipeline.

Enhanced need for relevant skills

* While these developments present strong market opportunities for the IT industry, it is imperative for companies in the IT Services space to transition from fast-commoditizing of traditional service offerings to attract and retain quality talent, re-examine cost structures, and leverage Automation for increased productivity.

* Companies will continue to hire talent and operate from their offices. However, work-from-anywhere model will also allow access to talent in towns and cities where TCS/INFO may not have offices and delivery centers.

* Both TCS and INFO are working towards institutionalizing their hybrid working model, so as to best serve clients, while getting access to relevant skills in the market.

* By CY25, TCS sees no more than 25% of its employees at its facilities at any point in time, and no individual would have to spend more than 25% of their time at its facility to be 100% productive.

Higher focus towards ESG

* INFO has turned carbon neutral 30 years ahead of global guidelines. In its ESG outlook, it said it would extend its Digital skills to over 10m people, including employees, clients’ workforce, students, teachers, and communities by FY25.

* TCS said it would be carbon neutral by CY50. Total reduction in its carbon footprint in FY21 was 49%. It has also achieved a power utilization efficiency of 1.6 at its 21 data centers. The management’s focus remains on growing sustainably, while following all major ESG guidelines set by the group.

* ESG remains a key focus area for both TCS and Infosys, with incremental progress made in FY21.

Enough levers to maintain margin resilience at FY21 levels

* TCS expects demand, revenue, and operating costs to normalize and return to its long-term comfort zone. That, along with higher quality revenue and greater operating efficiencies, will help sustain operating margin at current levels.

* INFO expects margin to remain resilient despite a 320bp increase in FY21.

* This will be majorly driven by better business mix, operating leverage, and additional cost levers enough to curtail some of the cost reversals (discounts, travel expenses, etc.) expected in FY22.

Robust balance sheets; improved working capital cycles

* Balance sheets remain strong and liquid (with cash at 25-29% of assets/3-5% of m-cap).

* Sub-optimal assets like goodwill/intangibles remained low for TCS and INFO (2- 11% of net worth).

* Contingent liabilities continued to be low and stable (4-5% of net worth).

* RoE of TCS (~38%) and INFO (~27%) remained among the best across industries.

* Working capital cycles of these companies reduced by 3-5 days during FY21, aiding pre-tax cash conversion.

* For both companies, OCF grew in the 20-37% range, while FCF grew 22-45%. OCF/EBITDA conversion stood ~83%, while FCF/PAT conversion was in the 107- 114% range.

Higher payouts on record high FCF

* TCS’ payout was 95% of FCF on the back of a 22% increase in FCF, at the higher end of its guidance level. FCF grew 44% YoY for INFO and payout stood at 94%.

* This translates into one of the highest returns of cash in absolute terms by both companies in any particular year.

* Both companies continue to deliver at the higher end of their capital allocation policy. TCS has a payout policy of 80-100% of FCF, while the same for INFO is 85%. INFO has reported the highest ever payout among its peer group in the past three years.

Valuation and view – Prefer INFO

* In the medium and longer term, both companies are seeing strong structural growth drivers, triggered by a multi-year technology refresh cycle and increased focus of customers on growth and transformation (G&T) initiatives.

* We remain positive on the industry as we expect the sector to sustain doubledigit topline growth in the medium term, led by: 1) increasing visibility on double-digit growth, 2) larger deals on a full-scale Digital transformation, and 3) higher spends on Cloud migration by large corporates.

* Both companies delivered strong margin in FY21. While some of the margin tailwinds are not sustainable, it will be offset by other cost levers and a structural shift towards offshoring. Therefore, we expect margins to stay within a narrow band.

* Our preference for INFO over TCS is premised on its headroom for increased growth potential and narrowing of the valuation gap between the stocks.

* As INFO has outperformed TCS in FY21, we expect the valuation divergence to continue to narrow. We retain our Buy on INFO, while maintaining our neutral stance on TCS on elevated valuations.

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