Should you invest in the TCS issue?

Proceeds for Tata Sons…
Before we get to that, let’s take a quick look at the structure of the issue and understand its objectives and implications. The issue is being undertaken primarily to list TCS on the stock exchange and to enable it to raise capital as and when required in future. The other objective is to provide Tata Sons with resources it requires for investments in its telecom and other businesses. The terms for transfer of the TCS division to TCS Ltd specify the payment of Rs 2,300 crore as consideration to Tata Sons. Given this, TCS is likely to have to pay a sum of Rs 250 crore or more in addition to what it receives from the issue of fresh equity (2,27,75,000 shares) to Tata Sons. The costs of transfer estimated at about Rs 67 crore and a charge for employee stock option estimated at Rs 215 crore are likely to be taken on the books in 2004-05.

In essence, TCS will not receive any amount from the current issue of Rs 4,942-5,739 crore. The payment to Tata Sons in excess of the book value of TCS shall be shown as goodwill in the books.

But the core issue is the business…
Even while TCS may be paying for acquiring the business of the TCS division from Tata Sons, which also enjoys a controlling stake in the payee, the key issue for an investor is to consider the business he’s buying into. TCS is the leader in the IT services segment in the country both in terms of revenues and profits, and if the stock lists at a premium, it might also emerge as the largest IT company by market capitalisation.

The most appropriate comparison of TCS would be with Infosys. Both companies derive significant share of revenues from financial services (40 per cent and 36 per cent, respectively) and have fairly significant contributions from telecom, manufacturing and retail segments. However, the operating performance of both companies is at a variance. This could also be because of their subsidiaries being in different business segments. But for an investor, it’s better to focus on the big picture.

A look at the consolidated figures for TCS division and Infosys (as per US GAAP) provides some interesting insights. While revenues for both companies have grown at a healthy pace over the past two years (fiscal 2002 to 2004), Infosys topline has grown at a faster compounded annual growth rate (CAGR) of 39.6 per cent against the 27.7 per cent growth registered by TCS. The operating and net income growth for the two companies also show Infosys as the better performer. Coming to operating margins, Infosys’s operating profit to revenues stood at 28 per cent in 2003-04 compared to 25 per cent for TCS. The net income to revenues also revealed a similar trend with the relevant numbers being 25 per cent and 23 per cent, respectively.

The difference becomes more stark when we evaluate the operating cash flow situation. For fiscal 2004, while TCS generated operating cash flows of Rs 1,624 crore, Infosys was only a tad behind with Rs 1,621 crore. This despite TCS having higher consolidated revenues of Rs 7,123 crore against Infosys’ Rs 4,612 crore.

It follows, that while TCS is clearly the bigger brother of the two, Infosys scores on most other counts.

And relative valuations…
Even while Infosys might appear better placed on certain operating parameters, the decision to invest should be based on valuations. It is here that the TCS offer scores. While the earnings per share for TCS on a consolidated basis stands at Rs 33.7 for the year ended March 31, 2004 on the post-issue equity, that for Infosys stands at Rs 44. At the current market price of Rs 1,442 per Infosys share, this indicates a PE of 32.8 against a PE band of 23-26.7 for TCS.

True, TCS should trade at a discount to Infosys, given the latter’s track record of revenue and earnings growth, but there is room for a narrowing of the valuation gap. An independent TCS could spruce up its act. The price trigger could come from an ADR listing and future M&As. So, even at the higher price band, there’s an upside.