TCS IPO: Is It Worth A Gamble

Updated: Jul 25 2004, 06:01am hrs
After much anticipation and much speculation, Tata Consultancy Services (TCS) issue is finally here. Investors will finally get an opportunity to bid for shares of Indias largest IT services company, when the lead managers open the book on July 29, 2004.

The offer of 6,37,70,480 shares (including the green-shoe option) at a price of between Rs 775-900 per share (Re 1 face value) closes on August 5, 2004. So, should you invest

Proceeds For Tata Sons...
Before we get to that, lets 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, which 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 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 paying company, the key issue for an investor is to consider the business hes buying into.

So, getting into issues like why the promoters decided to effect such a transfer, rather than de-merging the TCS division and taking it public through an offer for sale are not something retail investors should be concerned with. Leave that to the legal and financial experts to figure out.

As far as an investors are concerned, the business of the company and its financial strength should be the key determinants of investment.

From a business perspective, TCS is clearly the leader in IT services in the country both in terms of revenues and profits. Besides, if the stock lists at a premium, it could also emerge as the largest IT company by market capitalisation.

The most appropriate comparison of TCS would be with Infosys. Both the 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 the companies differs.

This could also be due their subsidiaries being in different business segments. But for an investor, its 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 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 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 starker when we evaluate the operating cash flow situation. For fiscal 2004, while TCS generated operating cash flow of Rs 1,624 crore, Infosys was only a tad behind with Rs 1,621 crore.

This was despite the fact that TCS registered higher consolidated revenue of Rs 7,123 crore as against Infosys Rs 4,612 crore. Whats more, if you were to view both the companies from a net asset value per share perspective, Infosys book value per share of Rs 155.25 implies a price to book value ratio of 9.3. In comparison, TCS would have a book value per share of Rs 43.15, indicating a price-to-book ratio of 18-21 times.

Thus, while TCS is clearly the bigger brother, big is not necessarily always beautiful. TCS does have the scale of operations on its side, but it needs to spruce up its act, if it is to command leadership valuations on the bourse.

After being hidden behind the Tata Sons wall for years, the company needs to be more conscious about its efficiency levels since it will be under close watch.

The good thing, though, is that future cash accruals and any proceeds from an overseas offering - if it is through a fresh issue of shares - will now get deployed in the companys operations and not diverted to other group companies.

A merger or acquisition that the company has been hinting at, could be a short-term trigger for upside.

As things stand, Infosys scores over TCS on most counts. But does that mean you should skip the offer Not really!

And Relative Valuations...
Even while Infosys appears better placed on operating parameters, the decision to invest should be based on valuations. Here the TCS offer has some merit. 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, the TCS stock should trade at some discount to Infosys, given their track record of revenue and earnings growth, but there appears room for some narrowing of the valuation gap, especially if we expect TCS to become more proactive after gaining its independence. So do bid for the TCS stock, but preferably at the lower end of the band.