TCS: Forex fillip

Stripped of other income, TCS' numbers are largely in line with those of Infosys Technologies

TCS sprang a big surprise when it reported a huge 23 per cent sequential jump in net profit, much higher than the most optimistic estimate. For perspective, Infy had announced a 11 per cent growth on Wednesday. How did it manage that?

To counter an appreciating rupee, TCS built up a huge forward cover position worth $606 million by end-December, up 121 per cent from the September quarter levels. The mark-to-market (at the end-December rate of Rs 43.27/dollar) gains from the forward cover, booked at an average rate of Rs 44.98/dollar, stood at Rs 109.58 crore.

Even after accounting for translation losses (when debtors turned into cash) and losses arising out of the revaluation of debtors at end-December rates, the company had a net gain of Rs 78.88 crore from forex transactions.

That amounts to 3 per cent of sales, and if excluded, growth in net profit would be much lower at 9.4 per cent.

The impact of the rupee appreciation on revenues and operating profit was not provided by the company. But despite the hit on profitability on that account, TCS managed an 80 basis points improvement in operating margin, thanks to higher proportion of value-added services, a shift to offshore work, and productivity gains. Infy had reported a 90 basis points improvement in operating margin.

The higher than expected profit in the December quarter would result in an upward revision in TCS's FY05 EPS estimates to over Rs 50 per share, from the current levels of Rs 48 per share.

Yet, the TCS stock fell marginally on Thursday despite an over 3 per cent rise in NSE's CNX IT index. This could be because the jump in profit was largely on account of the exceptional forex gain.

Moreover, TCS's valuation, at around 21 times estimated FY06 earnings, is rich considering that it's similar to that of Infosys, which scores over the former in terms of having a longer history of consistent quarterly performance, better disclosure and a much higher cash balance.

Mercator Lines

Everybody knows that shipping companies' results would be very good on a year-on-year basis, thanks to the huge rise in freight rates.

Mercator Lines' third-quarter results, however, show that the company has done well even on a quarter-on-quarter basis. Its profit after tax at Rs 58 crore has grown sequentially by an impressive 83 per cent. Y-o-y profit has grown 316 per cent.

MLL, like other Indian shipping companies, has an overwhelming emphasis on transporting oil and petroleum products. And average freight rates in this segment in the December quarter have improved considerably vis-a-vis the earlier quarter, mainly due to robust demand for petroleum products from the US, China and India.

In the case of VLCC, average freight rates have improved sequentially by about 111 per cent and for Aframax, they have risen 127 per cent.

Setting off this improvement in freight rates has been an increase in operating costs sequentially-staff costs have grown 58 per cent.

However, MLL's larger turnover base helped operating profit in the December quarter grow sequentially by 64.2 per cent to Rs 71.62 crore (excluding other income and profit on sale of assets) and operating profit margins have improved 817 basis points to 43.07 per cent.

If MLL is an indicator, other leading Indian shipping companies like Great Eastern Shipping and SCI are also expected to report aggressive sequential profit growth.

Looking forward, spot freight rates in the tanker segment had eased about 20 per cent in December from the unsustainable levels reached earlier, but they are expected to remain firm due to a favourable supply-demand balance of tanker capacity globally.

Hero Honda: Not much splendour

Competitive pressures in the two-wheeler industry are finally telling on Hero Honda's margins, as are the higher raw material costs. A combination of these drove down the company's operating margin to 15.5 per cent last quarter, a 150 basis points y-o-y drop.

Though revenues rose 27 per cent to Rs 2019 crore, expenses for the third quarter jumped almost 29 per cent. As a result, operating profit grew just 15.3 per cent. The growth in profit before tax was lower at 12 per cent, mainly because of a drop in other income.

The demand for two-wheelers continues to be strong, but given competitive pressures Hero Honda had to spend on marketing and promotion and offer freebies and discounts.

This is now beginning to impact the bottomline. This is reflected in the higher other expenditure which was at 10 per cent of sales last quarter, up from 8.9 per cent.

Though the industry is getting increasingly polarised with the market share of the top two players now almost 80 per cent, pricing power seems to be missing. Raw material costs as a percentage of sales have risen from 70 per cent in Q3FY04 to 71 per cent.

The pressure on margins is expected to continue in the medium-term, especially given the expected increase in competition (entry of Honda and Suzuki).

As a result, analysts expect earnings growth to be muted in FY06 at around Rs 46 per share, which gives it a forward PE of 12 times. Given the sharp appreciation in the Hero Honda stock late last year (See chart), further upside would largely be in line with the market.

With contributions by Mobis Philipose, Amriteshwar Mathur and Shobhana Subramanian