Near-term growth snags could keep IT services giant TCS in a bind

Yet, positioned for revenue growth with recent strong deals, driven by a strengthening US economy

As was the case in the October-December (Q3) quarter of 2023–24 (FY24), the country’s largest software company, Tata Consultancy Services (TCS), reported a better-than-expected operational performance, even as revenues were marginally lower than what the Street was working with.

While sequential revenue growth of 1.1 per cent missed most estimates, margin expansion continued for the third consecutive quarter.

Profitability (before interest and tax), also called Ebit (earnings before interest and tax) margins, at 26 per cent, was up 100 basis points (bps) sequentially and was the highest in 12 quarters.

Since the start of FY24, the software major has added 280 bps to its margins as cost optimisation moves have continued even as growth has moderated. The gains on the margin front were on account of lower subcontracting costs, higher productivity, and better utilisation, which led to a 190-bp improvement. However, these operational gains were partly negated by higher third-party costs and travel expenses, which reduced the margin effort by 90 bps.

The company expects pricing and pyramid restructuring to help it maintain its operating profit margin in the aspirational range of 26–28 per cent. While the subcontracting lever is exhausted, other levers like pyramiding, pricing, and utilisation are still there, say analysts at Nuvama Research, led by Vibhor Singhal.

The headcount reduction that started at the beginning of FY24 continued in the January–March quarter, which saw a 2.2 per cent drop year-on-year (Y-o-Y). While the company had over 614,000 employees at the start of the financial year, it is down to a shade over 600,000 at the end of the year. Further gains on the employee front could be hard to come by.

Say analysts at Dolat Capital, led by Rahul Jain, “While the company does not share utilisation data per se, however, a 2 per cent headcount cut with 3.4 per cent growth in revenue (Y-o-Y) and a significant decline in subcontractor expenses indicate that it is already stretched on the people front.”

In the near term, given the salary hike for employees starting April 1, the company could witness some headwinds on the margin front.

In addition to wage hikes, higher travel and onsite costs could lead to a contraction in margins in the April-June quarter. In addition to margins, the Street will focus on the pace of recovery and order outlook for the software leader.

The company’s constant currency revenue growth in the January-March quarter was below estimates, and sales growth was driven by the ramp-up of the Bharat Sanchar Nigam deal. The company has maintained its cautious outlook in the near term, given that discretionary spending has been put on hold as companies prioritise cost optimisation deals and budgets remain stagnant.

The company, however, has indicated that 2024–25 (FY25) will be better than the previous financial year on the back of strong deal wins and better execution. Further, it believes that North America, which accounts for half its revenues, and financial services, which is by far its largest vertical, accounting for over 31 per cent of revenues (retail is a distant second at about 15 per cent) have bottomed out.

While North America has witnessed a sequential decline for each of the past five quarters, financial services have been trending down in the last four.

A key positive on the outlook front is strong order wins. The company reported its highest-ever total contract value in a quarter at $13.2 billion, which was up 32 per cent Y-o-Y. For FY24, it has stood at $42.7 billion, which is up 25 per cent Y-o-Y and was led by a large order win from Aviva.

While the company continues to see pent-up demand in the financial services space, the consumer sector is impacted by macroeconomic (macro) headwinds. Brokerages are cautious about the near-term outlook, given demand worries and cuts in discretionary spends.

Although Nuvama Research believes the short-term demand will be volatile, which has made it cautious, it is bullish on the company over the medium term. The brokerage maintains that Q3FY24 was the bottom for the earnings downgrade cycle for the sector and expects the strong deal wins of the past few quarters to gradually convert into revenue in the coming quarters, even as the US macro becomes favourable.

It views TCS as a perfect largecap proxy to play this upcycle, with its strong deal wins and robust margin performance. Nuvama Research has a ‘buy’ rating with a target of Rs 4,560 per share.

Dolat Research, however, has a ‘reduce’ rating on the stock. The brokerage believes that TCS and other Tier-I information technology companies are likely to experience a few more quarters of subdued growth before any noticeable acceleration in growth occurs and thus does not see significant room for upside. It currently values TCS at 26x its 2025–26 (FY26) earnings and has a target price of Rs 3,920 per share.

Emkay Research, too, has a ‘reduce’ rating. While the brokerage has increased its FY25–26 earnings per share by 1-1.5 per cent factoring in the FY24 performance and higher margin assumptions, it has retained its ‘reduce’ rating on TCS, given the rich valuations. It has a target price of Rs 3,950 per share, valuing it at 25x its FY26 earnings.