Will TCS shake up the market?

If there is one public offer that the market has been most anxiously awaiting for more than a decade, it is that of the country's oldest and largest software services company, Tata Consultancy Services.

After several years of dilly dallying, the company filed its draft red-herring prospectus with Sebi last week. And stock markets welcomed the new comer, albeit in an unusual way.

Gripped by fears that institutional investors would cut their exposure to top-rung infotech stocks in order to accommodate the new comer, speculators triggered a sell-off early last week.

However, by the end of the week most stocks had gained back lost ground, closing with marginal gains.

After being an underdog in last year's bull rally, infotech sector is looking well-poised to take a major leap this year, going by both fundamental and technical factors. The underlying fundamentals look strong as the pricing environment looks more stable.

Company managements seem to be more optimistic than a year ago, making a strong case for a sector re-rating.

Why should institutions sell in such a scenario?

The sell-off in large tech counters last week is ironical, but not surprising if one knew the ownership pattern of the listed infotech companies.

The shareholding pattern on listed IT firms at the end of March tells us two striking points: a) the infotech sector has a high institutional ownership with domestic and foreign institutional investors commanding a 60 per cent share in the total free-float (non-promoter holdings) available; of this, 47 per cent is held by FIIs alone; b) the top three companies -- Infosys, Satyam and Wipro -- account for 72 per cent of the free-float market-cap of all listed infotech companies; Infosys alone constitutes around 47 per cent of the free-float.

Clearly, institutions will have a much bigger say in the way infotech sector moves and the changes will get reflected in big stocks. FII stake as percentage of free-float was around 58 per cent in Infosys while in the case of Satyam it was 63 per cent.

Thus, the reverberations of the TCS issue will be felt most notably in Infosys and Satyam in case FIIs don't wish to increase exposure to infotech stocks but want to de-risk their exposure by including the new entrant. In the latter half of the story we discuss why this may not happen.

Unlike the two biggies, in the case of Wipro, the FII stake in the total free-float was significantly lower at 27 per cent. One can read into this number in several ways. One comforting message is that the Wipro stock itself may not be vulnerable to selling from institutions, in case of any reshuffling.

But the other message it conveys, and this is important, is that institutions are inherently uncomfortable owning a substantial stake in a company with low floating stock.

Some market players suggest that the relatively steep valuation keeps ownership under check. Whatever may be the reason, if the same logic is applied to TCS, FIIs may not come with loads of money to buy TCS shares unless it is priced attractively.

With an equity capital of 47.82 crore (478.2 million) shares (with face value of Re 1), TCS will command a market-cap of Rs 53,805 crore (Rs 538.05 billion), if it is valued on par with Wipro (28x FY05 earnings) and  Rs 42,853 crore (Rs 428.53 billion) if it enjoys the same price-earnings multiple as Infosys (22x FY05 earnings).

Either way, the company will be the largest in terms market-cap in the infotech sector.

However, the available opportunity for the public will be rather small in the case of TCS. The company is offering 5.54 crore (Rs 55.4 million) equity shares, comprising 2.27 crore (Rs 22.7 million) fresh equity shares and an offer for sale of 3.26 crore (Rs 32.6 million) equity shares of Re 1 each for cash. The price of the issue will be determined through the book-building route.

Around 60 per cent of the new offer would be allocated on a discretionary basis to qualified institutional buyers while a minimum of 25 per cent will be allotted to retail individual bidders on a proportionate basis.

At least 15 per cent of the offer will be allocated on a proportionate basis to non-institutional bidders. If at least 60 per cent of the offer cannot be allocated to QIBs, then the entire application money shall be refunded.

Undersubscription, if any, in the non-institutional bidding and retail individual bidding categories, would be allowed to be met with the spill-over from other categories, at the discretion of TCS, Tata Sons and the book-running lead managers.

The public offer accounts for only 13.5 per cent of total equity capital. And depending on whether one takes Wipro or Infosys as the benchmark, the free-float market-cap will be Rs 7,043 crore (Rs 70.43 billion) or Rs 5,609 crore (Rs 56.09 billion).

Of this, the portion that QIBs have to cough up is 60 per cent of the offer -- Rs 4,226 crore (Rs 42.26 billion) or Rs 3,365 crore (Rs 33.65 billion), respectively.

If TCS were to attract the same level of ownership and valuations as Wipro, not more than Rs 1,901 crore (Rs 19.01 billion) (27 per cent of free-float) will flow from the FII side.

However, QIBs need to subscribe to 60 per cent of the public offer for the issue to go through. Can domestic institutions - banks and domestic mutual funds - make up for the rest of it? Clearly, the answer is no.

The key, thus, will be pricing of the issue. The issue will have to be priced attractively to make it a value proposition for investors - more value relative to Infosys.

Although pre-marketing - based on which merchant bankers arrive at the price band - has not yet begun for TCS, sources admit that the issue can not be benchmarked against Wipro as it will be difficult to explain the basis for valuation based on one company alone.

Assuming that the issue is priced attractively, say at a 10 per cent discount to the prevailing price of Infosys, institutions will have to cough up about Rs 2,282 crore (Rs 22.82 billion) for the issue to sail through. A substantial part will have to come from foreign institutions. Fund managers say that may not be such a tall order.

And then, it is a fact that the tech sector is presently under-owned by institutions. At the end of March, FIIs have a neutral stance in the tech sector compared to benchmark indices.

Domestic mutual funds were underweight by 2-3 per cent. So one can comfortably argue that there is no over-ownership in the sector which could put pressure on existing listed companies.

And then, a lot many factors are favouring the tech sector currently. Broking houses have already started putting up with bullish reports on the sector. They are suggesting an overweight of 3-6 per cent relative to benchmark indices.

The recovery in the United States is making companies spend more liberally on technology. Though there are no significant improvement in billing rates yet, incremental orders are commanding marginally higher rates, according to sources.

Global IT-spend in the second half is likely to see a 6 per cent growth as per some industry estimates. Volume growth is not an issue and large companies tend to get a disproportionate share of the pie in any case.

The only concern is rising salary and selling expenses which managements are trying to cope with and analysts have built into their projections. For fiscal 2005, analysts are assuming off-shore salaries to escalate by 12-15 per cent.

Kotak Securities, in its report elucidating the key finding from its May research field trip, said there are "incrementally more positives on fundamentals." "Although longer-term sector concern remains (read evolution of the off-shore model), near-term concerns appear to have subsided meaningfully. Specifically, major concerns, including billing rates, the Indian rupee and wages, have eased, allowing companies to focus on growth," the report said.

Other research houses hold similar views. In a recent research report, CLSA Emerging Markets said: "Companies have confirmed significant increase in client visits in 2004 and more broad-based service agreements. Continued hiring (of almost 25,000 people by the top vendors in FY04, 34 per cent of base) is the lead indicator of this confidence."

Inquire, the research wing of Motilal Oswal Securities, expects volume growth to be in the range of 35-40 per cent. Strong hiring despite low utilisation indicates that pipeline remains healthy.

Assuming that the improvement in utilisation could more than offset the impact of currency appreciation, "the net impact of margins, assuming a 15 per cent hike in offshore salaries and no improvement in billing rates, would be 100-120 basis points," said a report by Motilal Oswal released in mid-May.

Now the currency situation has only turned more favourable.

As per estimates by Inquire, a 1 per cent rise in rupee reduced EBITDA margins by 30-40 basis points. Most analysts were assuming that the rupee would appreciate by 4 per cent this year.

This may turn out to be a positive surprise if oil prices make the central bank hold the rupee from appreciating to check the import bill.

At a time when the market sees government policies and oil prices as the two gravest enemies for the market, tech looks more friendly compared to other sectors. The sector is untouched by rising oil prices; in fact, it benefits from it in a perverse way, and is relatively immune to domestic policy threats.

With fundamentals turning favourable for the infotech sector, all top-rung stocks in the sector should outperform the market.

Institutions, in all likelihood, would cut exposure to other sectors to subscribe to the TCS issue and thereby increase their weightage to the tech sector, than to reshuffle exiting tech portfolio and keep the weightage constant.