Why TCS Q3 results are not exciting enough

Revenue growth has been better, but profit margin was lower than expectations. Further, the management’s commentary does not offer any clarity on what lies ahead for TCS in terms of revenue growth or deal pipeline.

View Full Image

Sequentially, constant currency (CC) revenue growth stood at 2.2%, ahead of consensus estimates. This also indicates that the furlough situation is not as bad as anticipated earlier. However, growth was also partly driven by regional markets, where demand tends to be volatile and hence, predicting the sustainability of this is tricky.

In the earnings call, the TCS management indicated that while the manufacturing vertical has shown decent performance, it is wary of this segment due to global supply chain and energy disruptions. The management also pointed to rising caution among clients, especially in Europe.

In Q3, TCS saw a sequential drop in the total contract value (TCV) of deals to $7.8 billion. Consequently, the book-to-bill ratio dropped. Although the order book was in the guided range of $7-9 billion, the sequential drop reflects slower deal conversions due to increased uncertainty among clients.

“A declining headcount and book-to-bill ratio falling to a three-year low point to a sharp growth moderation,” said analysts at Jefferies India. Over FY23-25, the brokerage expects TCS to deliver 7.5% compound annual growth rate in CC revenues, much slower than the 14% year-on-year CC revenue growth expected in FY23.

TCS expects precise client spending trends to emerge only in the next few months. Further, hiring in Q3 was lower sequentially, after rising for several quarters. “Fresher addition of 7,000 implies that TCS is not backfilling certain lateral positions. Fresher addition will further moderate in Q4FY23, while we expect caution on lateral hiring to remain, which can lead to another quarter of decline in net headcount,” said analysts at Kotak Institutional Equities.

The TCS management said it is trying to utilize excess capacity and improve employee productivity after robust fresher hiring in the recent quarters. But according to some analysts, moderation in hiring could be another sign of caution. What is more, TCS’s performance relative to close competitors hasn’t been encouraging. “TCS growth has underperformed Accenture (Outsourcing) and Infosys Ltd for the last 12-13 quarters,” said analysts at Ambit Capital. They feel that the company’s exposure to BFSI/retail/high-tech and Europe that is higher than that of peers remains a risk to growth.

Clearly, in this backdrop, the expensive valuation of the TCS stock is an additional dampener. TCS’s FY24 price-to-earnings multiple of 26.8x is a 30% premium to its pre-covid three-year average, according to an Ambit report dated 10 January. Additionally, the mood among IT investors has been grim lately on recession fears hurting the sector’s FY24 revenue growth and deal momentum. These factors should cap meaningful near-term upsides in the TCS stock.

Meanwhile, the easing of supply-side pressures and increased vendor consolidation augurs well and is aiding the company’s market share. In Q3, TCS’s operating margin improved by 50 basis points sequentially to 24.5%, aided by forex gains, better utilizations and moderation in subcontracting expenses. Even though costs such as travel are inching back, TCS is confident of exiting FY23 with a margin of 25%.