IT bellwether Tata Consultancy Services (TCS) kicked off the earnings season with strong revenue growth, but with a sharp margin contraction. Constant currency (fixed exchange rate that eliminates fluctuations when calculating financial performance) revenue grew 1.8 percent quarter-on-quarter in a seasonally weak period.
From a year-on-year basis, at 12.1 percent, it was the highest in the past 14 quarters. Margin contraction of 90 basis points quarter-on-quarter disappointed and was largely due to exorbitant subcontracting charges, which in turn was because of higher cost of doing business.
One basis point is a hundredth of a percentage point.
The Culprit, An Industry Bugbear
It was because of the sharp increase in the cost of doing business that TCS missed its margin target. This aspect is symptomatic of a wider industry trend; it was first highlighted by Hrexaware, an IT, BPO and consulting services company, and software services firm Persistent Systems in the September quarter when they said fulfilling demand was a challenge due to supply crunch.
TCS did manage to fulfill demand, but it was at the cost of margins. The miss in the third quarter also pushed the company’s EBIT margins in the first nine months of the year to 25.7 percent, a shade below its margin guidance band of 26-28 percent. That this happened despite an over 6 percent depreciation in the rupee is a worry.
This puts TCS’ 2018-Y19 margin estimates at risk. If the company ends FY19 with a sub-26 percent growth, it would be the third such year on the trot.
Trouble is the impact is not a blip — limited to one or two quarters — but spread over the medium term. Brokerage CLSA cut TCS’ margins by 60-70 basis points over FY19-21.
Potentially Good Demand Outlook
That said, the company was extremely upbeat about the demand environment. Growth rates have accelerated in the Banking, Financial Services and Insurance vertical (8.6 percent year-on-year), deal wins have grown 20 percent quarter-on-quarter at $5.9 billion with a broad-based pickup across geographies and verticals. Addition of big clients continues to be positive. The number of deals in North America, a vital market, accelerated to $3.1 billion compared with $2.4 billion, BFSI to $2 billion compared with $1.6 billion and retail at $800-900 million compared with $700 million compared to the previous quarter.
What About Macro Concerns?
The market is fretting about macro concerns surrounding trade tensions, Brexit and slowing US growth, but the TCS management said it is too early to take a call on these now. They actually see no reason why the company shouldn’t enjoy a double-digit growth even in 2019-20.
The confidence of the management stems from the nature of the deal wins — they are broad based — and accelerating rather the concentrated order book of the past. The only pockets of weakness have been the performance of the BFSI vertical in the UK and the manufacturing vertical, led by the automotive sector. Clients in the UK and continental Europe are cautiously spending waiting to see which direction Brexit takes.
The CEO’s Take
Rajesh Gopinathan is also sanguine about the strong demand environment. CNBC-TV18 asked whether the fresh hires of more than 6,800 plus in the December quarter (compared with 700 in 2018-19) were to create a local bench. “We were planning to build on a bench but actually the demand is really been stronger than we had originally thought,” he replied.
Growth Over Margins?
Going by the management commentary, the demand environment is strong for the company. TCS seems to be aggressively looking to capture this demand. CNBC-TV18 also asked the management whether this quarter’s story — of strong revenues and margin miss — means the company is willing to trade margins in the near term as well.
“In terms of order of priority, investing for growth and participating on demand and backing the opportunity that we see in the field is a much higher priority for us than defending any given margin band. But we are quite confident that having participated, having invested the structure in the industry is such that we should be able to get back into our decided band over a period of time,” Gopinathan said.
The TCS stock has already corrected more than 19 percent from its lifetime peak of 2,275 hit in September 2018, but with estimated price earnings valuations of 19–19.5X in 2019-20, it is still the most expensive tier-1 IT stock. The recent correction notwithstanding, the stock is still up 40 percent in the past one year, outperforming the broader market and IT sector.Morgan Stanley estimates that TCS is on track to achieve strong revenue growth (more than 11 percent year-on-year in constant currency terms) in 2019-20, but sees downside risks to the margin expectations and the Street's, given the dismal performance in the third quarter.” The financial services company also highlighted that TCS’ actions on lower attrition rates in onsite geographies, better pricing etc. believe these will take time and margins could face headwinds in the interim.