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TCS FY06 results: ‘Integrated’ growth! - Views on News from Equitymaster
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TCS FY06 results: ‘Integrated’ growth!
Apr 17, 2006

Introduction to results
TCS announced its results for the fourth quarter and year ended March 2006 late yesterday. For 4QFY06, strong volume-led growth from the international business and strategic large deal wins has led to a good performance on the revenue front. However, due to expenses growing at a higher rate than revenues, margins took a dip. Higher other income, coupled with lower taxes, has led to a good sequential growth in net profit during the quarter. If we exclude the extraordinary items incurred during the quarter, the sequential net profit growth was in double digits. It should be noted that these figures are after consolidating the numbers of Tata Infotech, which has been merged into TCS with effect from April 1, 2005. For FY06, the company has also registered a good performance, aided by organic volume-led growth, a few acquisitions as well as large deal wins, such as ABN Amro and Pearl.

Financial performance (US GAAP Consolidated): A snapshot
(Rs m) 3QFY06 4QFY06 Change FY05 FY06 Change
Sales 34,527 37,328 8.1% 97,272 132,550 36.3%
Expenditure 25,498 28,052 10.0% 70,344 98,349 39.8%
Operating profit (EBIT)** 9,029 9,276 2.7% 26,928 34,202 27.0%
Operating profit margin (%) 26.2% 24.9%   27.7% 25.8%  
Other income (154) 16   757 257 -66.0%
Profit before tax 8,875 9,293 4.7% 27,685 34,459 24.5%
Equity in net earnings of affiliates (3) 33   18 16 -13.1%
Minority interest (48) (103)   (79) (280)  
Extraordinary income/(expenditure) (3) (232)   (3,038) (243)  
Tax 1,319 896 -32.1% 4,065 4,984 22.6%
Profit after tax/(loss) 7,502 8,094 7.9% 20,521 28,968 41.2%
Net profit margin (%) 21.7% 21.7%   21.1% 21.9%  
No. of shares (m) 480.1 489.3   480.1 489.3  
Diluted earnings per share (Rs)       41.9 59.2  
P/E ratio (x)         34.4  
* Numbers include Tata Infotech   ** Including depreciation

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. 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 FY06 at compounded rates of 34% and 30% respectively.

What has driven performance in FY06?
Topline driven by volumes, deal wins: During FY06, TCS registered a 36% YoY growth in its topline. The management indicated in the conference call that the pricing environment has been largely stable. Thus, the strong topline growth was a result of strong volume growth in its major businesses, such as package implementation, BPO and products. Enterprise Solutions (package implementation) continued to show strength, growing at a rate of 41% YoY. The ‘Others’ service line, which includes, among others, BPO, consulting and engineering services, grew at an impressive 76% YoY. This was a result of strong order wins, such as the one from Pearl. The company’s products business grew at 34% YoY and has seen some good order wins during the year. TCS had acquired a banking products company, FNS, in Australia earlier in FY06. Application development and maintenance (ADM) also saw robust growth of 34% YoY, aided by large deal wins, such as ABN Amro.

As regards delivery-based revenues, while onsite revenues grew at a strong pace of 38% YoY, offshore revenues saw a 31% YoY growth (both excluding domestic revenues). A shift to onsite was noticed, due to the fact that Tata Infotech, which was amalgamated into TCS with effect from FY06 (full year), has a couple of large engagements that are primarily onsite, and the fact that ramping up of new accounts, that initially entail greater onsite work.

For 4QFY06, TCS saw a strong 8% sequential volume growth, which led an equal sequential growth in revenues. Revenues were also realised from large order wins won recently by the company, with £ 5 m (approx. Rs 400 m) coming in from the Pearl deal this quarter, and US$ 13 m (Rs 585 m) coming in from FNS. Thus, apart from organic volume growth, the recent acquisitions made by the company, as well as large deals won, have led to a good performance on the revenue front.

At the end of FY06, TCS had 929 active clients, an addition of 330 clients for the year. As regards employees, TCS, along with its subsidiaries, had 66,480 employees at the end of FY06 (45,714 at the end of FY05). The company plans to hire a net of 23,000 employees in FY07, taking the total employee base to a possible 90,000+ at the end of March 2007. The attrition rate in FY06 increased to 9.9%, from 8.7% in FY05. This was the case with Infosys as well, and is a clear reflection of the pressure that not just TCS and Infosys, but other companies in the industry are facing with regards to retaining talent. This, we believe, is an industry-wide trend and is here to stay.

GE, the largest customer of the company, contributed to just over 10% of TCS’ consolidated international revenues in FY06, as compared to 14% in FY05. 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. In absolute terms, GE revenues actually declined by 0.7% YoY.

Margin pressure, as expected: During FY06, TCS saw a 1.9% decline in its EBIT margins. This was partly a result of expenses related to the integration of Tata Infotech with itself, as well as lower margins of subsidiaries that it acquired, such as FNS and Comicron. Higher employee costs, particularly on the SG&A side, along with higher depreciation charges, rent and travel costs, were the key factors that pressurised margins during the year. A higher proportion of onsite revenues during FY06 could also have put some pressure on the margin profile. Similar was the case for the quarter, with EBIT margins falling by 1.3%, due to reasons as mentioned above. The rupee movement during the quarter also impacted margins to the tune of 1.3% basis points during the quarter.

Net profit shines: TCS’ net profit grew at over 41% YoY in FY06, aided by a lower effective tax rate and effect of an extraordinary expense in FY05 (Rs 3 bn relating to employee compensation costs). Excluding these items, the net profit growth stood at 24% YoY in FY06. For the quarter, due to better other income and lower taxes, the net profit growth stood at 8% QoQ. Excluding the extraordinary items of Rs 232 m, which was mainly a one-time charge due to shares transferred on account of the Tata Infotech merger, the net profit grew by 11% QoQ.

Performance in the recent past…
  1QFY06 2QFY06 3QFY06 4QFY06
Sales growth (%, QoQ) 4.8 8.9 10.6 8.1
Cost of revenues (% of sales) 51.7 53.4 53.8 54.7
SG&A expenses (% of sales) 20.9 19.5 20.1 20.5
EBIT margins (%) 27.4 27.1 26.2 24.9
Profits growth (%, QoQ)* 9.0 8.8 11.4 7.9
* Net profit figures exclude all one-off items

What to expect?
At the current price of Rs 2,035, TCS’ stock is trading at a price-to-earnings multiple of 22.5 times our estimated FY08 earnings, after increasing the equity base due to the merger of Tata Infotech with itself. The board has recommended a bonus issue on the ratio of 1:1 (one additional equity share for every one share held), and has announced a final dividend of Rs 4.5 per share. This takes the total dividend for the year to Rs 13.5 per share (dividend yield of 0.7%). 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.

Going forward, given the fact that TCS has won a number of large deals, revenue visibility appears good. The management has said that the company has signed a US$ 500 m fixed price contract spread out over a period of 5 years. While the company has not named the client on grounds of confidentiality, it is likely that it could be Citigroup. Even margins seem to have bottomed out, as the management has mentioned in the conference call yesterday that all integration issues have been sorted out. The pricing and margin outlook for FY07 is stable, with new clients coming in at higher-than-average rates. 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 will have to continue to take steps to retain talent going forward, in order to compete effectively.

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