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TCS: Billion dollar quarter! - Views on News from Equitymaster
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TCS: Billion dollar quarter!
Jan 15, 2007

Introduction to results
Asia’s largest software services firm, TCS, has announced strong results for the third quarter and nine-month period ended December 2006. As per Indian GAAP consolidated results for 3QFY07, the company has sequentially grown its topline and bottomline by 8% and 9% respectively, thus outperforming Infosys, which had announced its results a few days ago. The company has also managed a 70 basis points (0.7%) expansion in operating margins during the quarter, mainly due to lower employee costs (as percentage of sales). For 9mFY07, while revenues and net profits have grown at strong YoY rates, operating margins have been under marginal pressure. Mainly due to the impact of wage hikes effected in April 2006 (1QFY07). The board has recommended a dividend of Rs 3 per share (dividend yield of 0.2%).

Financial performance (Indian GAAP Consolidated): A snapshot
(Rs m) 2QFY07 3QFY07 Change 9mFY06 9mFY07 Change
Sales 44,948 48,734 8.4% 89,263 135,231 51.5%
Expenditure 32,431 34,854 7.5% 62,576 98,534 57.5%
Operating profit (EBITDA) 12,517 13,881 10.9% 26,687 36,697 37.5%
Operating profit margin (%) 27.8% 28.5%   29.9% 27.1%  
Other income (Net) 191 382 100.0% 83 1,293 1453.6%
Depreciation 1,029 1,115 8.3% 1,870 3,034 62.2%
Interest 17 26   50 59 18.8%
Profit before tax 11,662 13,122 12.5% 24,851 34,898 40.4%
Equity in net earnings of affiliates 3 4 25.0% 9 8 -1.2%
Minority interest 76 144 89.9% 200 296 47.7%
Tax 1,403 1,821 29.8% 3,885 4,436 14.2%
Profit after tax/(loss) 10,187 11,161 9.6% 20,774 30,174 45.3%
Net profit margin (%) 22.7% 22.9%   23.3% 22.3%  
No. of shares (m)         978.6  
Diluted earnings per share (Rs)*         39.9  
P/E ratio (x)*         33.3  
* On a trailing 12-month basis

What is the company’s business?
TCS is the largest software company in Asia, having a wide range of offerings and catering to industries like banking and financial services, manufacturing, telecom and retail. TCS 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. The company's revenues and profits have grown at CAGR of 34% and 30% respectively over the period FY01 to FY06. TCS has the largest employee base in the Indian software sector and this highlights the fact that the company 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. For instance, the company has over 20 year relationships each with the GE Group and State Farm Insurance.

What has driven performance in 3QFY07?
All-round growth powers the topline: Noticeably, during 3QFY07, TCS became the first Indian technology company to clock revenues of over US$ 1 bn in a single quarter. The 8.4% QoQ growth in the company’s topline was due to strong performances from the company’s software development & maintenance services and product businesses. While the former, at 54% of consolidated revenues, grew by 11% QoQ, the latter (3% of revenues), recorded a growth of 21% QoQ. Other meaningful contributions came from enterprise solutions, business intelligence and BPO services. As regards verticals, BFSI remained the company’s strongest area (revenue growth of 11% QoQ), followed by telecom (10%) and manufacturing (8%). In the BFSI space, the company signed a US$ 140 m 5-year deal with a leading Latin American bank, as also a US$ 100 m deal from a Chinese bank.

Overall, while TCS recorded volume (total hours worked by all employees during the quarter) growth of 8% QoQ, blended billing rates were higher by 2% QoQ. Further, the management expects the billing environment to remain stable in the next few quarters.

At the end of 3QFY07, TCS had 754 active clients (net addition of 12 clients during the quarter). Also, if one were to look at the number of clients in different revenue buckets, this has continued to rise, and the total number of clients giving TCS revenues in excess of US$ 20 m (on a trailing 12-month basis) now stands at an impressive 37 (32 at the end of 2QFY07). During the quarter, the company generated around 4% of its business from new clients.

On the manpower front, TCS, along with its subsidiaries, added a net of 5,562 employees during 3QFY07, thus taking its total base to 83,500, which is the largest in the Indian technology sector. Further, the company plans to add 6,000 more employees during 4QFY07, to take the total employee addition to 30,000 in FY07. While attrition rate climbed 10.8% (10.6% in 2QFY07), the key factor is that it is still way below Infosys’ 13.5%. This is undoubtedly a positive for TCS, in what is becoming an increasingly competitive and cutthroat environment for hiring.

Lower employee costs aid margin expansion: TCS has recorded a 70 basis points (0.7%) expansion in operating margins during 3QFY07, which has mainly come about due to a reduction in employee costs. These, as a percentage of revenues, have declined from 41.8% of sales in 2QFY07 to 41.5% in 3QFY07. It is important to note that TCS, like most of its peers, had effected average salary hikes of 15% in April 2006, and there will be no further hikes during the fiscal. Leverage on the SG&A front and an offshore shift has also had a positive impact on the operating margins. From 41% of consolidated revenues in 2QFY07, the offshore proportion stood at 41.6% this quarter, recording revenue growth of 10% QoQ. TCS' management indicated in the conference call that a 45% offshore contribution will be an optimum level that it is looking for, and it expects to achieve the same in the next 3-4 quarters. It must be noted that an increase in offshore contribution to revenues is margin accretive, as costs of operating in an offshore location are relatively lower than those incurred onsite. But for a dip in utilisation (excluding trainees), from 79.4% in 2QFY07 to 78.2% in 3QFY07, the operating performance would have looked even better.

Margin expansion, higher other income aid bottomline: Apart from the expansion in operating margins, the fact that TCS’ other income almost doubled on a QoQ basis, also helped the strong sequential growth in the company’s net profits during 3QFY07. The robust growth in other income was due to TCS earning substantially higher interest and dividend income and miscellaneous income during 3QFY07.

What to expect?
At the current price of Rs 1,330, the stock is trading at a price to earnings multiple of 33.3 times its trailing 12-months earnings. The board has recommended a third interim dividend of Rs 3 per share (dividend yield of 0.2%). The management has indicated that the strong offshoring momentum will continue into the future, mainly in terms of build-up of clients, larger deal sizes and wider demand across service lines. TCS’ business is expected to get a boost due to maintenance of strong volume growth and an improved business mix, with greater focus on new services lines like infrastructure management and products. Margins are also expected to be stable. Overall, we remain upbeat on TCS’ future growth prospects and thus maintain our positive recommendation on the stock from a long-term perspective.

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