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TCS 2QFY07 results: Keeping up the tempo! - Views on News from Equitymaster
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TCS 2QFY07 results: Keeping up the tempo!
Oct 16, 2006

Introduction to results
TCS has announced its results for the second quarter and half-year ended September 2006. For the quarter, continued traction in major service lines and ramp ups by major clients across geographies and verticals led to a good performance on the topline front. Margins powered ahead, driven by lower employee costs, SG&A leverage and a strong shift towards offshore. The performance at the bottomline level has been impressive, which was driven entirely by the strong margin expansion seen during the quarter, even as other income fell significantly on a sequential basis and the effective tax rate was marginally higher. For the half-year, the performance has also been impressive.

Financial performance (US GAAP Consolidated): A snapshot
(Rs m) 1QFY07 2QFY07 Change 1HFY06 1HFY07 Change
Sales 41,443 44,822 8.2% 56,608 86,265 52.4%
Expenditure 31,316 32,528 3.9% 40,115 63,843 59.1%
Operating profit (EBITDA) 10,128 12,294 21.4% 16,492 22,422 36.0%
Operating profit margin (%) 24.4% 27.4%   29.1% 26.0%  
Other income 668 77 -88.4% 269 745 177.3%
Depreciation 863 958 11.0% 1,153 1,821 57.9%
Profit before tax 9,932 11,414 14.9% 15,608 21,346 36.8%
Equity in net earnings of affiliates 16 8   5 23  
Minority interest (85) (59)   (129) (144)  
Tax 1,238 1,447 16.9% 2,564 2,684 4.7%
Profit after tax/(loss) 8,626 9,915 14.9% 12,920 18,541 43.5%
Net profit margin (%) 20.8% 22.1%   22.8% 21.5%  
No. of shares (m) 489.3 978.6   480.1 978.6  
Diluted earnings per share (Rs)*         34.9  
P/E ratio (x)*         32.4  
* 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 2QFY07?
All-round growth powers the topline: During 2QFY07, TCS recorded a strong 8.2% sequential growth in its topline. This was a result of impressive across-the-board growth for the company, as was also the case in the previous quarter. During the quarter, TCS saw impressive traction, particularly in newer service lines such as business intelligence (19.3% QoQ growth), global consulting (18.3% QoQ), assurance (testing) services (44.2% QoQ) and BPO (10.0% QoQ). TCS continues to focus on getting maximum client wallet-share through the continuous expansion of its service lines, and its ‘full-service’ capabilities are clearly helping the company to drive growth at the topline level. As regards verticals, TCS saw good growth in banking, financial services and insurance (BFSI), which grew at 12.1% QoQ, as the company’s Latin American subsidiary, Comicrom, ramped up during the quarter on the back of deals won with companies in the banking and transportation verticals. TCS’ financial product software, QUARTZ, also won a few deals during the quarter, as did its anti-money laundering product. The ramping up of some enterprise solution deals won in previous quarters was the major driver for growth in the energy and utilities vertical, which saw an impressive 12.3% QoQ growth.

Talking of service lines, TCS’ newer service lines now account for as much as 45.4% of total revenues (excluding ADM and asset leveraged solutions/products). The company this quarter has seen continued strong client addition across most of its services, and the ramping up of these deals this quarter has contributed to the strong topline growth witnessed. It should be noted that from this quarter, TCS has disclosed significantly more information in terms of its service line break-up, which was not the case in previous quarters. This, in our view, is a positive, and going forward, will certainly showcase the company in a more investor-friendly light.

At the end of 2QFY07, TCS had 742 active clients (net decline of 22 clients). Even though on a gross basis, the company added 58 new clients. The fact that there was a net decline is a reflection that most of these clients were project-based. However, if we look at the number of clients in different revenue buckets, this has continued to rise, and the total number of clients giving TCS revenues in excess of US$ 50 m (on a trailing 12-month basis) now stands at an impressive 15 (6 at the end of 2QFY06).

As regards employees, TCS, along with its subsidiaries, had 78,028 employees at the end of 2QFY07 (56,311 at the end of 2QFY06). The net hiring was 6,663 employees. The attrition rate in 2QFY07 on a trailing 12-month basis was maintained at 10.6%, which is undoubtedly a positive for the company, in what is becoming an increasingly competitive and cutthroat environment for hiring.

Employee cost, offshore shift power margins: During 2QFY07, TCS saw an impressive 300 basis points (3.0%) expansion in its operating margins. Consequently, the EBITDA grew by as much as 21.4% QoQ. The major drivers for this growth were, primarily, savings in employee costs (TCS had effected average salary hikes of 15% in April, and there will be no further hikes during the fiscal), SG&A leverage and a strong offshore shift.

Employee costs as a percentage of sales reduced to 54.8% (55.8% in 1QFY07). SG&A expenses also reduced to 8.9% of sales (9.9% in 1QFY07), and, in fact, were actually lower in absolute terms as well, due to savings in various cost heads such as travel and communication costs. On the other hand, TCS also witnessed an impressive shift offshore this quarter, as the company moved major US clients’ work offshore. From 38.1% of international revenues in 1QFY07, the offshore proportion stood at 41.0% this quarter, recording strong growth of 19.2% QoQ. This is a major positive for TCS, as it helps to maintain profitability.

It boils down to the bottomline: As was the case with Infosys, the strong margin expansion witnessed by TCS this quarter was mainly responsible for the strong growth in the bottomline, which grew at 14.9% sequentially. This was despite considerably lower other income (down by as much as 88.4% QoQ).

Performance in the recent past…
  3QFY06 4QFY06 1QFY07 2QFY07
Sales growth (%, QoQ) 10.6 8.1 11.3 8.2
Cost of revenues (% of sales) 53.8 53.4 55.5 53.3
SG&A expenses (% of sales) 20.1 20.2 20.1 19.3
EBITDA margins (%) 26.2 26.4 24.4 27.4
Profits growth (%, QoQ) 11.4 7.9 8.4 14.9
Employees (Nos.) 59,384 66,480 71,190 78,028
Utilisation (%, including trainees) 75.5 75.8 77.3 75.2
Revenue per employee (Rs m, annualised) 2.2 2.2 2.3 2.3
Revenue per client (Rs m) 48.2 49.9 54.2 60.4

What to expect?
At the current price of Rs 1,130, the stock is trading at a price to earnings multiple of 24.5 times our estimated FY08 earnings. The board has recommended a second interim dividend of Rs 3 per share (dividend yield of 0.27%).

Going forward, we remain positive on TCS’ business prospects. The company continues to win deals across service lines, geographies and verticals. We believe that its ‘full-service’ capabilities will stand it in good stead going forward. The strong traction witnessed, particularly in newer service lines, give us confidence that the company is on the right track in terms of moving higher up the value chain, and getting a larger share of the client’s wallet. The company has by far the most vast reach in terms of global development centres, and with its strong management quality, scalability, execution excellence and top-tier status, we expect it to be one of the major beneficiaries of the offshoring story.

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. Of course, this quarter was an exception for TCS, with attrition rates remaining stable, but we do not believe that this is sustainable. 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 808, with a medium-term target price of Rs 1,107. Overall, we remain positive on TCS’ future growth prospects.

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