The weakening of the rupee over the past few months against the dollar will be favourable for IT companies. This is a reversal of the trend over the past year. Going forward, the rupee/dollar parity may remain stable; the prospect for further depreciation in the value of the rupee cannot be ruled out. This factor will lend stability to the earnings stream.

Add to these the inherent strengths of TCS such as its dominant scale and size of operations, strong expertise across verticals, broad range of service offerings and unmatched client relationships, and the rationale for investment in this IPO gets even stronger.

The listing will also help TCS leverage equity (or stock) as an acquisition currency to enhance its vertical capabilities or address gaps in industry, technical or service portfolios. For a large player such as TCS, selective acquisitions through this route may be beneficial, especially given its presence in the domestic market.

Risks and challenges

The risks associated with this IPO on the operational, strategic and investment front vis-à-vis its comparable listed peers, Infosys and Wipro Technologies (the Global IT Services and Products Unit of the diversified Wipro) are:

Operational risks

High onsite exposure: The onsite contribution of TCS at 64 per cent of revenues from international business is much higher than those of Infosys and Wipro Technologies. Typically, higher onsite contribution translates into lower operating margins.

The operating margin of TCS is, however, about 3 percentage points lower than that of Infosys but higher than that of Wipro. Due to higher fixed price contracts and lower employee costs, TCS has been able to mitigate to an extent the effect of its high onsite exposure on profitability levels.

A key reason for this is that TCS services a higher percentage of fixed price contracts in which productivity gains translate into higher margins. Between 2003 and 2004, TCS consciously increased the offshore exposure by 2 percentage points to 36 per cent. The challenge for TCS will be to sustain this onsite-offshore transition to maintain their margins.

The GE effect: The GE group is one of the largest clients of TCS, accounting for 18 per cent of revenues from international business and about 15 per cent of total revenues.

For TCS, the association with GE group goes back over a decade. With over Rs 1,000 crore in revenues coming from the GE group, TCS remains vulnerable on two fronts: revenue growth and billing rate pressures.

The outsourcing revenues from GE are likely to grow by 8-10 per cent. As the overall revenues of TCS grow at least in line with the industry, the contribution of GE will decline. GE is also known to be a tough client, which can demand fine billing rates in line with the performance of its international business units.

As a premium client, the margins of GE may be lower than the rest of TCS' clients. Both Infosys and Wipro snapped their business relationships with the GE Group in 1996 and 2002 respectively.

Other than TCS, which is GE's single largest vendor, Satyam, Patni Computers and iGate Global are the three listed vendors which continue their association with GE.

Domestic business presence: Nearly 12 per cent of TCS' revenues come from the domestic business. Part of this contribution comes from CMC, in which TCS holds a 51 per cent stake.

While it is true that the focus on a large domestic business is strategic to TCS, these businesses that typically involve hardware contribution, have considerably lower margins than the software business. If IT spending in the domestic market remains sluggish, this business unit may face pressure on the volume and pricing fronts.

Strategic risks

Evolving business model: The business model using the offshore delivery platform is undergoing a major transformation. To deepen and widen their relationship with clients in the developed world, Indian vendors are positioning their offerings along verticals and special service lines such as systems integration, infrastructure management or package implementation.

Frontline companies are also gearing up to strengthen their marketing in the US and Europe and are taking the first steps in setting up development centres in different geographies.

Responding to these threats from Indian vendors, multinational vendors such as IBM Global, Accenture or EDS are stepping up their presence in India.

These MNC players have superior project management skills, better client relationships and deeper pockets to take on the Indian vendors.

TCS, as the market leader in the software services space with the highest number of clients above $50 million, will be the first to face this turf war with multinational vendors over the next year or two.

This will be the first test of TCS' ability to sustain business volumes, maintain its margins and retain the middle management talent, especially among project/team leaders, with three to five years experience.

Managing turbulence: If the US economy turns turbulent once again or the US and European based clients kick off a fresh round of pricing pressure, the resilience of TCS will be put to test. As the market leader having export revenues that are at least 30 per cent higher than its closest peer, Infosys, TCS may be the first to be affected.

In the three years following the tech meltdown in 2000, TCS' performance was not as consistent as Infosys. Growth rates in revenue and earnings were impressive in 2001-02 and 2003-04; the performance in 2002-03, however, turned out to be indifferent with post-tax earnings rising by less than 1 per cent. In that year, TCS faced pricing pressure and had to offer volume discounts to retain its clients.

In a similar environment, Infosys showed resilience in maintaining its revenue and post-tax earnings growth, though on a lower base.

Investment risks

Low floating stock: Post-listing, a little over 10 per cent of TCS' equity will be available for trading. The effects on price and valuation levels of a low floating stock, and a higher degree of volatility, may be attributes that the TCS stock will share with Wipro.

Liquidity — in terms of trading volumes — would not be a problem, if one considers the trading experience with the Wipro stock.

Corporate governance: Considering the benchmarks already set by Infosys, and Wipro to a lesser extent, this factor would also play a crucial role in the valuation accorded to the TCS stock. As a Tata group outfit, TCS is bound to enjoy a premium on this score.

A higher premium, comparable to those of Infosys and Wipro, may emerge only over time.

For this purpose, TCS will be watched closely over the next few quarters for its transparency in market disclosures, financial performance and management excellence in execution.

IPO highlights

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