Friday, March 14, 2014

Tata Consultancy Services - Excellent performance & A Grade moat but slightly rich

BSE: 532540|NSE: TCS|ISIN: INE467B01029

This is the poster boy for the TATA group and the entire country of India - in terms of the scale, growth and return on capital. I have always been curious to know what makes this engine such a superstar company.

1. How big is the moat?

A Grade moat

  • Traditional thinking will tell you that an IT client will move from one provider to another overnight but it seems that TCS is beyond that. They have consistently grown the client base and the revenue. Their revenue from repeat business is 98%+ which is excellent.
  • Scale obviously gives TCS a huge moat in India & globally. By revenue its around the 10 Bil mark making it about the 2nd largest company in the IT services space after IBM and parallel to accenture - not including the Microsoft consulting division.
  • Between the largest players shifting is probably possible and the space is likely to become more competitive.
  • Margins for TCS are larger than Accenture, EMC and IBM which are other IT services companies in its league globally - probably because of its being headquartered in low cost India.
  • Brand: Global footprint has been established and now the company is reporting good numbers on diversity and global presence. They will have to shed the low cost brand to being a global high quality player brand rapidly.
  • Performance during recessions - during recessions the company has been able to grow its revenue on the back to outsourcing from clients to reduce costs. So far the strategy has worked out.
  • Moat is A grade because the company does not have a proprietary product and can be replaced with IBM or Accenture or Infosys or Wipro or others by customers.

2. Risks

  • Size has become large and finding large growth opportunities will be difficult
  • Talent turnover is a huge issue but the safeguards in place are good too
  • Protectionism in the US
  • High exposure to banking and financial services - is a double edged sword - slowdown risk but increased regulation means more business for TCS
  • High cash on balance sheet might be used to make high value acquisitions - the TATA group has fallen for this before - where it worked out for TATA motors but didn't so much for TATA steel
  • Another double edged sword is the exports angle - FX exposure

3. Financials

We are basically trying to see if the financials are presenting an accurate picture of reality and if that reality shows that this is a great business.
  • Very consistently high ROE - at 36% or so
  • No debt
  • Cash Flow from Operations is lagging net income as debtors rise when there is revenue growth. High debtors is a concern here as they stand at 22% of annual revenues which indicates a 2.5 months payment cycle which is not a very comfortable position to be in. Also debtors are 36% of equity and 44% of invested capital. 
  • Un-billed revenue - there is revenue that has been recognized but not billed capitalized on the balance sheet to the tune of 3000 Crores+. This could be a source of risk if customers end up not paying for it.
  • No inventory to really talk about
  • Over a billion dollars of cash on balance sheet
  • Loans and advances to related parties are not large but don't sound befitting to the reputation of the TATA group.
  • 35% to 50% of the earnings have been paid out as dividends
  • Overall other than a few small issues financials look great.

4. Soft Factors

  • Promoter shareholding has been around 73% for a while
  • FIIs hold 16% of the stock so volatility is to be expected
  • Sources of growth - given the size of this company growth has to slow down at some point. So far they have been able to defy gravity. 
  • The stock is the largest component of the Sensex and will probably be highly correlated with the Index. 

5. Pricing

This is a tricky one. The moat is A (not A+) but the management performance is stellar. Currently trading at 19.5 times Dec 2013 quarter annualized and 24.1 times TTM. Price to book for such a high ROE business is not relevant. The question here is that if we assume that after the growth abates this stock will trade at around 10 times earnings it will have growth at 30% per year for 8 years to give you a net 20% return with a final revenue almost 2 times that of IBM. If the final P/E is 15 it would give you a 20% CAGR with 3 years of 30% growth and a revenue number about half that of IBM. The margin of safety is low so I would hold at this price and be buying around 17 times earnings.

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