Results of Tata Consultancy Services Ltd (TCS) are above our expectations. The company’s dollar revenue grew 6.3% quarter-on-quarter (q-o-q) against the expectation of 3.9%. Its earnings before interest, tax, depreciation and amortization (Ebitda) margins are up 100 basis points (bps) against our estimate of 50 bps decline on higher volumes, better utilization and selling, general and administrative expense (SGA) leverage, despite the rupee’s appreciation of 3.2%.
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TCS posted a volume growth of 6.6% during the quarter, which is the highest over the past six quarters. Service lines grew sequentially, with consulting and assurance services growing by 40% and 13%, respectively. Such broad based growth was last seen eight quarters ago in the third quarter of FY08.
Even geographical growth was spread out with every area posting q-o-q growth. Ebitda margins reached a four-year high of 29.7% despite the rupee’s appreciation (-167 bps) due to productivity improvements (+217 bps), lower SGA (+36 bps) and offshoring (+17 bps).
TCS impressed with improved utilization during the quarter. Utilization including trainees rose by 360 bps q-o-q, to touch 77.2% from 69.4% in the fourth quarter of FY09. TCS posted three consecutive quarters of utilization improvement. Utilization, excluding trainees, increased 160 bps q-o-q to 81.1%. Excluding trainees, utilization has been relatively stable. Offshoring also marginally improved with 51.3% offshore contribution in revenue against 51.1% in the second quarter of FY10 and the management believes there is room to offshore more.
Demand commentary improved with deal cycles returning to normal. Ten large deals were signed, 20 large deals are in the pipeline and volume outlook is improving across even lagging segments, such as manufacturing, telecom and hi-tech. These three verticals reported sequential growth of 1.4%, 7.2% and 10.7%, respectively, in the third quarter of FY10.
We believe improvement in utilization with high employee additions (12,854 gross and 7,692 net) could indicate improved volume visibility.
While TCS had earlier cautioned about growth in verticals such as manufacturing, telecom and hi-tech, these verticals are now posting improvement.
The company’s management has indicated that wage inflation in FY11 is inevitable without quantifying the magnitude or effect on margins. We are building in 9% offshore and 1% onsite wage inflation in our FY11 estimates, higher than our expectation for Infosys Technologies Ltd due to the lack of mid year wage inflation.
TCS’ results mirrored Infosys’ impressive performance in the third quarter of FY10. However, going forward, we see Infosys having better operational scope, lower wage inflation in FY11, given mid-year wage inflation, greater delta on improvement in discretionary demand, higher dollar revenue compound annual growth rate, or CAGR, (19.6% against 18%) and earnings CAGR (16% against 10%) over FY10-12 on less tax increase affects.
We have upgraded TCS’ earnings per share estimates by 7% in FY11 and 8% in FY12. TCS trades at a price-earnings multiple of 20.2x FY11 estimates and 18.7x FY12 estimates, largely in line with Infosys’ valuation. We maintain a buy recommendation with a target price of Rs805 based on 19x FY12 estimated earnings.
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