Tata Consultancy's fourth-quarter results were mostly in line with our expectations although the firm's revenue performance was slightly above our forecast. After rolling our model forward and modestly adjusting our margin assumptions, we reiterate our fair value estimate of Rs 2,625 and maintain our narrow economic moat rating. Tata Consultancy remains our favored India IT outsourcing vendor from a business-quality perspective, and we believe it is well-positioned to accrue digital workloads from its entrenched client base over the midterm.
The company’s final quarter for the fiscal year illustrated general broad-based health for the IT services industry, with banking, financial services, and insurance, or BFSI, a notable exception. While Tata Consultancy's near-term view of the BFSI sector remains a wait-and-see approach, over the midterm, management remains more confident based on current demand visibility. We think the early demand indicators for BFSI are encouraging and expect the digital transformation agenda of this industry to improve with time. In terms of the broader digital marketplace, digital engagements made up 23.8% of Tata Consultancy's revenue in the fourth quarter, which represented a very strong year-over-year growth rate of 42.8% in constant currency.
We expect the company to aggressively pursue digitally led engagements given the higher-value nature of these contracts. With the company significantly investing in digital and agile training for its employees, this digital focus is adamantly obvious.
Consider Buy: Rs 1,575 / Consider Sell: Rs 4,068
Yesterday, April 24, the stock’s closing price on BSE was Rs 3,385.65.
With the stock appreciating noticeably since the start of the calendar year, we now believe investors should wait for a wider margin of safety before considering it for investment.
Valuation
After rolling our model forward and modestly adjusting our margin assumptions, we reiterate our fair value estimate of Rs 2,625. Our fair value estimate implies forward fiscal-year adjusted price/earnings of 17.6 times, an enterprise value/adjusted EBITDA of 13 times, and a free cash flow yield of 5.3%. 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 high-single-digit 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 over the midterm 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.
Economic 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.
