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Infosys: Premium on TCS justified? - Views on News from Equitymaster
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Infosys: Premium on TCS justified?
Jul 5, 2005

Over the past year, since the time TCS, Asia’s largest software company, listed on the Indian bourses, there has been haggling with regard to its valuations vis-à-vis the industry benchmark, Infosys. It should be noted that both these industry leaders have strong and credible management teams with enviable track records. They have both built up long-term relationships with clients over a period of time, giving them ‘repeat business’ as a percentage of total revenues in excess of 90%. Both are global corporations, with offices spanning the globe and follow the highly acclaimed global delivery model for process execution.

However, as regards valuations, Infosys has traditionally traded at a price to earnings multiple of an average 35.1 times trailing earnings. If we take the period since TCS got listed on the exchanges in August 2004, the ratio for Infosys increases to 39.8 times trailing earnings. This is a fairly significant premium to TCS, whose average P/E ratio is around 34.0 times trailing earnings. As regards forward P/E multiples, Infosys currently trades at 19.9 times our estimated FY07 earnings, while TCS trades at 18.8 times our estimated FY07 earnings.

Why the premium?

So what is it that makes Infosys trade at such a significant 15%-plus premium to TCS? Well, for starters, TCS has only recently listed, while Infosys has been listed since over a decade now. Clearly, the biggest reason as to why Infosys gets a premium over TCS is in the consistency of its performance, not just in one or two years, but over a period of 7 to 8 years. The company has consistently outperformed in good times and bad, showing the resilience of its business model. Even during the global slowdown in 2000 and 2001 post the ‘dotcom bubble’, 9/11 and slowdown particularly in the financial services and telecom industries, two verticals from which Infosys derives over 50% of its revenues, the company grew revenues and profits at 37.0% and 28.5% respectively. During the last four years, Infosys has grown revenues and profits at a CAGR of 39.2% and 31.7% respectively and the point to note is that there has hardly been any volatility in its performance. The comparative revenue and profit figures for TCS are 33.6% and 25.8% respectively, which is fairly impressive, but still lower than the industry bellwether, Infosys.

Infosys has also maintained a fair amount of transparency in terms of its disclosures in its accounts. Be it revenues by verticals, revenues by service lines, billing rates and other such metrics, Infosys, in each of its balance sheets, discloses a vast amount of information required by investors to analyse the company in detail. TCS, on the other hand, has recently been listed and the quality of its disclosures lags behind that of Infosys. The company does not divulge details about its billing rates, citing reasons that it is uncomfortable doing so.

Such consistency shows very clearly as to why the stock is a favourite of investors and is known as the ‘technology bellwether’. TCS’ first annual results turned out to be a bit of a disaster, with investors not taking too kindly to the fall in profits in 4QFY05 due to the additional EVA-based employee compensation costs. However, we believe that the reaction was a bit too harsh on the part of the markets and the stock has recovered handsomely since then.

But to conclude, we believe that even though Infosys gets a premium over TCS on valuations, going forward, this premium could reduce. In terms of operating metrics, TCS already enjoys superior operating margins compared to Infosys. For FY05, TCS’ operating margins were at 29.3%, while for Infosys, they stood at 28.8% (taken as per US GAAP, in order to facilitate a like-for-like comparison). Even in terms of revenues per employee, TCS scores over Infosys, at Rs 2.6 m per average employee, while Infosys enjoys revenues per average employee of Rs 2.3 m.

As TCS becomes more comfortable being in the glare of the public eye and starts to improve the quality of its disclosures, investors could start giving it similar valuations to Infosys. Given TCS’ strong positioning to take advantage of the strong offshoring momentum expected over the next few years, we believe that it will be among the major beneficiaries. TCS’ scale advantages, long term relationships formed with major clients such as GE and State Farm Insurance and credible management team are likely to give it equal weightage to Infosys, going forward, through better performances on the operational front.

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