TCS: Costly option

Positive response to TCS results has made IT stocks more expensive

Tata Consultancy Services' (TCS) June quarter results were taken rather well by the markets, although the numbers were marginally below consensus estimates. The stock jumped 5.9 per cent on Monday, thanks to positive surprises on profitability and order wins.

The revenue growth of 4.8 per cent was slightly lower than expectations, and was dragged down by the performance of the domestic business, which grew just 0.25 per cent. But the highlight of last quarter's results was a 100 basis points jump in operating margin, especially since Infosys had reported a 150 basis points drop in margin.

One way to look at this rise is that it came off a low base - operating margin had fallen 250 basis points in the March quarter. But what's surprised the markets is that margins rose last quarter despite salary hikes, a shift to onsite work, and a 200 basis points drop in utilisation.

One of the reasons for this is that the proportion of international revenues increased last quarter. Moreover, domestic business reported better margins thanks to a reduction in low-margin equipment sales.

According to the company, it also had efficiency gains from some fixed-price contracts. Fixed price contracts account for over 52 per cent of the company's revenues, which is much higher than peers.

Normally, this is seen as a risk to margins, since the company has to absorb any cost overrun. But the fact that TCS has managed to eke out efficiency gains is commendable.

The other highlight was a $100 million contract the company won last quarter. Although such large projects aren't profitable in the initial phase of execution, they propel growth numbers.

For now, TCS continues to grow at rates that are lower than that of Infy - its revenues and operating profit grew by 27 and 24 per cent respectively on a year-on-year basis last quarter.

Infosys, on the other hand, grew both revenues and operating profit by about 36 per cent. This is one of the reasons TCS continues to trade at a discount - despite the jump in its stock price, its forward PE is about 12 per cent lower than Infy's.

Analysts feel the differential is too high, given TCS's ability to execute large sized projects and its superior execution of fixed-price projects.

Besides, since there's room for improvement on utilisation, and the offshore-onsite mix, the differential in earnings growth is also expected to taper.

But it'll be strange if the TCS stock rises from current levels to close the gap with Infosys, given that both stocks enjoy rather high valuations of 21.3 and 24.2 times forward earnings.

Both firms need to grow earnings by 12.5 per cent sequentially on an average to meet consensus estimates, which means that there's ample room for disappointment. It would make more sense for these stocks to correct given their high valuations.

Hero Honda/Bajaj Auto

Hero Honda reported a mere 2.4 per cent rise in operating profit last quarter, despite a 14.8 per cent increase in sales. Interestingly, the scrip closed 4 per cent higher at Rs 654, which is about 14 times estimated FY06 earnings, much higher than the 7.6 per cent growth in net profit reported last quarter.

Hero Honda faced supply constraints owing to labour problems at a few of its suppliers' units. This led to a lower than industry volume growth of 12.88 per cent last quarter.

Worse still, margins fell by 180 basis points mainly owing to raw material pressure. The company's annualised sales last quarter was 2.75 million, which is very close to its capacity of about 2.8 million per annum.

While the company will soon announce plans of a new plant to augment capacity, it looks like sales growth in the immediate term would not be much higher than last quarter's levels.

Given the lacklustre performance, it's surprising that the scrip has been re-rated by about 20 per cent in just the past month. The reason Hero Honda and other two-wheeler stocks have been re-rated lately is the optimism about the impact of monsoon on two-wheeler demand.

Bajaj Auto, too, has risen by over 13 per cent to Rs 1425 in the past month, and now trades at about 15.7 times forward earnings. In Bajaj's case, the relatively high valuation seems justified, given the fact that its net earnings grew 27 per cent last quarter.

Thanks to a slew of successful motorcycle launches, Bajaj is leading the industry in terms of growth. Its motorcycle volumes grew 53 per cent last quarter, against the industry's growth of 24 per cent. Total volumes grew at a lower rate of 36 per cent, owing to a drop in sales of other two-wheelers and three-wheelers.

Nevertheless, the revenue growth of 33.3 per cent was way ahead of hero Honda. With operating leverage kicking in with the higher volumes, operating margin improved by 70 basis points and operating profit jumped by almost 40 per cent.

The improvement in margin was despite a 290 basis points increase in raw material expenses as a percentage of sales. Unlike Hero Honda, Bajaj has a fast growing stream of revenues coming from the insurance business. Last quarter, this segment grew by 116 per cent and accounted for 18 per cent of total segment revenues.

Further, its investment portfolio was worth Rs 574 per share at the end of June 2005. Adjusted for these, the core auto business appears reasonably valued.

With contributions from Mobis Philipose