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TCS: It isn't so bad!

Apr 19, 2005

Performance Summary
TCS has announced mixed results for the quarter and year ended March 2005. While the company has reported decent YoY growth for topline and bottomline in FY05, the performance for the fourth quarter has been poor. On the margins front, while FY05 margins have improved by 200 basis points, those for 4QFY05 have dipped by 250 basis points, partly on account of an additional Rs 1 bn payout to employees as incentive.

Financial performance (US GAAP Consolidated): A snapshot
(Rs m) 3QFY05 4QFY05 Change FY04 FY05 Change
Sales 25,784 25,846 0.2% 71,227 97,272 36.6%
Expenditure 18,400 19,098 3.8% 52,981 70,379 32.8%
Operating profit (EBIT)** 7,385 6,748 -8.6% 18,246 26,894 47.4%
Operating profit margin (%) 28.6% 26.1%   25.6% 27.6%  
Other income 1,041 (360)   988 810  
Profit before tax 8,425 6,387 -24.2% 19,234 27,704 44.0%
Equity in net earnings of affiliates 1 1 -54.9% 160 18 -88.7%
Minority interest (51) 115   (125)   (79)  
Extraordinary income/(expenditure) - (971)   - (3,057)  
Tax 1,283 834 -35.0% 2,899 4,065 40.2%
Profit after tax/(loss) 7,093 4,698 -33.8% 16,369 20,521 25.4%
Net profit margin (%) 27.5% 18.2%   23.0% 21.1%  
No. of shares 480.1 480.1   480.1 480.1  
Diluted earnings per share* (Rs) 59.1 39.1   34.1 42.7  
P/E ratio (x)         28.3  
(* annualised)** including depreciation

What is the company's business?
TCS is the largest software company in Asia and has become the first Indian software company to have cross the coveted US$ 2 bn revenue mark. TCS 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.

What has driven performance in FY05?
Volume growth drives revenues:  While particulars are not available, what we believe is that the topline growth has been a factor of both stable billing rates and strong volumes during the year. Also, growth in revenues across segments has helped TCS. Importantly, the key segments of application development and maintenance (73% of revenues) and enterprise solutions (21%) have performed decently in 4QFY05. Growth in software development segment is particularly important as it indicates improving tech spending scenario worldwide. Based on delivery, while offshore revenues have grown YoY by 31% for the fiscal, growth in onsite revenues has been faster at 46%. Importantly, the company has reduced the share of revenues from onsite services and the same now stands at 61% (64% in FY04). This is a positive particularly for the fact that a further increase in offshore-based contribution will be a fillip to the company's margins. For the quarter, the slow growth in revenues was a result of a slower ramp-up from some clients.

GE, the largest customer of the company, contributed to 13.9% of TCS' consolidated revenues in 4QFY05, down from 14.8% 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 516, with the company adding a gross of 53 (72 in 3QFY05) clients in this quarter itself. The net addition in the client has been 10 and this means that TCS has lost around 43 clients in the quarter, something similar to what was observed in Infosys' case as well.

Leverage from SG&A costs aid margin expansion:  The hiring in the fourth quarter for TCS was a bit muted when one compares to what was seen in the previous quarters. The company added a net of 1,775 employees in 4QFY05. This is seemingly the reason for a fall in cost of revenues (as % of sales) as most of the hiring was done at the freshers' level. Even for FY05, the cost of revenues has declined to 53.5% of sales, compared to 54.1% in FY04. Also, SG&A leverage has helped margins expansion for the company. These costs have declined from 20.3% of sales in FY04 to 18.8% in FY05. Attrition in 4QFY05 was 8%, slightly higher than 7.6% in the previous quarter but considerably lower than the industry average of over 20%.

A greater proportion of revenues coming from offshore services have also helped TCS on the margins front. However, at 61%, 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. The company in its earnings conference call has indicated that it expects the proportion of offshore revenues to increase going forward by an average of 1% every quarter.

Lower other income impacts net profits:  While a negative other income component combined with an incentive provision of Rs 1 bn has led to a profit decline in 4QFY05, the net profit growth in FY05 has been mutes as well on account of these very reasons. If one were to remove the effect of extraordinary items from FY05 numbers, the profit growth stand increased at an impressive 44% YoY, from the current 25% YoY.

What to expect?
At the current price of Rs 1,210, the stock is trading at a price to earnings multiple of 28.3 times FY05 earnings. The board has recommended a final dividend of Rs 5 per share (dividend yield of 0.4%). The results of TCS are very much in line with what we had estimated. Based on our FY07 estimated EPS, the stock trades at a price to earnings multiple of 18 times. As such we maintain our earlier recommendation of a ‘Hold' on the stock with a target price of Rs 1,600 for the long-term.

We would also request investors not to panic from the sharp selling that was seen in the stock in today's trades. This decline can be used as a buying opportunity especially if one has a long-term investment horizon. We continue to believe that the company will be one of the main beneficiaries of the increase in outsourcing activities from India in the future.

We will update our research report on TCS after a conference call with the management.

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