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TCS 1QFY08: Toeing the line - Views on News from Equitymaster
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TCS 1QFY08: Toeing the line
Jul 16, 2007

Introduction to results
  • Revenue grows marginally by 1% QoQ, largely impacted by rupee appreciation
  • EBITDA margins contracts 2.7% QoQ. Apart from rupee appreciation, salary hikes and visa costs hit margins.
  • Higher onsite component in revenues also impacts profitability
  • PAT grows by 0.7% QoQ due to high other income resulting from forex hedging of US$ 2.5 bn.
  • Adds 54 clients and 8,760 employees (gross) during the quarter. Attrition at 11.5%.
  • Declares interim dividend of Rs 3 per share – dividend yield of 0.3%.

Consolidated financial performance: A snapshot…
(Rs m) 4QFY07 1QFY08 Change
Sales 51,621 52,030 0.8%
Expenditure 36,979 38,640 4.5%
Operating profit (EBITDA) 14,642 13,390 -8.5%
Operating profit margin (%) 28.4% 25.7%
Other income (Net) 1,048 1,618 54.3%
Interest & depreciation 1,405 1,322 -5.9%
Profit before tax 14,285 13,686 -4.2%
Minority interest and share of profit of associates 129 112 -13.4%
Tax 2,204 1,543 -30.0%
Profit after tax/(loss) 11,952 12,031 0.7%
Net profit margin (%) 23.2% 23.1%
No. of shares (m) 978.6
Diluted earnings per share (Rs)* 46.5
P/E ratio (x) 25.0
*on a trailing twelve months basis

What is the company business?
TCS is the largest software company in Asia, having a wide range of offerings and catering to industries like banking and financial services, 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 works closely with its clients and this has helped the company in building long term relationships with some key customers. During the period between FY02 and FY07, TCS has grown its sales and net profits at compounded annual rates of 34% and 30% respectively.

What has driven performance in 1QFY08?
Volume growth and billing rates drive topline: TCS recorded a topline growth of 1% on QoQ basis largely driven by a 7.6% rise in volume and a 0.6% rise in billing rates, while rupee which has appreciated 7% during the quarter shaved off 6.6% from this growth. The management has indicated that around 80% of the contracts that are coming in for renegotiation are being booked at 3% higher billing rates with the rest being revised at 4% to 5% higher rates. This is in line with what we have estimated for the company for FY08. In terms of geographies, the US continues to be the most dominant region (QoQ growth of 1%) with 51% of the consolidated revenues coming from the region. However, compared to other IT majors, TCS share from US is relatively less. Endorsing the industry need to diversifying to other geographies in order to tackle rupee appreciation, the revenues from Middle East region grew by 15% QoQ.

In terms of services, application development and maintenance (ADM) services continue to dominate TCS’ offerings (QoQ growth of 1%). Understanding the need to move up the value chain in order to contain the growth of multinationals, services like assurance recorded a growth of 28% QoQ and the products business (asset leveraged solutions) recorded a growth of 7% QoQ. In terms of business verticals, the BFSI vertical recorded QoQ growth of 5% whereas retail and distribution and telecom segment recorded a growth of 19% and 8% on QoQ terms. The company is witnessing good traction in the BFSI as well as in retail and distribution segments.

On the clients side TCS added 3 new clients giving it annual revenues of over US$ 100 m and is pursuing 20 deals worth US$ 50 m. The attrition rate was stable at around the 11.5% mark and the company was able to increase its utilisation rate to 76% from less than 75% in 4QFY07. The company added a net of 5,483 employees and the intake for 2QFY08 is expected to be around 11,000.

TCS recently started its separate products division by transferring its core banking solution BANCS to the new division. We believe that this is a good move by the company as focusing on products and diversifying into economies is the need of the hour. The company has also opened new development centres in Mexico and Morocco and is also scaling up rapidly in Brazil, Chile and China. As a matter of fact, the Mexican centre is already handling 2 large clients and the workforce over there would touch 500 by the end of FY08.

TCS’ service offerings: Assurance services, products lead the way
Service lines Revenue share Revenue (Rs m) Revenue share Revenue (Rs m) QoQ growth
Application Development and Maintainance 51.3% 26,482 51.5% 26,795 1.2%
Business Intelligence 9.8% 5,059 9.6% 4,995 -1.3%
Engineering and Industrial Services 5.4% 2,788 5.3% 2,758 -1.1%
Infrastructure Services 6.0% 3,097 5.7% 2,966 -4.2%
Enterprises Solutions 12.3% 6,349 12.4% 6,452 1.6%
Global Consulting 3.5% 1,807 3.0% 1,561 -13.6%
Asset Leverage Solutions 3.1% 1,600 3.3% 1,717 7.3%
Assurance Services 2.6% 1,342 3.3% 1,717 27.9%
Businee Process Outsourcing 6.0% 3,097 5.9% 3,070 -0.9%

Wages, visa costs and rupee dampen margins: TCS’ operating margins contracted by 2.6% QoQ during 1QFY08, largely due to appreciation in the rupee against the dollar, which contributed to 2.6% decline in margins. Wage hikes dented margins by 2.1% but a favourable hedging policy helped the company to negate the impact by 2.1%. Generally, the impact on margins for IT company are much more severe in the first quarter mainly due to salary hikes and visa costs but in this quarter additional burden due to appreciation of rupee against the US dollar and most other major currencies impacted the margins severely.

Performance in recent past:
1QFY06 2QFY06 3QFY06 4QFY06 1QFY07 2QFY07 3QFY07 4QFY07 1QFY08
Sales growth (%, QoQ) 4.8 8.9 10.6 8.1 11.3 8.2 8.4 5.9 0.8
Cost of revenues (% of sales) 51.7 53.4 53.8 54.7 55.5 53.3 55.6 54.7 56.1
SG&A expenses (% of sales) 20.9 19.5 20.1 20.5 20.1 19.3 18.3 19.7 20.2
EBIT margins (%) 27.4 27.1 26.2 24.9 26.0 27.6 27.0 30.4 23.3
Profits growth (%, QoQ) 9.0 8.8 11.4 7.9 8.4 14.9 11.4 7.1 0.7

Other income and lower taxes boost net margins: TCS’ other income grew by 54% QoQ during 1QFY08, mainly due to adoption of favourable hedging policies. The company recorded a net forex gain of Rs 1.1 bn and interest income of Rs 443 m during the quarter. TCS now have hedged its receivables beyond one year and currently has a forex hedge of US$ 2.5 bn. Though the impact of forex gains was higher in this quarter because of sudden appreciation in rupee, going forward gains on forex hedging will come down, as the margins of banks on hedges will increase.

Secondly, the company recorded a write back is tax of Rs 253 m pertaining to earlier quarter which provided the much required impetus to the net margins. If this would not have happened, the net profit would have contracted by 1.5% QoQ.

What to expect?
At the current price of Rs 1,163, the stock is trading at a multiple of 16 times our estimated FY09 earnings. We have factored in margin contraction in our estimates for TCS. We shall soon update our numbers incorporating FY10 estimates for the company. In the meantime, we remain positive on the stock from a long-term perspective given the continued buoyancy in global offshoring activities and the company’s scalable business model that is capable of managing the strong growth momentum in the future.

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