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  • JUNE 28, 2010

Infosys vs. TCS: Round 2

In the first article of this series, we compared Infosys and TCS as per the P/E multiple. This showed us how much investors were willing to shell out for owning each of these stocks. We found out that TCS is currently trading at a premium to Infosys based on standalone earnings. A big difference from the situation a few years back. Anyways, in this article, we will compare how these companies fare in terms of profitability.

Profitability of Indian IT companies
Both TCS and Infosys work on the IT services outsourcing model. Most of their clients are overseas, but a large majority the work gets done in India and other low cost locations. Thus they are able to earn in dollars or pounds and spend in rupees. Exchange rates of the rupee versus these currencies make a big difference to their profitability. Rupee appreciation or depreciation causes net profits to see-saw. But, this situation is universal across all Indian IT companies.

Let us now discuss one of the key triggers that IT companies employ to improve their profitability. It's called the 'onsite-offshore revenue mix'.

Onsite employees refer to the employees working at the clients end, usually in an overseas location. Offshore employees are the ones working in an outsourcing hub (eg. India). As expected employees onsite get higher salaries than their counterparts in India. Billing rates for onsite employees are also higher

So simply put, for IT companies:

  • Onsite work= Higher revenues, low volumes, but low margins - as costs are also high

  • Offshore work = Lower revenues, high volumes, but high margins - as costs are low

Given this, It companies can play around with their margins using the onsite-offshore ratio. Here is how see how these two companies compare on this.

Source: Annual reports, Equitymaster Research,
*TCS's onsite mix includes revenues from its Global Development Centres

FY10 was a lesson in cost management for most IT companies. Pricing pressure from clients as well as a slowdown in discretionary IT spending caused most companies to face margin pressure. They reacted by cutting costs and improving operational efficiencies. TCS also changed its onsite-offshore mix. For many years TCS had one of the highest components of onsite revenues. This helped it increase visibility among clients and bid for large overseas deals. This is why its overall revenues were always higher than Infosys. But, Infosys was the king on the profitability front.

Source: Annual reports, Equitymaster Research,

During the recession however, as part of a strategic management decision TCS decided to build greater offshore capabilities. This lead to a huge jump in its offshoring mix as seen in FY10. Since this business has higher margins, it had an immediate impact on TCS's operating profits.

Source: Annual reports, Equitymaster Research,

TCS reported its best ever operating profit margin in FY10. Greater offshore abilities helped it provide greater value to clients at lower costs. Since most clients were also cash strapped during the recession, this move was a better option for them as well. TCS increased its offshoring presence sharply in FY10. But will it continue to increase it at such a pace going forward remains to be seen.

With the global situation improving and large contracts up for grabs, both companies will need to increase onsite presence. Certain contracts, especially ones from overseas governments, need a higher onsite presence. TCS has plans to recruit at least 3,000 employees onsite in FY11. Infosys plans to hire at least 1,000 people overseas.

Conclusion
We believe that Infosys still has the edge over TCS in operating margins. But, it has already leveraged its offshore presence. TCS still has room to use this margin lever and further increase offshore presence. Infosys recently expressed interest in overseas expansions to increase value added offerings such as consulting as well as growing its sales faster. It plans to raise its non-Indian employee base to 15% by 2012, from the current 5-6%.

We also believe that TCS may increase its offshoring presence further if it faces cost pressures. It may either keep offshore revenues at the same level or increase it marginally going forward. Infosys on the other hand wants to increase its employee base overseas. We thus see that with margins expected to shrink across the board in the future, the profitability gap between the two rivals may close down.

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