INFOSYS
Infosys reported a solid start to the fiscal year, with good operational execution across the business. Constant-currency revenue growth was in line with our expectations, operating margins were robust despite headwinds, utilization was the highest in recent record, and revenue productivity per employee improved. With management happy with its first-quarter performance, it reiterated its full-year constant-currency revenue guidance of 6.5% to 8.5% and maintained its operating margin outlook of 23% to 25%. Given the quarter, our $17.70 FVE remains unchanged (although we update our FVE to Rs 1,140 from Rs 1,177 based on an updated INR/USD rate) and we uphold our narrow economic moat rating. With Infosys trading at a 12% discount to our fair value estimate, we continue to think the company offers IT-focused investors rare value.
For the quarter, reported revenue increased 6.0% year over year to $2.65 billion (rose 6.3% in constant-currency terms). In Indian rupee terms, revenue grew by 1.8% year over year and was affected by an appreciation in the rupee against the U.S. dollar. The quarter was characterized by broad-based growth across both industries and geographies. Importantly, Infosys is expecting an improvement in its financial-services business (about 27% of group revenue) in the second half of the year as its sees a better macro picture for that industry, which is also corroborated by current client discussions. As a result, we expect a slightly improved performance from the business later in the fiscal year as certain discretionary spending comes back.
Fair Value Estimate, or FVE
Given Infosys’ first quarter of fiscal 2018, our $17.70 FVE remains unchanged (although we update our FVE to Rs 1,140 from Rs 1,177 based on an updated INR/USD rate). Our FVE implies forward fiscal-year price/earnings of 17.5 times, an enterprise value/EBITDA of 11.6 times, and a free cash flow yield of 5.1%. We forecast a five-year revenue compound annual growth rate of 9.2% and expect a broad-based contribution from the company's four major industry segments. We think the firm will actively pursue top-line growth and use its significant financial flexibility to achieve this.
Infosys is targeting larger outsourcing deals and has hired a raft of new salespeople to assist with these endeavors (the company added five $100 million clients in fiscal 2017). In addition, with clients increasingly investing in compliance, infrastructure modernization, digital transformation, analytics and cloud, and cyber security, Infosys has established the Center of Innovation for Tomorrow's Enterprise to help develop relevant next-generation products and services. Furthermore, the acquisition of Lodestone signifies a bigger focus on European growth, and we think the firm will attract more business from this region.
Operating margins are forecast to remain around the mid-20s in the short term, and going forward, we think margins will marginally improve because of cost reduction, process optimization initiatives, and significant emphasis on automation. Our discounted cash flow model assumes a return on invested capital that comfortably surpasses the company's 10.5% weighted average cost of capital.
TATA CONSULTANCY SERVICES (TCS)
In terms of financial metrics, TCS reported a rather lackluster start to fiscal 2018. While the company noted a good number of new signings and increasing customer penetration through spending share improvements in the first quarter, overall revenue growth was soft and operating margins were below our expectations. A sharp appreciation in the rupee versus the U.S. dollar was a headwind to TCS’ reported figures, while the quarter also included wage increases. We expect continued momentum in deal signings and strong ongoing demand for digital services should lead to better financial performance in the second half. Even so, we have slightly reduced our short-term top-line growth outlook for the firm and have reduced our fair value estimate to Rs 2,625 per share from Rs 2,725. We maintain our narrow economic moat rating and think the company remains a leading, high-quality IT services vendor. However, with TCS trading in 3-star territory, we would suggest a wider margin of safety before investing in this high-risk stock.
For the first quarter, revenue rose 1.0% year over year to Rs 296 billion (5.2% year over year to $4.6 billion). Notably, TCS’ digital revenue grew 26.0% year over year to Rs 56 billion, or 18.9% of total revenue, indicating the importance of this high-growth business to the future of TCS. With the company conducting a reorganization of its service lines and creating a new organization--the business and technology services group--its go-to-market initiatives are being fashioned to take advantage of high-growth digital spending. Most industries posted solid sequential revenue growth in the quarter, although the important banking, financial services, and insurance and retail segments remained muted as a result of industry-specific issues.
Moat
TCS has a narrow economic moat as 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 2017, TCS had expanded its $1 million-plus client base to more than 1,900 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, or FVE
We have slightly reduced our short-term top-line growth outlook for TCS and have reduced our FVE to Rs 2,625 per share from Rs 2,725. Our FVE implies forward fiscal-year adjusted price/earnings of 19.1 times, an enterprise value/adjusted EBITDA of 14 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 damp TCS’ growth rate. We forecast low teens revenue growth for TCS 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 and believe it will be able to offset commodification 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.
WIPRO
Wipro reported a good start to the fiscal year with revenue outperforming expectations. IT services sales for the quarter were $1.972 billion (ahead of management’s guidance of $1.915 billion-$1.955 billion) and were driven by broad-based demand across industries. However, management did note continued weakness in its healthcare and communications practices that remain in their “uncertain zone” over the short term. Like its peers, Wipro is seeing good demand for its digital transformation business (now constitutes 22.5% of its revenue) and, also significantly, is experiencing good demand for its consulting services. We think these two points are encouraging as Wipro adapts its services portfolio to the new ways of working, which requires new skills, technology, and a greater ability to provide localized hands-on consulting expertise. Given the quarter, we reiterate our Rs 325 FVE ($5.00) and narrow economic moat rating. With the INR-listed shares trading at a moderate discount to our fair value estimate, we’d recommend them to IT-focused investors (we don’t recommend the U.S.-listed shares due to the ADR premium baked into the price).
For the quarter, IT services revenue grew 2.1% year over year to $1.972 billion (increased 3.4% in constant currency). Notably, the firm is seeing a strong pipeline of business in its important banking and financial services offerings (Finance Solutions make up about 26% of group revenue) and a return to positive momentum for its Energy, Natural Resources, and Utilities business that has experienced poor macroeconomic conditions in recent history. Driving the performance is the company’s digital practice, with revenue up 3% sequentially during the quarter.
Fair Value Estimate, or FVE
After Wipro issued bonus equity shares at a rate of 1:1, we have halved our FVE to Rs 325 from Rs 650 (we reduce our U.S. dollar fair value of $10 to $5). Our updated financial model implies forward fiscal-year price/earnings of 18 times, enterprise value/adjusted EBITDA of 12 times, and a free cash flow yield of 5.5%. We expect Wipro to increase its revenue around 7.6% per year (in Indian rupee terms) over the next five years as it remains focused on top-line growth. We think the firm will supplement its organic growth in core markets such as energy, finance, manufacturing, and healthcare with acquisitions that enhance its industry expertise, skill sets, and global presence.
In terms of geographies, the European market is an obvious growth opportunity for Wipro, given the region's increasing willingness to adopt an outsourcing business model and an underpenetrated marketplace. We believe the firm will seek to increase its presence in Europe, and we expect it to use mergers and acquisitions to achieve this. We forecast a modest improvement in operating margins over the next five years (an approximate 200-250 basis-point improvement) after heightened reinvestment and restructuring abates. Greater focus on automation, process simplification, workforce utilization, and better acquisition integration is expected to help counter yearly wage inflation and reinvestment requirements too.
