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TCS: Path to growth...

Jan 13, 2005

Performance Summary
TCS has announced strong results for the third quarter of FY05. Apart from a decent sequential growth in the topline, the company has managed to improve its operating margins. While the sequential growth in net profits might seem significant at one glance, investors should note that this is due to the effect of a one-off item that the company had recorded in the previous quarter. Excluding that effect, the sequential net profit growth stands at 23% for 3QFY05.

Financial performance (US GAAP Consolidated): A snapshot
(Rs m) 2QFY05 3QFY05 Change 9mFY04 9mFY05 Change
Sales 24,307 25,784 6.1% 50,852 71,427 40.5%
Expenditure 17,540 18,400 4.9% 38,055 51,281 34.8%
Operating profit (EBIT)** 6,767 7,385 9.1% 12,796 20,146 57.4%
Operating profit margin (%) 27.8% 28.6% 25.2% 28.2%
Other income (8) 1,041 657 1,171 78.2%
Profit before tax 6,760 8,425 24.6% 13,453 21,316 58.4%
Equity in net earnings of affiliates 6 1 -75.7% 77 17 -77.5%
Minority interest (61) (51) (4) (194)
Extraordinary income/(expenditure) (2,086) - - (2,086)
Tax 940 1,283 36.4% 2,096 3,230 54.1%
Profit after tax/(loss) 3,678 7,093 92.8% 11,431 15,824 38.4%
Net profit margin (%) 15.1% 27.5% 22.5% 22.2%
No. of shares 480.1 480.1 480.1 480.1
Diluted earnings per share* (Rs) 30.6 59.1 31.7 43.9
P/E ratio (x) 29.2
(* annualised)** including depreciation

What is the company's business?
TCS is the largest software company in Asia and has the distinction of becoming the first Indian software company to have cross the coveted US$ 1 bn revenue mark (in FY03). In fact, the company crossed the US$ 1 bn revenue mark in the first half of FY05 itself and, at the end of 9mFY05, has revenues over US$ 1.6 bn. TCS has a wide range of offerings and caters to industries like BFSI, manufacturing, telecom, and retail. TCS was one of the pioneers of the much-acclaimed global delivery model and has the largest employee base in the Indian software sector.

What has driven performance in 3QFY05?
Volume growth drives revenues: While particulars are not available, what the company's management has indicated in the recently concluded conference call is that the topline growth has been a factor of both stable billing rates and strong volumes. Also, growth in revenues across segments has helped TCS. Both the key segments of application development and maintenance (72% of revenues) and enterprise solutions (22%) have performed decently in 3QFY05. Based on delivery, while offshore revenues have grown sequentially by 13%, growth in onsite revenues has been slower at 2%.

GE, the largest customer of the company, contributed to 14.8% of TCS' consolidated revenues in 3QFY05, down from 15.9% in the previous quarter. This decline in contribution seems to indicate TCS' conscious policy of derisking its business from large clients. The client base currently stands at 506, with the company adding a net of 72 (52 in 2QFY05) clients in this quarter itself.

Low employee costs aid margin expansion: While TCS continued with its aggressive hiring pace in 3QFY05, the fact that the company hired more at the freshers level caused its employee costs (as a % of revenues) to decline from 45% in 2QFY05 to 42% in this quarter. This was a major reason for the 80 basis points expansion that the company reported in its operating margins of 3QFY05. TCS has been as aggressive as Infosys as far as hiring is concerned (see adjoining graph). However, fresher level hiring has helped both these companies in expanding margins, as the incremental salary costs for freshers are lower than compared to hiring of experienced personnel. Attrition in 3QFY05 was 7.6%, lower than 7.9% that was witnessed in the previous quarter. As a matter of comparison, Infosys' attrition rates for 2QFY05 and 3QFY05 have been 10.8% and 10.3% respectively. With the onslaught of MNC competition, we expect attrition rates for both these companies to rise in the future, however remaining much lower than the industry average.

A greater proportion of revenues coming from offshore services have also helped TCS on the margins front. However, at 60%, TCS still has onsite revenues as the highest proportion to total revenues among frontline Indian software companies. We believe that this will give the company a greater leverage to move towards offshore and thus improve margins faster. This is because offshore services have higher margins than onsite services.

Strong other income aids net profits growth: Net profit growth in 3QFY05 has outperformed the growth in topline, mainly due to margin expansion and a higher other income. As a matter of fact, from a negative other income of Rs 8 m in 2QFY05, the company earned Rs 1 bn in this quarter.

What to expect?
At the current price of Rs 1,293, the stock is trading at a price to earnings multiple of 29.4 times annualised 9mFY05 earnings. The results are in line with our estimates, and based on our FY07 earnings estimates for the company, the stock trades at a price to earnings multiple of 19.3 times compared to Infosys' 18.3 times. While we believe that TCS gets a relatively lower valuations than Infosys based on the latter's better profitability margins and greater skills on the execution and delivery fronts, the gap seems to be declining as investors get more attuned to the company that was just listed four months back.

Moreover, we expect TCS to be one of the biggest beneficiaries of growth in offshoring to India in the future. Our confidence stems from the fact that the company has a visionary management at its helm and has a strong balance sheet, two key factors that are among the biggest competitive differentiators in the global IT services market.

In October 2004, we had recommended a ‘Hold' on the stock at Rs 1,127, with a target price of Rs 1,600 for a long-term investment horizon. At the current levels, we maintain our recommendation.

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