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TCS: Our post 1QFY06 view - Views on News from Equitymaster
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TCS: Our post 1QFY06 view
Jul 16, 2005

Introduction to results
TCS announced its results for 1QFY06 yesterday. The company has recorded a 4.8% QoQ rise in its topline largely driven by international operations, as Indian revenues were flat. Operating margins improved, helped by better billing rates and productivity improvements made during the quarter. The sequential growth in net profit stood at 32%, if we exclude the adjustment made for EVA (economic value added) in 4QFY05. However, in 4QFY05, there was an extraordinary item relating to EVA-based employee compensation expenses. Excluding the same, the sequential growth in net profit stands at 9%.

Financial performance (US GAAP Consolidated): A snapshot
(Rs m) 4QFY05 1QFY06 Change
Sales 25,846 27,094 4.8%
Expenditure 19,036 19,676 3.4%
Operating profit (EBIT)** 6,809 7,419 8.9%
Operating profit margin (%) 26.3% 27.4%  
Other income (414) 98  
Profit before tax 6,396 7,517 17.5%
Equity in net earnings of affiliates 1 2  
Minority interest 115 (85)  
Extraordinary income/(expenditure) (979) -  
Tax 834 1,247 49.4%
Adjustments for EVA 750 -  
Profit after tax/(loss) 5,448 6,187 13.6%
Net profit margin (%) 21.1% 22.8%  
No. of shares 480.1 480.1  
Diluted earnings per share* (Rs) 45.4 51.5  
P/E ratio (x)   24.2  
(* 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 cross the coveted US$ 2 bn revenue mark. It 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. TCS has grown revenues and profits from FY01 to FY05 at a CAGR of 33.6% and 25.8% respectively.

What has driven performance in 1QFY06?
Volume growth, better pricing drives revenues:  As is known, TCS does not give exact figures relating to volumes and billing rates. However, the management has clearly indicated in the conference call that the company earned better billing rates for its services. The main driver of this increase was efficiency in execution of fixed price projects (FPPs), which resulted in higher billing rates. These projects are generally turnkey projects with a high degree of complexity involved and as a result, earn better rates and margins for the company. TCS has a higher proportion of FPPs in its revenues (over 50%) as compared to other software majors (Infosys’ is at 30%). As far as volumes are concerned, the management has indicated that volume growth was in the region of 2.5% overall. This seems subdued and could be partly because the company did not book revenues for some of its FPPs that it started work on. However, going forward, the prospects appear robust and the revenue visibility is good.

The international revenues of the company grew at a decent 5.4% during 1QFY06. This helped to offset the flat growth witnessed in the India business, contributed in part by its subsidiary, CMC. Thus, these have been the main drivers of the 4.8% QoQ growth in revenues witnessed by TCS.

In terms of segments, TCS appears to be witnessing good traction in its enterprise business segment. TCS has the largest enterprise business practice among all software companies and managed to get good order wins from large clients during the quarter. However, during 1QFY06, the company’s onsite-offshore mix moved by 3.1% in favour of onsite revenues. The major reason given by the company is that a particular client shifted its rate structure from a blended rate model to a specific onsite/offshore model. Also, new FPPs have started to kick in. These projects are typically heavily onsite during the first phase of implementation and as a result, the revenue mix has shifted towards onsite during the quarter.

GE, the largest customer of the company, contributed to 13.1% of TCS’ consolidated international revenues in 1QFY06, down from 13.9% in the previous quarter. This decline in contribution seems to indicate 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. The active client base currently stands at 553 with the company adding a gross of 68 (53 in 4QFY05) clients in this quarter itself.

Better billing rates and cost management aid margins:  As mentioned above, TCS earned better billing rates due to execution efficiencies in FPPs. Further, despite the company raising Indian salaries by 11% and overseas salaries by 4% and the utilisation rates having fallen by 2.1%, the EBIT margins improved by 110 basis points, due in part to the better billing rates earned by the company. The other reason was better traction in international revenues as compared to India, where margins are typically higher. TCS also resorted to productivity improvements and cost rationalisation, resulting in a positive impact on margins. Equipment and software costs as well as communication cost savings helped drive the costs lower. The company’s cost of revenues reduced as a percentage of sales to 51.7% in 1QFY06 from 52.9% during the previous quarter. However, the appreciation of the rupee against the Euro and Pound negatively impacted TCS to the tune of Rs 200 m.

TCS hired 2,690 employees during 1QFY06, considerably more than the 1,775 employees added in 4QFY05. However, the rise in employee costs was lower partly due to the fact that the company increased salaries mostly at the lower levels. Employee costs increased as a percentage of sales to 51.7% in 1QFY06 from 50.0% in the last quarter. Attrition in 1QFY06 was 8.2%, marginally higher than 8.0% in the previous quarter but considerably lower than the industry average of around 16%-17%.

Going forward, there appears to be scope for margin expansion. TCS is expected to increase the contribution of offshore services, as a number of FPPs are shifted offshore. Also, the scope to move a greater amount of work from existing clients offshore is strong. Given the fact that the salary increases have also been factored in, there does appear to be an upside to margins, currently at 27.4%, among the highest in the industry. Better utilisation rates are also expected to help margin expansion and TCS expects to increase utilisation rates by 3% over the next few quarters.

Better margins, higher other income raises net profits:  TCS reported a negative other income component in 4QFY05, due in part to foreign exchange losses. During 1QFY06, however, TCS reported Rs 98 m as other income. The higher margins at the EBIT level also helped mitigate the impact of higher taxes, which increased by as much as 49% on a QoQ basis. The impact of the fringe benefits tax (FBT) was Rs 90 m. Net profit growth after considering the one-off extraordinary item of EVA-based employee compensation expenses in 4QFY05 and EVA adjustment comes to a strong 13.6%. However, if we exclude these adjustments, the growth is at 9.0%. From this year onwards, the impact of the EVA-based compensation expenses will be spread out over all four quarters.

Performance in the recent past…
  2QFY05 3QFY05 4QFY05 1QFY06
Sales growth (%, QoQ) 13.9 6.1 0.2 4.8
Cost of revenues (% of sales) 55.1 52.6 52.9 51.7
SG&A expenses (% of sales) 17.0 18.9 20.7 20.9
EBIT margins (%) 27.9 28.5 26.3 27.4
Profits growth (%, QoQ)* 14.3 22.5 (19.7) 9.0
* Net profit figures exclude all one-off items

What to expect?
At the current price of Rs 1,248, TCS’ stock is trading at a price to earnings multiple of 24.2 times annualised 1QFY06 earnings. This is at the lower end of the valuation spectrum and is attractive from a long-term perspective. The company has also announced that Tata Infotech Limited (TIL) will be merged with it, effective April 1, 2005. Tata Infotech is an IT firm having strengths in systems integration, manufacturing, education and training. TIL employs 3,600 professionals and has a strong presence in the US, UK and Australia. This merger is expected to enable TCS to become a true end-to-end services provider, providing services across the value chain, training in upstream as well as downstream activities. TCS will also get access to Fortune 500 clients of TIL and be in a position to service a greater number of verticals as well as geographies. Investors will get 1 TCS share (face value Re 1) for every 10 TIL shares (face value Rs 10) held by them. Post-merger, the paid-up capital of TCS will increase from Rs 480 m to Rs 489 m.

Based on our FY07 estimated EPS, the stock trades at a price to earnings multiple of 17.3 times. As such, we maintain our earlier recommendation of a ‘Buy’ on the stock with a target price of Rs 1,730 (CAGR 18%). 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.

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