What’s worrying TCS investors
Premium- TCS’ Q1FY23 Ebit margin and constant currency revenue growth missed consensus estimates
- The management commentary on demand outlook and deal pipeline remains robust
Investors in Indian information technology (IT) stocks are jittery largely because of a fear that a potential economic recession triggered by interest rate hikes would hamper the deal pipeline of Indian IT companies, thus impacting their FY24 revenue growth. Second, wage hikes and the return of other costs are seen playing out in the June 2022 quarter (Q1FY23), eroding margins.
Here, Q1 results of sector bellwether Tata Consultancy Services Ltd (TCS) offer little comfort. In constant currency terms revenue grew 3.5% sequentially, a tad lower than consensus earnings estimates of 3.6%. However, management commentary on demand continues to be robust. As of now, the company is not seeing any signs of a demand slowdown and the deal pipeline remains strong. That said, the management is observant of macroeconomic conditions and is constantly interacting with clients. The TCS management did not share any views on how FY24 is expected to pan out, in terms of revenue or margin performance.
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“Despite intact commentary, they indicated that the US will do better than Europe because of client concerns over the slowdown. In our view, this is an initial sign of industry commentary turning more realistic compared to the current view of no impact on tech spends," said analysts at Motilal Oswal Financial Services Ltd in a report on 9 July.
The Ebit (earnings before interest and taxes) margin fell to a multi-year low of 23.1%, from 25% in the previous quarter, missing the consensus estimate of 23.6%. As such, TCS’ Ebit margin is lower than its aspirational range of 26-28%. The margin was hurt by salary hikes, supply-side challenges, higher subcontracting costs, and an increase in travel expenses. The margin is expected to start recovering sequentially from Q2FY23, the management said.
Analysts are cautious. “TCS’ margin has to see a swift recovery for the company to avoid further earnings downgrades," said an analyst with an international brokerage house requesting anonymity. It will take a few more quarters for attrition to start declining meaningfully, unlike what was expected initially, he said. “Overall, a key takeaway for investors in IT stocks is that margin pressure is underestimated by the Street. Post TCS’ Q1 earnings, we feel that Infosys could also disappoint on margins," he said.
In Q1, TCS’ attrition on LTM (last twelve months) basis, rose to 19.7% from 17.4% in Q4FY22. The management is hopeful that the attrition rate will start to moderate in the second half of FY23, but only after seeing a further spike in Q2FY23.
Besides, TCS hired a net 14,136 employees in Q1FY23, which is soft. This compares with the previous six quarters’ average of around 23,000, said analysts at Nirmal Bang Institutional Equities. Investors in IT stocks would do well by monitoring this metric. TCS has a fresher hiring target of 40,000 for FY23.
Another important measure, the order book, was flat year-on-year (y-o-y) in 1QFY23 at $8.2 billion. Unless there is a good spike in order inflow in the next few quarters, TCS’ total order inflow for FY23 will at best be flat y-o-y and very likely be lower, said the Nirmal Bang report.
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Meanwhile, so far in this calendar year, the TCS stock has declined by 13%. Given the factors mentioned above, the stock is unlikely to see a quick recovery. TCS shares are trading at a price-to-earnings multiple of 25x on FY24 earnings estimates, according to Bloomberg data. A couple of brokerages have trimmed the company’s FY23 and FY24 earnings estimates after the Q1 result. How valuations shape up from here would also depend on whether or not earnings downgrades get steeper.