Economic Moat: Narrow
The moat is a result of meaningful switching costs. The company is focused on establishing and fostering deep customer relationships that provide it with long-dated and consistent business. Once established within a client, TCS’ end-to-end services portfolio and ubiquitous global presence allow it to cross-sell and develop deeper roots with clients. At the end of fiscal 2016, TCS had expanded its $1 million-plus client base to more than 1,800 from roughly 360 in 2005, which demonstrates its ability to attract and expand within large clients. In addition, we estimate group revenue from repeat business to be in the high 90s. This high rate of repeat business exemplifies clients’ reluctance to switch between IT service vendors as established end-to-end vendors become more intertwined in its customers' central IT operations. Still, we are reluctant to assign TCS a wide economic moat, given the firm’s use of an industrial model that leverages a largely junior workforce, which often relies on scale to be competitive.
In addition, TCS lacks a strong consulting practice and faces competitive threats in service areas such as business process outsourcing and application development and maintenance.
Fair Value Estimate: Rs 2,725
After rolling our financial model forward one year, we maintain our FVE. It implies forward fiscal-year adjusted price/earnings of 18.7 times, an enterprise value/adjusted EBITDA of 13.8 times, and a free cash flow yield of 5%. Barring any momentous acquisitions, we think the firm’s top-line growth will be less prolific than its historical average, owing to the increasing maturity of the North American and European outsourcing markets (excluding continental Europe). In addition, we believe the law of larger numbers and tougher comparable growth rates will dampen TCS’ forward growth rate. We forecast low-teen revenue growth for the company over our explicit forecast period, which is still impressive for such a large company. TCS has a targeted operating margin band of roughly 26%-28%. We assume the firm will be able to manage this margin level going forward and believe it will be able to offset commoditization of legacy services and pricing pressure with services delivery such as as-a-service and automation with a greater focus on higher margin digital services.
Our discounted cash flow model assumes that TCS will generate a return on invested capital that comfortably covers its 10.5% weighted average cost of capital.
Stewardship of shareholder capital: Exemplary
TCS was previously headed by CEO and managing director Natarajan Chandrasekaran, who had been instrumental in streamlining the firm and creating more agile business segments that were focused on specific verticals and geographies. However, Natarajan Chandrasekaran was appointed as Tata Sons new chairman. Nevertheless, we think it will be business as usual for TCS following Chandra’s departure on February 21, 2017, and maintain our Exemplary stewardship rating.
Rajesh Gopinathan, who was previously TCS’ CFO, takes over as CEO and plans to adhere to the firm’s already established vision and roadmap, saying, “We are not expecting any major changes in TCS. We know what we are up to. We know the direction that we're going in, and we intend to continue with that.”
Approximately three quarters of TCS is held by Tata Sons. This concentrated ownership structure sidelines all other investors. However, we think TCS’ market positioning and impressive financial performance signify the board's and management’s commitment to maximizing shareholder returns. In fact, since 2005, TCS has increased revenue at a mid to low-20s CAGR. In addition, over the same period, the dividend has increased substantially and the firm has raised its payout ratio (excluding special dividends) to around 40% from the mid 20% range.TCS is focused on expanding its geographic presence and reducing its concentration in North America and the United Kingdom. The firm has made further inroads into the underpenetrated continental European market via its acquisition of Alti, which is regarded as a premier systems integrator in France across various industries. In addition, TCS wishes to expand into higher-growth markets, such as Asia-Pacific, Latin America, and the Middle East and Africa. The revenue contribution from these markets has more than doubled over the past decade to approximately 18%. Furthermore, management has targeted newer service lines (about 33% of group revenue) in order to reduce its reliance on application development and maintenance work and increased intellectual property development associated with social, mobile, analytic, cloud, and robotic technologies.
TCS’ primary risk is the highly competitive IT services industry. The firm must continually reinvest in new intellectual property and deliver differentiated services, or face commodification and competitive displacement. Furthermore, potentially restrictive immigration reform could reduce TCS’ ability to use offshore leverage for onshore work, which would increase staff costs. With TCS generating the majority of its revenue from offshore markets, fluctuations in the rupee can have a noticeable impact on financial results. Macroeconomic weakness in the North American market (roughly 53%-55% of group revenue) or the banking, financial services, and insurance industry (approximately 40%-41% of group revenue) will have a substantial impact on the company’s overall results.