TCS: The new favourite

TCS' numbers surprise on the upside

Tata Consultancy Services (TCS) has finally filed the draft prospectus for its initial public offer (IPO) with the Securities and Exchange Board of India.

This gives an opportunity to look at the financials of the country's largest software player and compare it with the current market favourite in the sector, Infosys Technologies.

Based on profitability parameters, TCS is placed well, with an operating margin of 25.23 per cent (based on US GAAP (consolidated numbers) in the nine months till December 2003.

Of course, Infosys has a much better operating margin of 33 per cent, but that's partly because TCS's selling and marketing expenses stood at a huge 20 per cent of sales compared with just 14.3 per cent for Infosys.

At the gross profit level, TCS's margin of 48 per cent (consultancy services division) compared favourably with Infosys' 47.6 per cent. Considering the high spend on selling and marketing currently, one could expect a scale down in this head of expense as a percentage of sales, which would result in an improvement in operating margin.

Players such as Infosys, on the other hand, are expected to increase selling and marketing expense because of increased competition from multinationals.

Surprisingly, TCS witnessed a big improvement of over 250 basis points in operating margin in the nine months till December when compared with fiscal 2003.

Infosys, like most other players, saw margins falling instead, by almost 300 basis points. The draft prospectus doesn't explain how the company managed this in a year when the whole industry struggled with increasing staff costs on one hand and flat-negative billing rates on the other.

But one reason could be that fiscal 2003 represented a rather low base - operating margin in FY03 had fallen over 600 basis points compared with FY02.

But what's really surprising is that TCS's consultancy services business enjoys a gross margin of as high as 48 per cent. Surprising because some parameters such as percentage of offshore revenues are inferior compared with Infosys and other majors.

Offshore revenues as a percentage of total revenues was just 35.9 per cent in the nine months till December 2003, compared with a level of around 50 per cent for other top players.

Besides, fixed price contracts (a big proportion of which is considered negative because it could hurt margins in case of a cost overrun) accounted for 56.3 per cent of revenues, amongst the highest in the industry. Companies such as Infosys have a lower proportion of around 35 per cent coming from fixed price contracts.

Worse still, the General Electric group of companies, which markets perceive pay less than market billing rates because of the huge volumes it gives, accounts for 19 per cent of revenues. Keeping all these factors in mind, the gross margin which is slightly higher than Infosys is impressive indeed.

But the gross margin for the whole company is lower at 45.6 per cent thanks to the inclusion of lower margin businesses like the sale of equipment and software licenses. These businesses are primarily done by subsidiary CMC.

On the whole, TCS's profitability numbers currently may compare well with peers, but the risk factors including the high client concentration and high proportion of revenues from fixed price contracts could dampen valuations.

In a best case scenario, the company is expected to enjoy a valuation as much as Infosys, which trades at 23 times FY05 earnings. Rough estimates for its EPS is Rs 40 a share, factoring in a growth of 25 per cent over FY04.

Assuming a discounting of 23 times, the stock could enjoy a price of Rs 920 after listing. The issue price will obviously be at a reasonable discount to this, and the discount would depend on prevailing market conditions.

In any case, unless market sentiment for the IT sector improves dramatically, the TCS issue price may be lower than the Rs 850-950 range doing the rounds of the markets. There could be a surprise upside though if the markets decide to use Wipro instead as the benchmark, which enjoys a much better valuation thanks to a low floating stock. And the price could also be higher if the market improves after the budget.

Further, given the quantum of the issue, there should be sufficient foreign institutional investor (FII) interest, not only because of the quality of the stock, but also because FIIs prefer stocks in which large volumes are available. In any case, any exposure to Indian technology sector cannot ignore the market leader.

With contributions from Mobis Philipose