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October 14, 2015

Idea Of The Week: Tata Consultancy – Valuation Is Key

by Steven Carroll.

One of the last bastions of ‘traditional’ growth in the IT space has been consulting, with Tata Consultancy Services Ltd. (TCS.NS) and its peers managing to eke out respectable gains in recent quarters, despite the challenged market. Based in Mumbai, it’s India’s largest software services exporter.

The continued growth does, however, seem to mask failures against market expectations, with the Asian CIMB bank noting in a recent report that Tata has now missed revenue expectations for five quarters in a row.

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Source: Thomson Reuters Eikon

Adjusting the sails

As the market adjusts to macro headwinds everywhere, we wonder what is the appropriate valuation for the industry and for Tata specifically? Despite the recent misses, StarMine calculates that TCS still has double digit five-year compound EPS growth expectations (11.2%) embedded in the price. One factor in support of this number is recent history: TCS delivered 23.2% over the last five years, against a peer median of 14.6%.

Given the macro challenges mentioned above and the challenging environment for winning new deals cited by sellside analysts, one wonders at the sustainability of the company’s EPS growth and ROE premium. ROE has declined significantly over the last 10 years, and sellside commentary about the tougher pricing environment is rife across recent reports.

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Source: Thomson Reuters Eikon

Yin and yang

We are not in any way talking down the company’s prospects – it is exposed to ongoing technology cycle upgrades and capital spending and has a premium valuation that reflects its strong historic outperformance. The stock also continues to scores well across numerous StarMine factors – with top decile scores for the Analyst Revisions Model (ARM) which measures change in analyst sentiment, another top decile score for Earnings Quality – which decomposes underlying reported earnings, giving more weight to traditionally sustainable (cash flow backed) sources, and it looks excellent from a credit perspective.

The Achilles heel, crucially, appears is in the valuation. Despite revenue misses and declining ROE, the company trades in line with its historic F12M P/E at 19.6x. We would expect that some type of discount to the historic valuation would be likely, given the macro outlook and the slowdown in revenue growth.

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Source: Thomson Reuters Eikon

What’s ahead?

If U.S. and European spending does moderate, there seems little doubt that industry/competitor pricing will becomes more aggressive, further depressing ROE and growth.

In an environment where companies delivering double digit earnings attract a scarcity premium, it pays to be particularly cautious. Growth does not deliver capital growth where expectations are for even stronger growth – so caveat emptor.

TCS has had a phenomenal run in recent years and while its growth spurt may last a while longer – that’s the easy part to forecast – the hard bit is whether the growth it delivers will be enough to sustain the company at near 20 times earnings. That’s less clear cut and likely to be the crux of any investment decision. If it looks like spending may slow next year, then patience may well be strongly rewarded.


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