Status quo not good enough for TCS investors

Investors should have been pleased after officials from Tata Consultancy Services Ltd (TCS) told analysts on Monday that there is no change to its revenue growth outlook for the year to March. After all, just last month, Cognizant Technology Solutions Corp. lowered its revenue target for the fiscal year and the two companies have a reasonable level of commonality in terms of clients and businesses.

Still, TCS shares fell marginally on Tuesday, along with other large-cap stocks. Its latest comments weren’t exciting enough because of its soft outlook on margins. Margins aren’t expected to be much higher than the June quarter levels of 26.3%. What this essentially means is that on a year-on-year basis, margins would be about 300-350 basis points lower. Also, operating profit growth could well be in low single digits, despite revenue growth being in the late teens. One basis point is one-hundredth of a percentage point.

Of course, it was already known that the joint venture with Mitsubishi will dilute margins. The company said that the incremental $100 million in revenues owing to the Mitsubishi deal will hit margins by about 75 basis points in the September quarter. This will entirely offset the one-off depreciation impact in the June quarter results that wouldn’t recur this time around. And although one would have imagined that the depreciation in the rupee would have helped margins, the company said currency movements will have no impact on margins.

The softness in the company’s margins comes as a disappointment, especially keeping in mind the rally in the company’s shares. TCS trades at an estimated multiple of 21-22 times. It’s interesting to note that even analysts at JP Morgan, who are bullish about the company’s prospects, said in a recent note to clients that valuations are a tad punchy. Their price target for March is ₹ 2,500; TCS currently trades at ₹ 2,630. If margins remain soft, there is no scope for analysts to upgrade earnings estimates and justify the rally in the shares.

To be sure, the company continues to execute well on the business front, which is evident from its confident outlook about revenue growth. It continues to expect growth in organic revenues to be higher this fiscal year, than last year’s growth of about 16%. With other well-performing companies such as Cognizant struggling to maintain growth rates on an ever-increasing base, TCS’s volume and revenue growth is commendable. Its 5.5% sequential growth in the June quarter has made the task all the more achievable. Also, the recent Purchasing Manager’s Index (PMI) data from the US and the gross domestic product (GDP) data suggest that demand for IT services should remain healthy.

If the markets remain buoyant, investors may ignore the fact that earnings upgrades are unlikely this year; but if markets turn wobbly, this issue will come to the fore.