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Taking stock of TCS

Krishnan Thiagarajan

The price fixation process will have to necessarily factor in the relative financial and operational parameters of TCS vis--vis Infosys Technologies and Wipro, the two billion-dollar peers in the software sector.

THE long awaited "mother of all public offers" is finally on the homestretch. This may be a terribly clichd phrase, but nothing better describes the filing of the draft prospectus by Tata Consultancy Services to the Securities and Exchange Board of India. As the initial public offering is imminent, both the pecking order and the fund allocation patterns among frontline and second-rung software companies is poised to undergo a change. In the coming weeks, the portfolio churn among mutual funds and high networth investors is also slated to gather momentum.

Pricing holds the key

With the filing of the draft prospectus, all eyes will be trained on two variables: One, obviously, the timing of the offer. Two, and far more critical, the pricing. Speculation on these two elements, particularly the offer price, has already started doing the rounds. From the financials of TCS that have been available in the public domain, the pricing may be dominated by a combination of factors:

  • The offer price may be conservative or aggressive depending on the perception of the TCS top management about the FII (foreign institutional investor) and domestic institutional appetite for software stocks, as at least 60 per cent of the offer is to be made to Qualified Institutional Buyers. If the QIB appetite for quality offerings in recent times is anything to go by (Biocon and ONGC are recent examples), we believe that TCS' offering would have a distinct aggressive tilt.

  • The timing of the offer will be critical. If the stock market rallies immediately after the Budget, on July 8, or there is a flight of funds towards the software sector stocks improving overall valuation, TCS should provide further fodder to price the offer aggressively.

  • Relative valuations will hold the key. It will be interesting to see if TCS prices its offer below the price earnings multiple of Infosys Technologies, its closest peer, or between the PE multiple of Infosys and Wipro.

    ... Dictated by financial variables

    Apart from the market perception, the price fixation process will have to necessarily factor in the relative financial and operational parameters of TCS vis--vis Infosys Technologies and Wipro, the two billion-dollar peers in the software sector. As information on these two fronts is available in the public domain for the first time, it is interesting to see how TCS stacks up relative to Infosys, in particular, and Wipro to some extent on these two parameters.

    Financial parameters

    On the profitability front, Infosys scores over TCS, though not by a wide margin. On a standalone basis, for the nine months ended December 31, 2003, the profit before interest and tax (PBIT) margin of Infosys at 30.3 per cent is higher than TCS' 28 per cent followed by Wipro. Even the gross and operating margins of Infosys are higher than that of TCS'.

    Two factors underscore the higher profitability of Infosys relative to TCS. The offshore contribution of Infosys at 49 per cent is considerably higher than the 36 per cent for TCS.

    Typically, a higher offshore contribution yields a higher operating margin and this has helped Infosys. Second, the selling and marketing, general and administrative expense of Infosys at 15 per cent of consolidated revenues is lower than the 20 per cent for TCS.

    As offshoring becomes mainstream, particularly in the US, TCS may be in a good position to enhance its offshore contribution and lower its selling/marketing expenses to push up its operating margins in the future.

    Besides this, the pace of revenue and post-tax earnings growth of Infosys has been far more consistent than that of TCS. For instance, the post-tax earnings of TCS in 2001-02 grew by 42 per cent, but declined by about 1 per cent in 2002-03.

    Obviously, profitability comparisons alone cannot be viewed in isolation. The shareholder funds (or net worth) of TCS at about Rs. 1,200 crore for the period ended December 31, 2003 is sharply lower than the Rs 3,250 crore of Infosys.

    This translates into a much higher return on shareholder funds for TCS vis--vis Infosys. This will be another financial variable that will play a key role in the pricing of the offer.

    Operational parameters

    TCS compares quite favourably with Infosys in terms of its revenues from different verticals (with focus on financial services and manufacturing), geography (the US and Europe) and service offerings (application development and maintenance). The client profile of TCS in terms of $10-50 million clients is even stronger than that of Infosys.

    Two other factors will be monitored in the price fixation process. One, the client concentration levels of TCS compared to Infosys. The top client of TCS and Infosys accounted for 5-6 per cent of revenues for both companies for 2003-04. But, interestingly, for TCS, the GE Group accounted for nearly 19 per cent of the revenues and the risk element associated with this exposure is fairly high.

    Two, the higher risk associated with fixed price contracts vis--vis the time and materials contract. For TCS, the fixed price contracts (representing better project management capability) at 56 per cent are considerably higher than 36 per cent for Infosys.

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