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TCS: Research meeting extracts

Jun 27, 2005

We recently met with the management of TCS in order to get a first-hand understanding of the company’s business and its future plans. Here are the extracts of the meeting.

Key extracts
View on the industry: Like most of the other software companies, TCS is also fairly optimistic about the future prospects of the Indian IT industry. The company expects the increase in IT spending to slow down this year, although it believes that this is not a cause for worry, as there is still plenty of scope for growth. Around 400 of the Global 500 companies have taken to outsourcing in some form or the other in FY05, compared to 300 in FY04. TCS expects this number to increase. Given that the IT budgets of these corporations are in the range of US$ 400 to US$ 500 m, the growth prospects appear robust. This is in line with what the managements of other software companies had said when we talked to them.

Onsite-offshore mix: TCS currently derives around 61% of revenues from onsite services. The management intends to improve this ratio in favour of a greater proportion of offshore revenues, which would have the beneficial impact of improving margins. Over a two-year period, the management expects to improve this ratio to 55:45 in favour of onsite revenues.

The ‘GE’ factor: As is well known, GE is TCS’ largest client, giving the company annual business in excess of US$ 300 m, or about 14% of revenues. However, during 4QFY05, revenues from GE declined by about US$ 8 m, due to work being transferred offshore. TCS believes that this trend will continue, as the company continues to de-focus on the GE business and makes efforts to de-risk its client base further. The company expects GE’s contribution to revenues to reduce as a percentage of sales, as well as in absolute terms. This is a good sign, as it implies reducing dependence on a single client.

The BPO factor: Contrary to public perception, TCS does operate in the high-growth BPO sector. The kind of work carried out by the company in this business is relatively high-end work, such as insurance claims processing, revenue accounting, loan sanctioning and credit appraisal. TCS’ voice component is negligible, as the company is not seeking to operate in the call centre business, which is characterised by high attrition rates in the region of over 30%, commoditisation and high employee burnout rates.

Products business: TCS has also developed its own intellectual property (IP) and has its own software products. The company calls these as ‘Asset-leveraged solutions’ or ‘Solution frameworks’, which can be customised to meet the specific requirements of the client, as opposed to ‘shrink-wrapped products’, like Microsoft Windows. TCS has developed software products for the banking and financial services, insurance, brokerage, cement and hospital management industries, and also has a Sarbanes-Oxley compliance tool and anti-money laundering product.

Effect of fringe benefits tax: TCS has not yet estimated any specific impact of the fringe benefits tax announced in this year’s Union Budget. The company believes that there is not enough clarity as yet on the modalities of how the tax will work. Therefore, the situation on this count will be largely status quo, pending further clarity from the North Block.

Capex plans: TCS expended around Rs 6 bn in capex during FY05. While the management has not given any specific figure for FY06, it has indicated that the amount of capex will be similar to, if not more than, the figure in FY05. This translates to around 5% of our estimated FY06 consolidated revenues for TCS.

The cash picture: TCS’ cash reserves were severely depleted after it made a payout to Tata Sons Limited, the company of which it was a division, for transfer of the business from a division to a company. TCS had to pay around Rs 23 bn to Tata Sons in 2004 after it got transferred from being a division of Tata Sons to a public limited company. The company paid Rs 19 bn through internal cash accruals, while the balance was paid off by borrowings. As a result, the cash reserves available with TCS are significantly lower than those of its peers, like Infosys, Wipro and Satyam. However, going forward, with robust business expected to come India’s way through the offshoring story and TCS expected to garner a major share of this business, the company’s cash reserves should increase significantly over the coming years, to enable it to fund expansion. At present, TCS’ cash levels stand at close to Rs 3 bn.

Future growth drivers: TCS believes that the major growth drivers in future will be banking and financial services, healthcare, BPO, infrastructure management services and products, what TCS refers to as “Asset-leveraged solutions” or “Solution frameworks”. While the company believes that products are a significant growth area, it will not become a product-based company.

Challenges ahead: TCS views the major challenges faced by it as currency fluctuations, as adverse currency movements can affect realisations. Cost management is another area that the company feels will be a challenge, as employee costs will play a major role in determining this.

Managing growth will also be a key challenge, as the company grows larger in size. The company will have to keep on growing in terms of employees, global offices and clients. TCS already employs 45,714 employees and, not too far into the future, that number could well swell to over 100,000, as per the management. In that case, maintaining employee attrition rates so that quality of output does not suffer will be a huge challenge faced by the company. TCS will also have to manage growth on a larger base.

The US economy will be another major challenge before TCS. Although the company has reduced its dependence on the US economy to less than 60% of revenues, that still constitutes a large chunk. If the US economy sneezes, the entire world will get an infection! Such is the role played by this economy. As a result, continuous de-risking of the business model through client and geographical diversification is the need of the hour.

What to expect?
At the current market price of Rs 1,327, TCS’ stock trades at a price to earnings multiple of 18.3 times our estimated FY07 earnings. We expect the company to grow its revenues and profits at CAGR of 28.0% and 26.8% respectively over the next three years. Considering the strong management quality, scalability, improving onsite-offshore mix, ever-improving client and geographical diversification, strong track record of execution and long-term relationships with marquee clients, we are positive on the company from a 2-3 year perspective.

Key concerns remain issues relating to managing growth, attrition rates, short-term concerns relating to offshoring, which have recently become exacerbated due to scams and adverse publicity and constantly moving up the value chain, facing competition from the likes of IBM, Accenture and BearingPoint.

Company background
TCS is the largest software company in Asia and has become the first Indian software company to have crossed the coveted US$ 2 bn revenue mark. TCS has a wide range of service offerings and caters to industries like BFSI, manufacturing, telecom and retail. The company has been in existence for a greater while than most of the other software companies and has established strong relationships with key marquee clients like GE and State Farm Insurance. 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.

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