Equitymaster Agora Research Private Limited Independent Investment Research 15 May, 2010

Tata Consultancy Services Ltd.

Buy
Market data
Current price Market cap Face value FY10 DPS BSE Code NSE symbol No. of shares Free float 52 week H/L Rs 764 (BSE) Rs 1,484,356 m Rs 1.0 Rs 20.0 532540 TCS 1,957 m 25.9% Rs 844 / 300

Target price: Rs 1,160

Investment Rationale
Valuations remain attractive for long term investors: We had last recommended TCS in October 2009 when the stock was trading at Rs 601. The stock has since then crossed our target of Rs 820. At the current price of Rs 764, it is trading at a multiple of around 14.4 times our estimated FY13 earnings, which we believe makes it an attractive opportunity for long term investors. Given that our last recommendation on the stock was made when the industry was still ambiguous about the nature and pace of recovery, and that the situation has progressively improved since then, we have raised our forward estimates for the company. While TCS posted a topline slightly lower than our FY10 estimates, its bottomline exceeded our estimates by a decent 10%. Our profit estimates for the next two years now stand upgraded by around 4% and 7% respectively. This has subsequently made us revise our target for the stock to Rs 1,160. This implies a point to point return of around 54% from the current levels, or average annual return of nearly 15%. We thus reiterate a Buy on the stock from a 2 to 3 years perspective. Recovery in IT spending taking wings: The recently declared annual results of all the major Indian IT companies testify one fact. That the worst is over for global IT spending. The top honchos of almost all IT majors appear a lot more upbeat and confident of the recovery in IT spending. Though the pre-downturn levels of stupendous growth rates are not expected to arrive sometime soon, significant uptick is being witnessed from the recession levels. More encouraging are the sentiment in the IT markets where the clients have begun to finalise their IT budgets. This brings reasonable visibility in terms of deal pipelines and revenue run rates. Industry verticals like banking & financial services, healthcare and retail and geographies like the US, Continental Europe and Asia Pacific are leading the recovery. Most of the traction is witnessed in the running the business kind of deals i.e., deals which take cost out and bring efficiencies for clients. Large multi-million dollar deals are making a comeback. Even the decision making appears to be picking speed, contract cycles are getting shorter and deals closures are happening. Even discretionary IT spending is improving with clients seeking to transform their business to encash on recovery. Such deals are sporadic and occur in phases. But yes, they are reoccurring. Billing rates are stabalising. Pricing power is expected to return by the second half of FY11. All this bodes well for the Indian IT majors. We believe that TCS with its diversified portfolio stands to gain a lot from this uptick. Recovering in style: Last six quarters have been tough for almost everyone, common people like us, economies, industries and businesses. During the downturn, the going got tough for the Indian
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Rs 100 invested is now worth

500 375 250 125 0 Aug-04 Jan-06 Jul-07 Dec-08 May-10

TCS: Rs 309 Sensex: Rs 333

Stock price Performance

1-Yr 3-Yr 5-Yr TCS 148.2% 6.8% 21.6% Index* 45.5% 7.2% 21.4%

Returns over 1 year are compounded annual averages (CAGR) * BSE Sensex

Shareholding (Mar-2010)
Category Promoters Banks, FIs and MFs FIIs Others Total (%) 74.1 7.9 12.4 5.6 100.0

Report prepared by Equitymaster Agora Research Private Limited. www.equitymaster.com info@equitymaster.com

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IT industry as well. There was a slowdown in IT demand globally. Many clients went bankrupt. The ones that survived reduced their investments in non-core operations like IT. Even in such tough times, TCS kept going. It not only managed to post decent topline and bottomline growth in the darkest hours of the crisis (during FY09), it also topped that growth with a better performance in FY10. It bettered its performance every quarter, posting an overall industry leading growth during FY10. Recovering in style, its topline and bottomline surged by 8% YoY and 33% YoY during FY10. This was on back of 17% jump in annual volumes. During FY10, TCS saw a significant increase in revenue concentration from its top clients. Now its top, top 5 and top 10 clients contribute 8%, 22%, and 30% respectively to its topline as compared to 5%, 19% and 27% in FY09. The company added 127 new clients during FY10, taking the total number of active clients to 1,034. All this provides it with a strong deal pipeline. For instance, during 4QFY10 itself, it won 10 large deals including a US$ 500 m deal from the UK government. Its deal pipeline is spread across verticals and geographies. Government focus pays dividends: Governments round the globe are waking up to the fact that IT can help them become more efficient and lean in processes. Indian government is no different. The following table encapsulates major reform projects being undertaken by the government of India along with estimated spending on the same. Indian government spent around US$ 3 bn on IT in 2009. It is pegged to reach US$ 4 bn in FY11. It means that the technology spending will be around 3% of the government budget. Nasscom has projected governments IT spending to touch US$ 9 bn in couple of years.

from all round the world. The UK government has an annual IT budget of 8 bn, 65% of which is expected to be outsourced. Similar multimillion dollar deals are emanating from the Nordic countries as well as Middle East and Asia Pacific. IT mega-vendors are vying with 37 global players for the UK governments IT project worth over Rs 220 bn. Indian companies are expected to mop up at least 5-10% of this project. TCS is aggressively pursuing this sea of opportunities. We believe that the company with its credibility and excellent track record is wellpoised to tap into this opportunity. It already generates 9% of its revenues from India, most of which comes from government assignments. In India, it has already bagged critical government projects like e-Passport (Rs 1 bn) and APDRP or Accelerated Power Development Reform Project (Rs 7.7 bn for states like MP, Gujarat & West Bengal). The wins are not restricted to India alone. TCS bagged several critical projects from government agencies and PSUs of countries like the UK, China and Malaysia. Margins at all time high: At the end of FY10, TCS margins stood at their all time historic high. Despite significant currency headwinds, its operating and net profit margins stood at 29% and 23% respectively (second only to Infosys).

30
Margins, %

Margins at all time high

25 20 EBDITA margin 15 FY06 FY07 FY08 FY09 FY10 Net margin

Opportunities in e-governance
Marquee government projects APDRP N-eGP Unique Identity (UIDAI) Crime and Criminal Tracking Estimated spending (In Rs bn) 200 230 270 20

Source: Company, Equitymaster Research

Source: igovernment.in, Economic Times Thats not all. Such government deals are appearing
Tata Consultancy Services Ltd.

TCS has pulled all its margin levers over the last six quarters or so. The company lowered its sales, general and administrative expenditure (49% of total cost) by as much as 3% during FY10. Also employee cost saw a benign increase of 10% in FY10. The company is also striving to increase its operational efficiencies along with organisation-wide curtailment of discretionary spending.
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Furthermore, the company is increasing the contribution of offshore revenues in its total business (see chart), which will be margin accretive. The company is also focusing on fixed price projects, which will help it garner the benefits of increasing efficiencies while providing the client with certainty of outcome. We believe these measures adopted will help the company maintain its margin going forward or at worst pare any major pressure on margins posed by currency volatility and wage inflation.

Deeper recession can impact business: While IT demand is seeing some recovery from the US, Latin America, Asia Pacific and Middle East, Europe remains a big question mark. The Euro zone which already lagged rest of the world in recovery is still imperiled by economic weakness in countries like Greece, Portugal and Spain. The economic uncertainty in Europe is a cause of concern as TCS derives around 27% of its revenues from this region. Even the US recovery can get jolted by the ongoing row over Goldman Sachs and other big financial institutions. These events also have a direct impact on foreign exchange rate which is a decisive variable for IT industry. Also industries like manufacturing, telecom and hitech are still writhing under stress round the world. So the companys short-term and medium term prospects are dependent on the sustainability of global recovery.

70 60
% share

Reducing onsite revenue share

Onsite Offshore

50 40 30 1Q08 3Q08 1Q09 3Q09 1Q10 3Q10

Source: Company, Equitymaster Research

Background
TCS is the largest software services company in Asia, ahead of other Indian software service providers like Infosys and Wipro. The company has a wide range of offerings and caters to industries like banking, insurance and financial services, manufacturing, telecom, and retail. The company was one of the pioneers of the much-acclaimed global delivery model and the same has helped it to post good results in the past. Its revenues and profits have grown at average annual rates of 23% and 25% respectively over the period FY06 to FY10. The company has the largest manpower base in the Indian software sector, and employs over 160,400 professionals. This highlights the fact that it has managed to build significant scale in its business. Also, with a high onsite presence, TCS works closely with its clients and this has helped the company in building up long-term relationships with some key customers.

Investment Concerns
Volatile currency: The Indian rupee has been very volatile against the US dollar over the past few years. In 2007, rupee touched a high of nearly 38.5 against the dollar but after that is started depreciating and hit a low of nearly 51 in March 2009. Since then, the rupee has again appreciated by around 8%. This kind of movement of the rupee has added to volatility in IT services exporters' revenues. In addition to that, the fact that many companies enter into hedges also adds to their risk on the profit and loss account and balance sheet.

55 50 45

Rupee Vs US Dollar

Industry Prospects
The last couple of quarters have been encouraging for the Indian IT industry. During the downturn, Indian IT got hit by cost-cutting practiced by their clients. Nevertheless, things appear to be on an upswing now. Global IT spending is expected to increase by 3.3% during this year after witnessing a 3.6% decline in 2009. IT services spending in particular is expected to rebound by a decent 4.5%
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40
35 Jan-07 Feb-08 Mar-09 Apr-10

Source: Trend

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to reach US$ 816 bn by the end of 2010. This growth will bode well for the Indian IT industry as well. In fact, the industry regulator Nasscom also sees an uptick in IT demand and expects the industry to register a double-digit growth during the current fiscal (FY11). Though the Indian IT industry might take some time to return to pre-downturn growth rates, it has a strong chance to grow at an average rate of 15-20% for the next 5-10 years.

sales. Given this large size of operations, we assign a low-risk rating of 10 to the stock. Operating margin: Operating margin is a measurement of what proportion of a company's revenue is left over after paying for variable costs of production such as raw materials, wages, and sales and marketing costs. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt. The higher the margin, the better it is for the company as it indicates its operating efficiency. TCS average operating margins for the past five years have been 27% and we expect the same to be average 27% over the next three years. As such, we assign a low risk rating of 8 to the stock on this parameter. Long term EPS growth: TCS net profits grew at a compounded rate of around 25% during the period FY06-FY10. Going forward, we believe that the company has the potential to achieve around 14% growth over the next two to three years and hence, the rating assigned is 6. Return on capital invested (ROIC): ROIC is an important tool to assess a company's potential to be a quality investment by determining how well the management is able to allocate capital into its operations for future growth. A ROIC of above 15% is considered decent for companies that are in an expansionary phase. Considering TCS last five years average ROIC of around 47%, we have assigned a low-risk rating of 8 to the stock on this parameter. Dividend history: A stable dividend history inspires confidence in the management's intentions of rewarding shareholders. Given the fact that TCS was listed only in August 2004, we have taken history between FY05 and FY10 for the purpose of calculating the payout ratio. TCS average payout ratio was a healthy 28% in these six fiscals. Thus, we have assigned a low-risk rating of 8. Promoter holding: A larger share of promoter holding indicates the confidence of the people who run it. We believe that a greater than 40% promoter holding indicates safety for retail investors. At the end of March 2010, the promoter holding in TCS stood at 74%, which is healthy. We have assigned a low-risk rating of 10 to the stock. FII holding: We believe that FII holding of greater than 25% can lead to high volatility in the stock price. FII holding in TCS at the end of March 2010
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Key management personnel

N. Chandrasekaran is the Chief Executive Officer and Managing Director of TCS. He took over as CEO in October 2009. Prior to this position, he was Chief Operating Officer and Executive Director. He joined TCS in 1987 and has over 20 years of experience in the software industry and business operations. He has a Bachelor's degree in Applied Sciences and a Master's Degree in Computer Applications. In April 2006, he was named by Consulting Magazine, US, as one of the top 25 most influential consultants in the world. S. Mahalingam, CFO & Executive Director, joined TCS in 1970 and has over 35 years of experience in the software industry. He holds a Bachelor's degree in Commerce (Honours) and is a qualified Chartered Accountant. He was conferred the 'CFO of the Year' award 2006 by IMA, India. Risk Analysis
Please see Risk Matrix table on page 6 of this report

Sector: The Indian software industry has maintained its strong growth momentum over the past few years, with the top-tier players growing at a rate of over 25% annually. However, amidst economic slowdown, increasing competition from MNC software companies and volatile currency movement are the major headwinds that top-tier Indian software incumbents are facing. Based on these factors, we have assigned the sector a medium risk rating. Company standing: TCS has a long operational history and strong pedigree. The founder members of the company are some of the people who have played key role in shaping the Indian IT industry. The company is well entrenched in software service segment. We have assigned a strong rating to the company. Sales: TCS generated average revenues to the tune of nearly US$ 5.1 bn over the last five years. Further, in the latest completed financial year (FY10), the company earned over US$ 6.3 bn in

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stood at around 12%, which is comfortably within the limits. Therefore, the rating assigned is 7. Liquidity: The average daily trading volumes in TCS stock over the past 52-weeks have been high around 436,760 shares. This indicates the high level of liquidity in the stock. The rating assigned is 7. Current ratio: TCS' average current ratio during the period FY06 to FY10 has been 2.1 times. This indicates that the company has a reasonably comfortable ability to pay off its short-term obligations. We assign a medium-risk rating of 6. Debt to equity ratio: A highly leveraged business is the first to get hit during times of economic downturn, as companies have to consistently pay interest costs, despite lower profitability. We believe that a debt to equity ratio of greater than 1 is a highrisk proposition. Considering, TCS' average debt to equity ratio of almost nil over the past five fiscals, we have assigned a low-risk rating of 10 to the stock. Interest coverage ratio: It is used to determine how comfortably a company is placed in terms of payment of interest on outstanding debt. The interest coverage ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expense for a given period. The lower the ratio, the greater are the risks. Given TCS almost zero-debt status, there is almost no interest expense that the company incurs. We have thus accorded a low risk rating of 10 to the stock on this parameter.

P/E Ratio: The P/E ratio (price-to-earnings ratio) of a stock is a measure of the price paid for a share relative to the per share income or profit earned by the company. This is one of the important metrics to judge the attractiveness of a stock, and thus gets the highest weightage in our risk matrix. TCS P/E on its earnings of the trailing 12-months stands at 22 times. We have assigned a rating of 3 to the stock on this parameter. Considering the above parameters, the total ranking assigned to the company is 93, that on a weighted basis stands at 7.2. This makes the stock a low-risk investment from a long-term perspective. Valuations We had last recommended TCS in October 2009 when the stock was trading at Rs 601. The stock has since then crossed our target of Rs 820. At the current priced of Rs 764, it is trading at a multiple of around 14.4 times our estimated FY13 earnings, which we believe makes it an attractive opportunity for long term investors. Given that our last recommendation on the stock was made when the industry was still ambiguous about the nature and pace of recovery, and that the situation has progressively improved since then, we have raised our forward estimates for the company. While the company posted a topline slightly lower than our FY10 estimates, its bottomline exceeded our estimates by a decent 10%. Our profit estimates for the next two years now stand upgraded by around 4% and 7% respectively. This has subsequently made us revise our target for the stock to Rs 1,160. This implies a point to point return of around 54% from the current levels, or average annual return of nearly 15%. We thus reiterate a Buy on the stock from a 2 to 3 years perspective.

Valuations
(Rs m) Net sales (Rs m) Net profit (Rs m) No. of shares (m) Diluted EPS (Rs) Price to earnings (x) Price to sales (x) Price to book value (x) FY10 300,289 70,006 1,957.2 35.8 21.4 5.0 8.1 FY11E 340,573 74,972 1,957.2 38.3 19.9 4.4 7.1 FY12E 404,690 87,200 1,957.2 44.6 17.1 3.7 6.2 FY13E 486,009 103,751 1,957.2 53.0 14.4 3.1 5.4

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Risk Matrix
Rating Sector risk Company's standing Performance parameters Sales Operating margins Long term EPS growth Return on invested capital Technical parameters Dividend payout Promoter holding FII holding Liquidity Safety parameters Current ratio Debt to equity ratio Interest coverage ratio P/E ratio Final Rating** Weightage* (A) 5.0% 5.0% 10.0% 10.0% 5.0% 10.0% 5.0% 10.0% 5.0% 10.0% 5.0% 20.0% Rating# (B) Medium Strong 10 8 6 8 8 10 7 7 6 10 10 3 93 Rating accorded Weighted (A*B) NA NA 0.5 0.4 0.6 0.8 0.4 1.0 0.4 0.7 0.3 1.0 0.5 0.6 7.2

# Rating has been assigned on the basis of the company's performance over the past five years and expected performance over the next 3 to 5 years. Rating is on a scale of 1 to 10, with 1 indicating highest risk and 10 indicating lowest risk. * 'Weightage' indicates the relative importance in percentage terms of the parameter. For instance, for an investor, given all the performance metrics, Return on Equity should be the foremost criteria for buying/not buying stocks. ** The final rating has been arrived at by multiplying the rating/points given on each parameter with the respective weightage

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Financials at a glance
(Rs m) Sales Sales growth (%) Operating profit Operating profit margin (%) Net profit Net profit margin (%) Balance Sheet Fixed assets Current assets Other assets Investments Total assets Current liabilities Net worth Total debt Other liabilities Total liabilities FY10 300,289 8.0% 86,945 29.0% 70,006 23.3% FY11E 340,573 13.4% 95,045 27.9% 74,972 22.0% FY12E 404,690 18.8% 111,458 27.5% 87,200 21.5% FY13E 486,009 20.1% 132,058 27.2% 103,751 21.3%

45,394 1 57,889 33,839 36,821 273,942 83,939 184,667 1,033 4,304 273,942

58,643 181,938 30,623 42,344 313,548 96,601 210,616 981 5,350 313,548

60,646 226,583 27,728 48,697 363,654 115,370 240,798 932 6,554 363,654

63,588 280,079 25,124 56,000 424,790 139,260 276,708 885 7,937 424,790

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