TCS: Project delays mar performance

Performance summary

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• Net sales grow 22% YoY in FY08, 3% QoQ in 4QFY08. Full year sales 1% lower than our estimates. Banking and financial services vertical leads growth for FY08 with 26% YoY higher sales.

• Operating margins contract by 1.5% YoY for the fiscal. Significantly higher overseas business expenditure dents margins. Staff costs decline from 43% of sales in FY07 to 34% in FY08, thus lowering pressure on margins.

• Net profits grow 19% YoY during FY08, decline 6% QoQ during 4QFY08. Contraction in operating margins and lower other income - the chief culprits of fourth quarter’s poor performance. Even if one were to exclude the one time exchange gain of Rs 671 m from 3QFY08 other income, net profits still show a QoQ decline for the fourth quarter. Full year profit 3% lower than our estimates.

• Adds a net of 22,100 employees during the fourth quarter – manpower base stands at 111,400.

• Recommends final dividend of Rs 5 per share (dividend yield of 0.5%).

Consolidated financial snapshot

(Rs m)	3QFY08	4QFY08	Change	FY07	FY08	Change
Sales	59,230	60,978	3.0%	186,852	228,634	22.4%
Expenditure	43,549	45,297	4.0%	135,464	169,098	24.8%
Operating profit (EBITDA)	15,681	15,681	0.0%	51,389	59,536	15.9%
Operating profit margin (%)	26.5%	25.7%		27.5%	26.0%
Other income	1,190	833	-30.0%	2,291	4,861	112.2%
Depreciation	1,442	1,598	10.8%	4,402	5,637	28.1%
Interest	76	69	-9.1%	95	300	217.6%
Profit before tax	15,353	14,847	-3.3%	49,183	58,460	18.9%
Tax	2,001	2,275	13.7%	6,640	7,863	18.4%
Minority interest	89	123	38.1%	428	344	-19.5%
Share of profit of associates	3	(1)	-146.4%	11	8	-25.9%
Profit after tax/(loss)	13,267	12,448	-6.2%	42,126	50,260	19.3%
Net profit margin (%)	22.4%	20.4%		22.5%	22.0%
No. of shares (m)					978.6
Diluted earnings per share (Rs)					51.4
P/E ratio (x)					19.3

What has driven performance in FY08?

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• Despite growing sales by 22% YoY, TCS ranks low amongst its peers if one were to compare their performance for FY08. While a key reason for this subdued performance on the topline front can be attributed to the rupee’s 11% YoY appreciation against the US dollar (which actually cost the company Rs 18 bn in revenue), the management has also indicated that it has seen slow ramp up in a couple of projects in the financial services space. This has impacted the company’s 4QFY08 performance, as sales for this period have grown by a mere 3% QoQ. The management expects these clients to ramp up over the next 2 quarters.

  Based on industry verticals, banking and financial services (BFSI) was the lead performer, raking in sales growth of 26% YoY during the fiscal. This was followed by the telecom vertical where sales grew by 25% YoY. As for specific service offerings, the company’s application development and maintenance (ADM) service recorded a growth of 13% YoY during FY08. The share of this segment to TCS’ total sales, however, dropped to 48% as compared to 52% in FY07. A part of this decline in ADM’s share can be attributed, and positively, to the increased contribution from high value services like consulting and infrastructure management.

• TCS’ operating margins contracted by 1.5% YoY during FY08, 0.5% higher than what we had estimated. The management indicated during the conference call that around 0.4% of the contraction could be attributed to the rupee’s appreciation against the US dollar. Based on specific cost heads, while salary costs declined from 42.8% of sales in FY07 to 34.4% in FY08, it was the substantial increase in overseas business expenditure that really hurt TCS hard on operating margins. These costs increased from 7.3% of sales in FY07 to 17.5% in FY08. A large part of this increase was owing to a three-fold jump in overseas employee allowances on the back of implementation of a new pay model effective May 2007.

• TCS reported a 19% YoY growth in net profits for FY08, which was subdued on the back of a poor 4QFY08 performance, wherein profits declined by 6% QoQ. This can be attributed to delays in a few projects during the quarter, where initial costs have been booked. The bottomline performance for the fiscal would have been worse but for a 112% YoY jump in other income. This rise in other income was helped by Rs 2.6 bn inflow that the company recorded as exchange gains on its currency derivative contracts.

What to expect?

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At the current price of Rs 917, the stock is trading at a multiple of 13.4 times our estimated FY10 earnings. TCS’ FY08 performance has been fairly in line with our estimates. While the management has indicated of keeping a close watch on the external environment, especially considering the US economic situation, it remains confident of the offshoring momentum from a medium to long-term perspective. It expects the pricing environment to remain strong during the current fiscal. We shall soon update our research report in the company incorporating FY08 actual numbers as also our estimates for FY11.