TCS enters big league but does its growth justify its valuation?

WHEN Tata Consultancy Services (TCS), India's largest information technology (IT) company, crossed US$100 billion in market value towards the end of April, it became the country's most valuable company and finally broke into the global big league.

TCS had overtaken the previous market leader Infosys to become the country's biggest software exporter almost a decade back, and its consistently higher growth rate ensured that it stayed at the top.

Its latest growth, for the 2017-18 financial year, however did not touch the double-digit pace that was common in the industry a decade back, even falling below industry body Nasscom's 7.8 per cent estimate. TCS reported a 6.7 per cent growth in revenue in fiscal 2018 while Infosys and Wipro managed a 5.8 per cent and 2.9 per cent increase respectively.

TCS, Infosys and Wipro now account for 23 per cent of the country's US$167 billion IT industry, and analysts argue that it is unreasonable to expect the big three companies to grow at the pace of much smaller firms.

With its new market capitalisation, TCS has also overtaken outsourcing and consultancy giant Accenture plc, which has a market cap of US$98.20 billion. This is despite Accenture having fiscal 2018 revenues of US$34.90 billion, far higher than TCS's annual revenue of US$19.1 billion. TCS's market cap is below IBM's US$133.48 billion, but the latter has both hardware and technology services operations.

According to Bloomberg data, there are currently 96 companies that have market capitalisation of over US$100 billion. And TCS now ranks 97th in the world's 100 most valued organisations.

DIGITAL TRANSFORMATION

The company has crossed this milestone while on the cusp of digital transformation, as is the software industry as a whole. TCS's "digital" revenue - generated from technologies such as mobile, analytics, cloud computing and Internet of Things (IoT) - grew 43 per cent to US$4.5 billion, or about 24 per cent of company's overall revenue in its fiscal Q4.

Four of its industry verticals - oil and gas; health care and life sciences; communication and media; and travel and hospitality - reported double-digit growth in the January-March 2018 quarter, helping the company end the year on a strong footing.

A US$2.25 billion deal renewal from television ratings measurement company Nielsen - which now translates into more business every year for the company than in the past - is reflected in the 14.8 per cent growth in the latest fiscal year for TCS's communication and media industry vertical, which accounted for US$1.412 billion of its overall revenue.

The TCS strategy for the future is its "Business 4.0" plan to get revenues of over US$5 billion from new age technologies such as automation, cloud and IoT. Business 4.0 seems to have worked for the company, with the potential to drive large-scale transformation across sectors such as retail, travel and hospitality, and utilities.

TCS has written the software that has powered some of the world's biggest corporations such as Citigroup Inc and General Electric. Growth in Europe was primarily led by large deal wins, including a US$690 million, 10-year contract from a unit of British insurer Prudential, Lloyds Banking Group, Rolls Royce Group and Marks and Spencer.

Now that its market cap has hit US$100 billion, doubts have surfaced about whether TCS' growth justifies its valuation or whether its shares are riding on hope rather than substance.

In a note to clients, analysts at Kotak Institutional Equities noted: "TCS requires incremental revenue addition of US$2.1 billion in FY2019 and about 11 per cent CAGR (compound annual growth rate) in incremental revenues over the next seven years to justify the price. We like the business model of TCS but struggle to justify valuations."

EXPENSIVE VALUATIONS

In FY2018, the company added US$1.5 billion in revenues. TCS stock now trades at 22.94 times one-year forward price-to-earnings (PE) while Infosys trades at 17.16 times of one-year PE. Nomura finds valuations of TCS to be expensive at 20 times projected fiscal 2020 earnings and sees risk to street expectations of double-digit constant currency revenue growth and flattish margin. The brokerage has a cautious stance on the stock due to sluggishness in large segments, margin pressures and expensive valuations.

Said Credit Suisse in an April 19 note: "TCS continues to execute solidly for a company of its size. Its recent deal wins have also been strong, and it appears to be transitioning to digital services well. However, even with growth acceleration in FY2019, we expect earnings CAGR of around 10-11 per cent."