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TCS 2QFY08: Our view - Views on News from Equitymaster
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TCS 2QFY08: Our view
Oct 15, 2007

Performance summary
  • Revenue grows by 8.2% QoQ driven by 8.2% QoQ growth in volumes and 0.9% QoQ growth in billing rates. Rupee dampens topline growth by 0.51%.

  • EBITDA margins expand 0.5% QoQ mainly due to cost rationalisation. Rupee dampens operating margins by 0.3%.

  • The company will put in mechanism to diversify across geographies and hedging strategies.

  • PAT grows by 4% QoQ largely impacted due by the lower other income and higher tax incidence. Forex hedging stood at US$ 2.6 bn.

  • Adds 51 new clients and 9,268 employees during the quarter. Attrition rate in IT services stood at 10.9% and BPO at 17.1%

Consolidated financial performance: A snapshot…
(Rs m) 1QFY08 2QFY08 Change 1HFY07 1HFY08 Change
Sales 52,029 56,397 8.4% 86,497 108,426 25.4%
Expenditure 38,643 41,610 7.7% 63,641 80,253 26.1%
Operating profit (EBITDA) 13,386 14,787 10.5% 22,856 28,173 23.3%
Operating profit margin (%) 25.7% 26.2%   26.4% 26.0%  
Other income (Net) 1,618 1,221 -24.5% 871 2,839 225.9%
Interest & depreciation 1,322 1,431 8.2% 1,951 2,753 41.1%
Profit before tax 13,682 14,577 6.5% 21,776 28,259 29.8%
Minority interest and share of profit of associates 110 16 -85.0% 148 126 -14.9%
Tax 1,543 2,045 32.5% 2,614 3,588  
Profit after tax/(loss) 12,029 12,516 4.0% 19,013 24,545 29.1%
Net profit margin (%) 23.1% 22.2%   22.0% 22.6%  
No. of shares (m)         978.6  
Diluted earnings per share (Rs)*         48.7  
P/E ratio (x)         21.9  
*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 2QFY08?
Volume growth and billing rates drives topline: TCS recorded a topline growth of 8.4% QoQ driven by 8.2% QoQ growth in volumes and 0.85% QoQ growth in billing rates. The appreciation in rupee shaved off 0.5% from the company’s topline. The average rupee dollar realisation rate for the company was Rs 40.5. In terms of geographies US still remains the most dominant market for TCS with 52% of revenues coming from there. The US revenues recorded a growth of 10% QoQ while Latin America, Asia Pacific and Middle East and African (MEA) recorded growth of 20%, 13% and 29% QoQ respectively. The growth in Latin America is primarily because the company has many development centres over there and is also planning to increase the headcount in those areas to reap the benefits of similar time zones and lower costs. The growth is Asia Pacific market is due to company’s consistent move to diversify across geographies and TCS will be bidding for big domestic projects along with CMC going forward.

In terms of domain specialisation, BFSI still remains the dominant vertical with over 43% of revenues coming from it. The BFSI and telecom vertical, which are the two most important segments for TCS grew at 9% QoQ and 10% QoQ respectively. But the major contributor to the overall growth was the transportation segment which recorded a growth of 49% QoQ with energy and utilities vertical recording a growth of 18% QoQ. While the contribution of these two segments is relatively small to the overall revenues the company expects these verticals to contribute more in future.

TCS’ service offerings: Infrastructure services, assurance services and consulting leads the way

  1QFY08 2QFY08  
Service lines Revenue share Revenue (Rs m) Revenue share Revenue (Rs m) QoQ growth
Application Development and Maintainance 51.5% 26,795 48.6% 27,409 2.3%
Business Intelligence 9.6% 4,995 9.7% 5,471 9.5%
Engineering and Industrial Services 5.3% 2,758 5.3% 2,989 8.4%
Infrastructure Services 5.7% 2,966 6.9% 3,891 31.2%
Enterprises Solutions 12.4% 6,452 12.8% 7,219 11.9%
Global Consulting 3.0% 1,561 3.3% 1,861 19.2%
Asset Leverage Solutions 3.3% 1,717 3.4% 1,918 11.7%
Assurance Services 3.3% 1,717 3.8% 2,143 24.8%
Businee Process Outsourcing 5.9% 3,070 6.2% 3,497 13.9%

In terms of service offerings, the ADM segment contributes to a little over 48% of total revenues but for the first time non-ADM services have contributed to more than 50% of total revenues. This is an encouraging development as for Indian companies to move up the value chain it needs to focus more on the higher end jobs. The IMS services recorded a growth of 31% QoQ, while Assurance services and consulting recorded a growth of 25% QoQ and 19% QoQ respectively.

The company lost out 0.99% due to offshoring leverage as offshore revenues increased from 41% in 1QFY08 to 43% in 2QFY08. TCS added a net of 9,268 employees during the quarter and the attrition rate remained stable at 11.5%. On the client side, it added 51 new clients during 2QFY08 and 63% of the new clients (32 of them) have come from countries other than the US.

Cost rationalisation drives operating margins: TCS’ operating margins improved by 0.5% under the Indian GAAP in 2QFY08 (0.77% under the US GAAP). The drivers for the expansion in operating margins were the pricing increase, hedging gains and leverage due to offshoring. The dampeners in case of margins was appreciation rupee and partial wage hikes affected during the quarter. The costs of revenues as % of sales increased by 7% QoQ while the SG&A increased by 11% QoQ.

Lower other income and higher taxes dampens bottomline: TCS recorded a bottomline growth of 4% QoQ. The growth in bottomline was pared mainly due to lower other income and higher taxes. Lower other income was mainly due to change in hedging policy in 1QFY08. Another significant change in 2QFY08 was that the company took forex gains of Rs 450 m in topline and balance forex gains of Rs 577 m in other income so the operating margins change should be looked in this context. However, in totality it will have no effect on bottomline.

The effective tax rates increased from 11% in 1QFY08 to 14% in 2QFY08, which resulted a 33%, QoQ increase in tax outflows. While the taxes for IT sector are bound to go up after STP (software technology park) scheme comes to an end one should not believe that the STP benefit will not be extended.

Performance in recent past:
  1QFY06 2QFY06 3QFY06 4QFY06 1QFY07 2QFY07 3QFY07 4QFY07 1QFY08 2QFY08
Sales growth (%, QoQ) 4.8 8.9 10.6 8.1 11.3 8.2 8.4 5.9 0.8 8.4
Cost of revenues (% of sales) 51.7 53.4 53.8 54.7 55.5 53.3 55.6 54.7 56.1 55.2
SG&A expenses (% of sales) 20.9 19.5 20.1 20.5 20.1 19.3 18.3 19.7 20.2 20.7
EBIT margins (%) 27.4 27.1 26.2 24.9 26.0 27.6 27.0 30.4 23.3 26.1
Profits growth (%, QoQ) 9.0 8.8 11.4 7.9 8.4 14.9 11.4 7.1 0.7 4.0

What to expect?
At the current price of Rs 1,066, the stock is trading at a multiple of 12.6 times our estimated FY10 earnings. The company has already made 22,000 campus offers for the coming year and this serves as an indication of good volume growth for the future. On the pricing front, the company has been able to negotiate new contracts at 4% to 5% higher billing rates while the existing contracts are being renegotiated at 2% to 3% upwards in terms of pricing. The company is continuously diversifying across geographies and service offerings to offset the impact of rupee appreciation and with higher end service contributing more to revenues make things look good for the company. As regards attrition the company has been able to maintain its attrition level as the same rate as on 1QFY08 at 11.5%, which is commendable considering its employee base of over 1 lakh people. We maintain our positive view on the stock from a long-term perspective

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