Will TCS deliver on its margin promise?

Currency volatility and slowing growth could weigh on its profitability in coming quarters

A stronger rupee versus the dollar, coupled with fall in revenues of its key verticals – Banking, Financial Services and Insurance (BFSI) and Retail, impacted Tata Consultancy Services’ (TCS’) performance in the March 2017 quarter (Q4). Not only did the company lag street expectations of 1.5-2 per cent revenue growth in constant currency terms (reported growth at one per cent), but its operating profit margin at 25.7 per cent fell short of its own targeted band of 26-28 per cent. Even if one were to adjust for the currency fluctuations, the operating profit margin works out to 26.1 per cent, which is at the lower band of guidance. What's more, while the management has maintained this band and not moderated the same for 2017-18, experts believe it will be increasingly difficult for the company to deliver on the margin promise. The company believes rising automation and ramp-up of value-added services will enable it to maintain margins in this band. But, analysts are not buying the argument.

Apurva Prasad, IT analyst at HDFC Securities, says, “It will be difficult for TCS to deliver an operating margin of 26 to 28 per cent, and this guidance could be toned down.” The USD-INR estimates of TCS are based on current levels and do not factor in likely volatility in currency, he said, adding automation benefits are not yet quantified.

Margin concerns also stem from slowing growth for the company. TCS posted sequential fall in constant currency revenues from its key market of North America as well as the largest vertical of BFSI. With smaller deal tenures in the digital business, most technology companies could see heightened volatility in their revenues going forward, believe analysts. Any change in visa norms would also require some realignment in their business models, which could have some bearing on growth. The impact of another macro event, Brexit, is yet to play out fully, and the management is watching the situation closely. TCS’ strong position in this market, though, lends some comfort.

Against this backdrop, analysts are cautious on TCS and believe there is more valuation comfort in Infosys, which trades at about 20 per cent discount to the former. Both these companies are trading much lower than their historical average one-year forward price to earnings ratio.

The risk reward, however, seems to favour Infosys purely on the valuation front. At current levels, TCS trades at 15.5 times FY19 estimated earnings as against 13 times for Infosys. Infosys posted a better show in the BFSI vertical as compared to TCS, and also enjoys higher revenue per employee. Given the muted set of numbers, expect the TCS stock to come under pressure on Wednesday.