TCS 1QFY07 results: All-round growth!

Introduction to results

---

TCS announced its results for the first quarter ended June 2006 late today evening. For the quarter, strong volume growth, favourable exchange rate movements and traction in key service lines and geographies has led to an impressive double-digit growth in the topline. However, margins have contracted, mainly due to higher employee costs on the back of salary increases made effective from April 2006. Nonetheless, despite the lower margins and a considerably higher effective tax rate, higher other income has led to the bottomline growing at a decent sequential pace.

Financial performance (US GAAP Consolidated): A snapshot

(Rs m)	4QFY06	1QFY07	Change
Sales	37,234	41,443	11.3%
Expenditure	27,404	31,428	14.7%
Operating profit (EBITDA)	9,830	10,016	1.9%
Operating profit margin (%)	26.4%	24.2%
Other income	(40)	668
Depreciation	865	751	-13.1%
Profit before tax	8,925	9,932	11.3%
Equity in net earnings of affiliates	33	16
Minority interest	(103)	(85)
Tax	898	1,238	37.9%
Profit after tax/(loss)	7,958	8,626	8.4%
Net profit margin (%)	21.4%	20.8%
No. of shares (m)	489.3	489.3
Diluted earnings per share (Rs)*		62.6
P/E ratio (x)*		29.3

* On a trailing 12-month basis.

What is the company’s 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 has grown revenues and profits from FY01 to FY06 at compounded rates of 34% and 30% respectively.

What has driven performance in 1QFY07?

---

Growth across-the-board: During 1QFY07, TCS recorded a strong 11.3% QoQ growth in its topline. The company saw a strong 8.1% sequential volume growth, which was the primary driver for the double-digit revenue growth. Favourable exchange rate movement during the quarter contributed to the balance revenue growth of 3.2%, leading to the total 11.3% QoQ growth in revenues. During the quarter, the rupee depreciated by around 3.1% against the US dollar, by 6.9% against the pound and by 8.5% against the euro.

TCS also witnessed impressive performances in its key service lines and geographies. The company’s major service lines continue to witness strong traction, with package implementation (Enterprise Solutions) growing at nearly 15% QoQ, application development and maintenance (ADM) at 10.7% QoQ and other major services, such as BPO, engineering services, assurance services, infrastructure support and consulting witnessing 8.2% QoQ growth. The management has indicated that major orders won during FY06, such as ABN Amro and Pearl, are proceeding according to plan, and have started ramping up significantly. TCS’ UK subsidiary for executing the Pearl deal, ‘Diligenta’, became operational during the quarter.

As regards delivery-based revenues, with effect from 1QFY07, TCS has started classifying these as onsite, offshore and GDC/RDC (revenues from its global delivery centres across the globe), excluding its domestic revenues. While onsite revenues grew at 11.9% QoQ, offshore revenues saw a more impressive 14.8% QoQ growth. On the other hand, revenues from the GDC/RDCs declined by 2.8% QoQ. A shift to offshore was seen this quarter, which is a positive, as margins are higher offshore. The company has said that offshore leverage remains a key focus area and that existing accounts are moving offshore as per plan.

TCS also saw strong traction in its key verticals, with banking, financial services and insurance (BFSI), telecom and manufacturing in particular witnessing good growth rates of 9.7% QoQ, 28.4% QoQ and 8.6% QoQ respectively. Emerging verticals such as retail and distribution also grew at a strong rate of 16.5% QoQ. Thus, TCS continues to deepen the breadth and depth of its services to serve a greater number of verticals.

At the end of 1QFY07, TCS had 764 active clients (addition of 62 new clients). As regards employees, TCS, along with its subsidiaries, had 71,190 employees at the end of 1QFY07 (51,792 at the end of 1QFY06). The net hiring was 4,698 employees, excluding its Indian subsidiaries. The attrition rate in 1QFY07 on a trailing 12-month basis increased to 10.6% from 9.9% at the end of FY06. This has been the case with Infosys as well, and in fact, with all the other software companies over the past few quarters. We believe that this is a clear reflection of the pressure that all these companies are facing with regards to retaining talent. This is an industry-wide trend and is here to stay.

Annual wage hikes impact margins: During 1QFY07, TCS saw a 223 basis points decline in its operating margins. This was primarily a result of higher employee costs, which increased as a percentage of sales from 53.9% in 4QFY06 to 55.5% this quarter. TCS increased salaries of its employees by around 15% for the year, in line with what other software companies have done. Part of the margin contraction was also due to higher other expenditure, which was mainly a result of expenses incurred on the integration of some of its subsidiaries, such as ‘Diligenta’, in order to execute the Pearl deal.

Other income saves the day: Despite the margin contraction and a considerably higher effective tax rate, higher other income due to the exchange rate movements led to a decent 8.4% QoQ growth in TCS’ bottomline. While in 4QFY06, TCS incurred a Rs 40 m loss on account of forex movements, this quarter, there was a profit of Rs 668 m seen, leading to the improved bottomline performance.

Performance in the recent past…

	2QFY06	3QFY06	4QFY06	1QFY06
Sales growth (%, QoQ)	8.9	10.6	8.1	11.3
Cost of revenues (% of sales)	53.4	53.8	53.4	55.7
SG&A expenses (% of sales)	19.5	20.1	20.2	20.2
EBITDA margins (%)	27.1	26.2	26.4	24.2
Profits growth (%, QoQ)	8.8	11.4	7.9	8.4
Employees (Nos.)	53,329	59,384	66,480	71,190
Utilisation (%, including trainees)	75.0	75.5	75.8	77.3
Revenue per employee (Rs m, annualised)	2.2	2.2	2.2	2.3
Revenue per client (Rs m)	47.3	48.2	49.8	54.2

What to expect?

---

At the current price of Rs 1,835, the stock is trading at a price to earnings multiple of 19.9 times our estimated FY08 earnings. The board has recommended an interim dividend of Rs 3 per share (dividend yield of 0.2%).

Going forward, given the fact that TCS has won a number of large deals, revenue visibility appears good. The management has said that all salary hikes for the year have been affected and no further hikes will take place during the course of the fiscal. The pricing and margin outlook for FY07 continues to remain stable, with new clients and contracts for renegotiation coming in at higher-than-average rates. As we have been saying for some time now, the major concern for TCS, and other software companies as well, is the fact that attrition rates are on the rise, particularly at the mid-management levels. The company will have to continue to take steps to retain talent going forward, in order to compete effectively.

We had recommended a ‘Buy’ on TCS in June 2006 at Rs 1,617, with a medium-term target price of Rs 2,215. Overall, we remain positive on TCS’ future growth prospects, and have a ‘HOLD’ view on the stock from these levels.