BPO is a key differentiator of sustained market leadership: Busi-ness process outsour- cing (BPO) contributed nearly 12% of revenue for Tata Consultancy Services (TCS) in FY15. TCS is the Indian largest vendor in this segment, though revenue base is small at $1.8 bn out of a forecast market size of $192 bn by 2018. We expect TCS’ strong competitive position in this segment will help keep its revenue growth faster than the industry average. BPO lends itself well to digital services adoption, with greater uptake of as-a-Service outsourcing models as well as process automation, offering TCS the potential for differentiation and sustained market leadership.
While the growth opportunity in infrastructure services is well understood, with many vendors aggressively pursuing market share, the BPO opportunity is currently under-appreciated.
At $1.8 bn in revenue, TCS’s BPO segment is now nearly the same size as that of Genpact, and is nearly three times the size of its nearest Indian competitor. This segment grew at a 20% CAGR (compound annual growth rate) in FY10-15, despite the slowdown in the UK-based subsidiary Diligenta in FY14-15. The company sees BPO as a significant growth opportunity in the future, given that large IT users are increasingly looking to outsource business processes other than support functions like HR, payroll and administration. According to Gartner data, BPO outsourcing is expected to grow at a 6% CAGR to $192 bn in 2018, outpacing other services that are expected to grow at a 3.5% CAGR in 2013- 2018.
BPO also lends itself well to robotic process automation, allowing service providers to offer platform-based solutions that can dramatically reduce reliance on headcount. The company currently reports over $500m from its platform-based BPO initiatives. The company can, in theory, grow BPO revenue from new digital business models faster than it cannibalises its legacy base ($1.3 bn compared with more than $9 bn in applications). This should make the company more aggressive in selling BPO deals on new outsourcing models such as BPaaS (Business Process as a Service) and hosted solutions.
Incumbency could delay changes to business model: TCS expects two trends to impact the IT services sector in the next few years: (i) mass adoption of digital services, and (ii) continued efficiency initiatives in large IT organisations driving increased automation of business processes. We believe TCS has the technical capabilities to offer solutions that address both trends. However, we expect the company could face the classic incumbent’s dilemma of trying to prevent legacy revenue erosion by selectively moving to digital outsourcing models.
TCS’s key concern as it moves into the digital era is likely to be the cannibalisation of its large installed base in its applications business. At over $9 bn in revenue at present, a sharp slowdown in revenue growth in this segment could impact overall revenue growth.
High consensus expectations to impede stock upsides: We expect TCS to sustain strong near-term revenue growth (we assume constant currency growth of over 13%) and outpace its India-listed peers in FY16. We expect Ebit (earnings before interest and taxes) margins to remain stable at 26-28% in FY16. Our medium-term estimates factor in 13.9% earnings growth in FY15-18, versus consensus expectations of 16.2%. Valuations at current levels offer limited room for execution errors. We expect this to cap stock-price upsides.
Maintain Neutral rating and R2,725 price target: We expect market leadership in growth segments to keep earnings momentum above the industry average. We see little upside to TCS’ stock price as we expect limited triggers to earnings other than rupee depreciation. Our R2,725 price target is based on 20.2x FY17e PE (price-to-earnings ratio).
