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TCS FY07: US$ 4 bn, and counting… - Views on News from Equitymaster

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TCS FY07: US$ 4 bn, and counting…
Apr 16, 2007

Introduction to results

Asia’s largest software services firm, TCS, has announced strong results for the fourth quarter and full year ended March 2007. As per Indian GAAP consolidated results for FY07, while revenues have grown by 41% YoY, thus crossing the US$ 4 bn mark, net profits have recorded a strong 42% YoY growth. Operating margins have, however, recorded a marginal 10 basis points contraction.

Consolidated financial performance: A snapshot…
(Rs m) 3QFY07 4QFY07 Change FY06 FY07 Change
Sales 48,734 51,621 5.9% 132,640 186,852 40.9%
Expenditure 34,845 36,979 6.1% 95,797 135,464 41.4%
Operating profit (EBITDA) 13,889 14,642 5.4% 36,843 51,389 39.5%
Operating profit margin (%) 28.5% 28.4%   27.8% 27.5%  
Other income (Net) 373 1,048 180.9% 1,139 2,291 101.1%
Interest & depreciation 1,141 1,405 23.2% 2,916 4,496 54.2%
Profit before tax 13,122 14,285 8.9% 35,066 49,183 40.3%
Minority interest and share of profit of associates 140 129 -7.4% 303 417 37.5%
Tax 1,821 2,204 21.0% 5,096 6,640 30.3%
Profit after tax/(loss) 11,161 11,952 7.1% 29,667 42,126 42.0%
Net profit margin (%) 22.9% 23.2%   22.4% 22.5%  
No. of shares (m)         978.6  
Diluted earnings per share (Rs)         43.0  
P/E ratio (x)         28.8  

What is the company 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. 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 works closely with its clients and this has helped the company in building long term relationships with some key customers.

What has driven performance in FY07?
Major deal wins and large volumes drive topline: During FY07, TCS registered a 41% YoY growth in its topline. This was due to a combination of improvement in billing rates and continuatio9n of strong volume momentum. As for the future, although the company does not provide any specific guidance, the management has indicated that the pricing environment is relatively stable and it is also confident of successfully renegotiating the existing contracts at 3% to 5% higher rates. In case of new contracts, it estimates a pricing upside of 5% to 10%.

Based on services lines, TCS’ strong topline performance during FY07 was a result of robust performances from all its key business segments. As we have indicated earlier, the company is focusing on five key segments to sustain strong growth in the future. These segments are Engineering services, Infrastructure services, Consulting, Products and BPO. During FY07, these segments contributed to 24% of the company’s consolidated revenues, up from 18% in FY06, thus vindicating the management’s focus on the same. More than providing a way for TCS to penetrate the high growth and value added businesses, higher contribution from these businesses is also expected to aid the company in reducing pressure on margins due to rising employee costs and rupee appreciation.

On the clientele front, TCS closed the fiscal with an active client base of 780, an addition of 218 clients for the year. The company derived almost 97% of its revenues from repeat business. The company is consistently de-risking its business, which is evident by the fact that its largest customer GE is contributing only 6.6% (FY06 figures: 10.3%). Going forward we expect its contribution to go down further. During FY07, TCS won 3 deals worth US$ 100 m and 9 deals worth US$ 50m.

As regards employees, TCS, along with its subsidiaries, had 89,419 employees at the end of FY07 (66,480 at the end of FY06). The company has already made campus offers to 12,000 engineering graduates. The attrition rate in FY07 increased to 11.3%, from 9.9% in FY06 (10.8% in 3QFY07). While rising attrition is a lingering issue for all Indian IT companies, the fact that TCS, despite having the largest manpower base, has still managed to keep attrition at the lowest levels is commendable.

In terms of the delivery-based revenues, while onsite revenues grew at a strong pace of 34% YoY, offshore revenues grew at a scorching pace 53% YoY. Importantly, the share of offshore contribution to revenues increased to 40.5% in FY07, from 37.4% in FY06. TCS currently has amongst the lowest share of revenues coming from offshore when compared to its larger peers. The management intents to bring the offshore-onsite ratio to 45:55 in the next few years, which shall be beneficial for the company’s consolidated margins, as offshore projects command relatively better margins than onsite projects. The utilisation rate saw a marginal growth of 70 basis points and the company expects to maintain the effective utilisation rate at 79% for FY08.

For 4QFY07, TCS saw a 6% sequential growth in revenues, which was led by a 6.4% QoQ growth in volumes and marginal benefits due to better pricing and improved revenue mix. However, the company took a hit of about 2% on this growth because of rupee appreciation.

Factors contributing to revenue growth in 4QFY07
Volume growth 6.4%
Pricing growth 0.9%
Change in revenue mix 0.4%
Rupee appreciation -1.9%
Revenue growth for Q4FY07 5.9%

Margin dampeners: During FY07, TCS saw a 30 basis points (0.3%) decline in its EBITDA margins. This was mainly due to rupee appreciation, which has appreciated by 4% and 2% in 3QFY07 and 4QFY07 respectively. Higher employee costs, particularly on the SG&A side, along with higher rent and travel costs were the key factors that pressurised margins during the year.

Expanding bottomline: TCS’ net profit grew at over 42% YoY during FY07, aided by a lower effective tax rate of 13.5% as compared to 14.5% in FY06 as also higher other income. Going forward, the company expects the effective tax rate to be in the range of 13.5% to 14%. As a matter of fact, TCS’ actual FY07 net profits were higher by 1.7% than our estimates.

Performance in recent past:
  1QFY06 2QFY06 3QFY06 4QFY06 1QFY07 2QFY07 3QFY07 4QFY07
Sales growth (%, QoQ) 4.8 8.9 10.6 8.1 11.3 8.2 8.4 5.9
Cost of revenues (% of sales) 51.7 53.4 53.8 54.7 55.5 53.3 55.6 54.7
SG&A expenses (% of sales) 20.9 19.5 20.1 20.5 20.1 19.3 18.3 19.7
EBIT margins (%) 27.4 27.1 26.2 24.9 26.0 27.6 27.0 30.4
Profits growth (%, QoQ) 9.0 8.8 11.4 7.9 8.4 14.9 11.4 7.1

What to expect?
At the current price of Rs 1,240, the stock is trading at a multiple of 17.1 times our estimated FY09 earnings. The board has announced a final dividend of Rs 4 per share (dividend yield of 0.3%). The deal pipeline of TCS looks promising from the fact that there are 10 deals each worth US$ 50 m, which are coming up for negotiation. The pricing and margin outlook for FY08 is stable, with new clients coming in at higher-than-average rates. However, we believe that the main concern for TCS, and other software companies as well, is the fact that attrition rates are on the rise, particularly at the mid-management level. The company even though it has the lowest attrition level in the industry will have to continue to take steps to retain talent going forward, in order to compete effectively. We maintain our positive recommendation ion the stock from a 2-3 years perspective.

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