Are TCS operating margins sustainable?

Tata Consultancy Services’s (TCS)'s September quarter (Q2) results disappointed on multiple fronts. First, the company posted one of its weakest sequential dollar revenue growth of 0.3 per cent on delayed orders in India and slowdown in its top two verticals — banking, financial services, and insurance (BFSI grew 1.2 per cent in constant currency terms) and retail (down 3.1 per cent) compared to the June quarter. Thus, this metric lagged Street estimates of 1.5 to 2.5 per cent sequential growth in dollar revenues by a big margin. Revenue growth in the quarter was also impacted by client-specific issues, with a top client migrating to a lower revenue bucket for TCS.

Second, rising caution in the management commentary as compared to a quarter ago is a concern. Management hinted at uncertainty on how events such as Brexit and US elections could impact revenues (but no impact yet). Also, while the digital business is growing at a good rate, management said ramp-ups in  select digital businesses are getting delayed. Although management expects to post better performance in the second half of this financial year (compared to year-ago period), analysts believe this uptick will be driven largely by last year's low base and not by structural, sustainable improvement in growth. Thus, better growth seems factored in. Rollover of some delayed orders from India will also aid the current (December) quarter's performance.

A key positive in TCS’s performance in Q2 was the 94-basis-point expansion in operating profit margin to 26.2 per cent compared to the June quarter, which enabled the company to post a higher-than-expected net profit. Better efficiency gains fuelled margin expansion and more than offset the negative impact from cross-currency moves. The question is are these margins sustainable? Harit Shah, analyst, Reliance Securities, says, "To sustain margins, TCS has to achieve higher revenue growth at some point. It will not be easy for TCS to achieve margin forecast of 26-28 per cent as they can't do both revenue growth and margin expansion at the same time." High competitive environment and continued pricing pressure are a few pressure points for margins. Thus, investors need to watch the margin movement closely.

The stock could remain under pressure. Most analysts are likely to trim their full-year revenue growth estimates for TCS from nine per cent and above, to 7.5-8 per cent.