Improving returns despite pressures; AI at spotlight in IT services companies: IIFL Capital Services

7 Jul 2023 , 10:20 AM

Analysts of IIFL Capital Services analysed the FY23 annual reports of the big-3 IT services companies (TCS/INFO/WPRO), on metrics such as cash conversion, return ratios, cost structures, subsidiaries’ health and deals. Key conclusions: (1) TCS remains the sector leader, with a consistent, profitable and high-return track record over the past 6 years. (2)After demonstrating consistent improvement on most parameters in the prior 5 years, INFO witnessed a pause. (3) Lower growth, payouts and margins dented WPRO’s returns and cashflows. Tough supply-side compressed margins for all 3, but better capital allocation drove higher returns for TCS/INFO. AI came in spotlight in the ARs and companies highlighted their investments and capabilities. Valuation gap among the firms has widened to historical averages after converging to decadal lows in Jan’22. Analysts of IIFL Capital Services prefer INFO and TCS for better ability to navigate macro pressures and maintain REDUCE on WPRO.

Cash generation moderates but still remains healthy; WPRO recovers: 

TCS/INFO registered lower CFO/Ebitda conversion in FY23, with free cashflow generation also normalising back to pre-Covid levels. The driver was primarily the increase in working capital. WPRO witnessed improved cash generation on lower M&A intensity. TCS consistently converts 71-83% of Ebitda-to-OCF, while INFO has steadily improved OCF over the past 5 years but seen a sharp deterioration in FY23. WPRO’s average OCF generation has been volatile. In FY23, receivable days inched higher for INFO and WPRO, while TCS maintained at 6yr-low levels.

Return ratios continue to witness an upward curve – a sign of strong capital allocation: 

Higher asset turnover and equity multiplier (on higher pay-outs) led to higher ROE for TCS/INFO; while WPRO suffered due to a sharp decline in margins and no buybacks in FY23. TCS saw the sharpest increase in ROE (~320bps) followed by INFO (~290bps). WPRO saw a decline by ~440bps. An analysis of the historical ROE trajectory for TCS/INFO reveals 800bps+ improvement in ROE since FY19, as capital allocation towards shareholder pay-outs increased and asset turns rose. ROCE also witnessed the same trend of improvement for TCS and INFO, while it declined for WPRO.

Rising supply-side costs dent margins across the board: 

All 3 companies saw margins fall in FY23, due to rising employee costs across the board. TCS saw headwinds from higher sub-contracting costs too while INFO saw headwinds from higher cost of equipment and software license due to large deal ramp-ups. WPRO has historically relied a lot more on subcontracting to fulfil delivery vs INFO/TCS. However, its sub-contracting expense as a % of sales declined by 100bps in FY23. Over the medium term, sub-contracting expense, cost of equipment and software licenses are likely to be significant margin levers for INFO. WPRO’s margins contracted the most in FY22 on the impact of higher employee expenses, exaggerated by weaker growth. CEO compensations took a breather for the first time in 6 years after witnessing an upward trajectory since FY18, when compared with median remuneration of employees in all the 3 firms. WPRO’s ratio remains the highest among the 3, while that of TCS has consistently remained low.

Subsidiaries’ performance mixed: 

Most of the key subsidiaries of TCS performed well in FY23, including TCS Japan and Diligenta delivering doubledigit growth. Diligenta – the insurance platform saw PAT margins improving in FY23 but still was at 420bps lower vs FY19. Interestingly, INFO’s insurance BPM subsidiary McCamish Systems saw second year of strong momentum, with 21% YoY revenue growth and stable margins since FY19. For WPRO, continued deterioration in Appirio Inc., its salesforce consulting and Cloud implementation subsidiary, is surprising despite a healthy environment WPRO’s largest acquisition Capco and Healthplan saw slower growth YoY; TopCoder saw another year of strong growth at 25% YoY.