Is TCS really doing better than Infosys?

The financial media is ripe with the articles of praise for TCS and Infosys seems to have lost its glory over the last one year. See the headlines below:

• TCS takes over Infosys (livemint)
• TCS Infosys treading different paths (livemint)
• TCS topples Infosys as the most valued IT company (trak)
• TCS tops Infosys (DNA)

Most of the analysts are not looking at the results of companies with sharp eyes. See the following table:
* 9 months FY11

Year	Infosys			TCS
	PBT	Tax	Tax/PBT	PBT	Tax	Tax/PBT
2007	4249	386	9.08	4876.59	663.96	13.61
2008	5344	685	12.82	5812.33	786.31	13.53
2009	6907	919	13.31	6095.37	838.95	13.76
2010	7899	1681	21.28	8197.61	1196.97	14.60
2011	9313	2490	26.74	7812.19*	1367.08*	17.5

If we forget about the quarterly movements of revenues then over the last 6 years, Infosys consolidated revenue increased from 7129.65 Crore in FY05 to 27501 Crore in FY11. During the same time TCS revenue increased from 9748.47 Crore in FY05 to estimated around 37000 Crore in FY11, not much difference between the two in terms of growth.

The annual report of Infosys clearly provides details about the expiry of tax exemption due to Software Technology Park(STP) scheme of government of India. There were five big centers (Bangalore, Pune, Mysore, Hyderabad, and Chandigarh) whose tax exemption expired in 2009 and there are three more (Chennai, Bhubaneshwar and Mangalore) whose exemption expired in 2010 and so the effective tax rate for Infosys has increased from 13.31% to 26.74% over the last two years. If the tax rate had remained the same, Infosys EPS this year would have been higher by INR 20. Due to new SEZ policy of government, the tax rate may again go down a bit due to lower MAT rates on SEZ and Infosys annual report does mention five centers whose tax exemption expires after 2020. On the other hand, TCS annual report does not give any information about this but STP is going to expire in March 2011 so TCS' tax ratio is likely to move higher in the next year which not a single analyst seems to be talking about right now.

Yes; the operating profit margin of TCS has caught up with that of Infosys over the last two years but I doubt they can do better than Infosys going forward. Let's see.

Being too far ahead of your time is indistinguishable from being wrong
 - Howard Marks

Image: xedos / FreeDigitalPhotos.net

Can you rely on increasing Margins?

Many renowned investors including Buffett, Philip Fisher prefer buying companies with high margins over low margins and companies with increasing margins compared to decreasing margins. But how good this measures are in the short run? Let's understand this with examples. Britannia had an operating profit margin of 10% and net profit margins of around 5.5% (excluding extraordinary items) in FY2001 and FY2002. This improved to 12.2% and 9.3% in FY2005. But the entry of newer players like Surya Agro (PriyaGold fame) and ITC took this down again to 8.3% and 5.8% in FY2009.

Contrary to this, Nestle had a permanent expansion in profit margins between CY1998 when its net profit margin was around 5.5% and CY2003 when its margin became 12.5%. During these five years, the revenue of Nestle increased from INR 1612 Crore to INR 2160 Crore, i.e. by 34% or 6% CAGR but net profits rose from INR 86.2 Crore to INR 263.08 Crore, i.e. by 25% CAGR. Since then margin expansion has stopped and revenue and net profits are almost in sync. Revenues rose to INR 4358.13 Crore in CY2008, i.e. by 100% or 15% CAGR and net profits rose to INR 534.08 Crore, i.e. by 103% or 15.2% CAGR.

We can conservatively say that Nestle has almost reached a saturation for margin expansion. Conservatively since The Coca Cola Company in the US has net profit margins near high teens, i.e. 17-19%. Britannia's counter part in the US, the Kraft Foods Company also suffers from low net profit margin of around 6-7%.

We can conclude that investors must remain cautious when relying on margin expansion.

Competition eating Margins

Most people reading this blog would have seen a lot of posts discussing competition in business. Let me discuss an example of Finolex Cables. Following table shows revenues and profits of the company over last 13 years:

Year	Revenue	Profits	Margin
1996	514.1	55.1	10.71%
1997	480.6	48.4	10.07%
1998	460.9	48.6	10.54%
1999	465.6	62	13.31%
2000	576.1	70.1	12.17%
2001	627.9	72.5	11.55%
2002	675	66	9.78%
2003	518.9	24.7	4.76%
2004	568.9	29.6	5.2%
2005	670.1	30.8	4.6%
2006	889.9	50.4	5.67%
2007	1140	81.18	7.12%
2008	1417.9	88.91	6.27%
TTM	1463.41	-28.23	-1.93%

It is clearly seen that during the last business cycle of 1996-1997 the margins were in double digits but the margins started collapsing in 2003, both due to competition and increase in raw material prices. Even at the peak of business cycle in 2007, margins never went up to the last business cycle. This is due to newer players like KEI, Diamond Cables, Delton Cables and Paramount Communications etc. eating into Finolex brand.

The impact of competition on profits

Let me give you an example of what impact the competition has on company's profits. Following are the profits of two companies:

Year	Profit 1	Profit 2
1992	98.48	21.5
1993	127.27	33
1994	189.96	40.5
1995	239.22	53.2
1996	412.7	54.2
1997	580.25	74.3
1998	837.44	86.2
1999	1069.94	98.5
2000	1310.09	118.6
2001	1540.95	173.15
2002	1701.46	201.52
CAGR 1992-2002	32.96%	25.08%

Now look at the results of these same companies after 2002:

Year	Profit 1	Profit 2
2002	1701.46	201.52
2003	1771.79	263.08
2004	1208.4	251.92
2005	1408.1	309.57
2006	1890.53	315.1
2007	1914.88	413.81
2008	2117.18	534.08
CAGR 1992-2002	3.71%	17.64%

The first company is none other than HUL and the second one is Nestle. Both of them started on the same footing in 1992 where HUL's profits were almost 4.5 times that of Nestle. Since there were no competition, HUL ran up very fast to achieve a ratio of almost 11(1310.09/118.6) in 2000, more than twice what it was in 1992. Then P&G and Colgate realized the potential of India becoming huge market, increased their penetration and threw HUL on the back foot. Look at the sluggish growth of HUL between 2002-2008. The FMCG market has grown phenomenally well over the last 6 years but HUL couldn't capture most of it since the competition went ahead of it. We can conclude that the profits of HUL between 1995-2002 were inflated because of no real competition from anybody. When you invest in a blue-chip, make sure it is facing tough competition otherwise your investment will go sour.