Infosys Technologies Ltd’s revenue has, on an average, been around 25% lower than that reported by market leader Tata Consultancy Services Ltd (TCS). This is based on the cumulative revenue for the past five fiscal years. But despite this large gap in size in revenue terms, Infosys’ market capitalization, on an average, has been higher than that of its competitor.
Even if one were to leave the period from early 2008 until mid-2009, when a flight to safety benefited Infosys shares, it turns out that the company’s market cap has been neck-to-neck with that of TCS, despite its smaller size in revenue terms.
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But that privilege is now a thing of the past. Last Friday, when Infosys shares fell by 9.6% and those of TCS fell by a much lower 1.5%, the difference between the market cap of the two companies widened significantly.
Infosys’ market cap is now 26.4% lower than that of TCS. Its revenue for the year ended March is 25-26% lower than TCS’ estimated revenue for the period.
For the first time ever, the market cap of the two companies reflects the difference in their size in revenue terms. Put differently, Infosys’ valuation using the market cap to revenue multiple has fallen below that of TCS for the first time.
At the peak of the financial crisis, when there was a flight to safety, Infosys shares traded at a 100% premium to TCS shares based on the revenue multiple. But again, even if one were to leave the period from early 2008 until mid-2009, Infosys shares have traded at an average valuation premium of well over 30%. Investors rewarded Infosys for its superior profit margins and better cash flow generation, among other things.
Two major factors have led to the recent derating of Infosys shares vis-à-vis those of TCS. First, the Tata group firm has improved its financial performance significantly since the financial crisis.
While its revenue growth has been marginally ahead of Infosys, it has outperformed significantly in terms of profit growth, thanks to a sharp improvement in margins.
During the crisis, TCS’ Ebit (earnings before interest and tax) margin was over 700 basis points lower than that of Infosys. In the December quarter, the gap fell to a little over 200 basis points. It is likely to shrink further in the March quarter. While Infosys reported a 125 basis points decline in margins, TCS is expected to maintain margins. One basis point is one-hundredth of a percentage point.
Similarly, there isn’t a very huge difference in the cash flow generation in the previous fiscal. Infosys’ free cash flow as a percentage of its revenue stood at 16.75% in 2010-11, while TCS translated 15.4% of its revenue into free cash flow during the nine months till December.
Of course, the latter still trails in metrics such as debtor days, but investors seem to be enthused by the sharp improvement in the company’s financials.
The second major factor that has worked against Infosys is that it has trailed TCS in volume and revenue growth in the past few quarters.
Also, its management’s commentary has been relatively cautious, while TCS’ management has been sounding rather sanguine about the demand environment.
After Infosys’ disastrous results announcement on Friday, analysts are predicting a similar script would play out this time around as well. Few analysts and investors expect TCS to face the problems Infosys did last quarter, which is why the former’s shares fell at a much lower rate.
In sum, the crash in Infosys’ valuation last week marks the end of an era, when Infosys was not only the darling of tech investors, but all who invested in Indian companies. In the tech space at least, TCS clearly wears that mantle now.
Graphic by Yogesh Kumar/Mint