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TCS: Stringing ‘Pearls’! - Views on News from Equitymaster
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TCS: Stringing ‘Pearls’!
Jan 12, 2006

Introduction to results
TCS has announced its results for the third quarter ended December 2005. Strong volume-led growth, aided by strong ramp ups from clients acquired earlier and key order wins has helped the company register a double-digit topline growth during 3QFY06. Due to expenses growing at about the same pace as revenues, margins were flat. However, due to a negative other income component, as was the case with Infosys as well, the sequential net profit growth, although good, trailed the topline growth. Since the year-to-date (9mFY06) figures are not available from the company, we have not included these in our analysis.

Financial performance (US GAAP Consolidated): A snapshot
(Rs m) 2QFY06 3QFY06 Change
Sales 29,513 32,646 10.6%
Expenditure 21,513 23,831 10.8%
Operating profit (EBIT)* 8,001 8,815 10.2%
Operating profit margin (%) 27.1% 27.0%  
Other income 90 (197) -318.7%
Profit before tax 8,091 8,618 6.5%
Equity in net earnings of affiliates 3 4 34.9%
Minority interest (43) (48)  
Tax 1,317 1,254 -4.7%
Profit after tax/(loss) 6,734 7,319 8.7%
Net profit margin (%) 22.8% 22.4%  
No. of shares 480.1 480.1  
Diluted earnings per share** (Rs)   61.0  
P/E ratio (x)***   31.0  
* Including depreciation   ** Annualised   *** P/E ratio calculated on a trailing 12-month basis

What is the company’s business?
TCS is the largest software company in Asia. It has a wide range of offerings and caters to industries like BFSI, manufacturing, telecom, and retail. The company was one of the pioneers of the much-acclaimed global delivery model and has the largest employee base in the Indian software sector. TCS has grown revenues and profits from FY01 to FY05 at compounded rates of 33.6% and 25.8% respectively.

What has driven performance in 3QFY06?
Volume-led growth again: In 3QFY06, TCS registered a strong 10.6% sequential growth in consolidated revenues. As has been the case over the past few quarters with most top-tier software companies, the growth was primarily volume-led, aided by strong ramp ups from earlier client wins. The past few months have proved to be fairly active for TCS, particularly in terms of making moves in order to achieve its stated long-term goal of hitting US$ 10 bn in revenues by FY10. In line with its inorganic growth strategy, TCS acquired an Australian company called FNS, which is a provider of core banking solutions. The company also acquired a Chilean BPO firm called Comicrom, which is the leader in the Chilean insurance, pensions and banking BPO market. The revenue contribution from this company was US$ 6 m in 3QFY06. The highlight of the quarter was, undoubtedly, the winning of the US$ 847 m Pearl deal, the largest-ever deal won by any Indian software or BPO company. TCS took over 950 employees under the deal, revenues from which will start to flow through in 4QFY06.

As regards geographical spread, TCS increased the proportion of European revenues to the total, reflecting good traction in that geography, a major highlight for which was the ABN Amro deal. European revenues grew at a robust sequential rate of 17.7%. As regards service lines, TCS’ saw strong sequential growth in both application development and maintenance (ADM) as well as enterprise solutions, which grew at rates of 12.0% and 11.6% respectively. TCS has the largest enterprise solutions practice among all the major software companies and this high-end business now contributes to nearly a fourth of revenues. This revenue performance by TCS has been the highest in the past five quarters.

GE, the largest customer of the company, contributed to 11.4% of TCS’ consolidated international revenues on a trailing 12-month basis in 3QFY06, compared to 12.3% in the previous quarter. This decline in contribution is a clear reflection of the success of TCS’ conscious policy of derisking its revenue mix. Going forward, the contribution of GE to revenues is expected to decrease further, as it is growing at a slower rate compared to TCS’ overall revenues. The active client base currently stands at 677 with the company adding a gross of 83 (74 in 2QFY06) and a net of 53 clients in this quarter itself.

The company’s ‘select’ growth engines, like platform-based BPO, enterprise solutions, infrastructure services, engineering and industrial services (EIS) and consulting continued to witness healthy client additions. The BPO business in particular, where TCS has been accused of being a laggard in the past, now has 50 active clients and, together with the subsidiary Comicrom and the Pearl employees, has a total headcount of 4,598.

Going forward, the prospects appear robust and the revenue visibility is good. The ABN Amro deal has already started billing and TCS has in hand, the Tata Teleservices deal, the Pearl deal and strong wins in its core-banking product, FNS as well. Comicrom has also started contributing to the topline.

Margins flat: TCS’ margins were largely flat during 3QFY06, reducing by a marginal 10 basis points during the quarter. Employee costs increased as a percentage of revenues to 53.1% from 52.3% in the previous quarter. Thus, a slight leverage on the SG&A front did not help the margins. The company’s cost of revenues also increased as a percentage of sales to 53.8% in 3QFY06 from 53.4% during the previous quarter.

TCS hired a net of 6,076 employees during 3QFY06, considerably higher than the 4,224 employees added in 2QFY06. This also includes the employees absorbed after the recent acquisitions of FNS, Comicrom and Pearl. This is a clear indication of the strong business expected to come TCS’ way with the strong order wins seen in the recent past. Attrition in 3QFY06 was steady at 8.7%, the same as in 2QFY06.

Lower other income reduces profit growth: As seen with Infosys as well, due to a loss on the other income front, TCS’ growth at the net level was lower than the topline growth. To put it in numbers, the net profit grew at 8.7% sequentially.

Performance in the recent past…
  4QFY05 1QFY06 2QFY06 3QFY06
Sales growth (%, QoQ) 0.2 4.8 8.9 10.6
Cost of revenues (% of sales) 52.9 51.7 53.4 53.8
SG&A expenses (% of sales) 20.7 20.9 19.5 19.2
EBIT margins (%) 26.3 27.4 27.1 27.0
Profits growth (%, QoQ)* (19.7) 9.0 8.8 8.7
* Net profit figures exclude all one-off items

What to expect?
At the current price of Rs 1,671, TCS’ stock is trading at a price to earnings multiple of 18.9 times our estimated FY08 earnings. We had recommended a ‘Buy’ on TCS in June 2005, with a medium-term target price of Rs 1,740, which has already been achieved.

We believe that the recent big order wins, such as the ABN Amro deal and the Tata Teleservices deal are proof of the scalability of TCS and its ability to handle large, complex projects. With the Pearl deal, TCS has hit another level as far as its BPO business is concerned. Its strong focus on fast-growing service lines, such as BPO, products, infrastructure services, consulting and engineering services is expected to drive growth in future. We expect TCS to witness a greater number of such large deals going forward and thus, revenue visibility remains strong over the medium term. However, one concern would be the almost-certain deterioration in the margin quality, since the firms that have been acquired have considerably lower margins than TCS.

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