After several quarters of sedate growth, Tata Consultancy Services Ltd (TCS) has returned to double-digit growth this fiscal year. Its growth of 12.1% in the December quarter (Q3), on an annualized revenue base of nearly $20 billion, is nothing to sneeze at. And, especially so, considering its peers are growing at a lower rate on a lower revenue base.

Who says elephants can’t dance? But things can sometimes get a bit wobbly when they do. In TCS’s case, while growth last quarter turned out to be almost exactly in line with investors’ expectations, profit margins were considerably lower.

Earnings before interest and tax stood at 25.6% of revenue, about 100 basis points lower than consensus estimates on the Street. A basis point is 0.01%.

After TCS had reported record margins in the September quarter, analysts and investors seemed to have assumed that things will be smooth on the costs front.

But employee and sub-contracting costs rose last quarter, far more than anyone had anticipated. The risk of a higher cost structure owing to more stringent visa norms is rearing its head.

“The tightening of conditions for visas comes at a time when unemployment rates are at a record low. Even as IT companies have stepped up local hiring, the fact is that talent is not easily available at the mid-level. This could potentially impact cost structure in the US or even impact demand fulfilment. Companies have to resort to a mix of subcontracting and offshore/near-shoring to meet demand. This impacts margins," analysts at Kotak Institutional Equities had said in its TCS Q3 results preview note.

Even so, the broker had pencilled in a 40 basis points improvement in margins last quarter. The fact that TCS reported a 90 basis points drop instead, suggests visa-related shocks to the cost structure may have been higher than expected. “Clients will let these costs be passed on, but with a lag," CEO Rajesh Gopinathan told analysts on a call.

Another worry on the margins front is the company’s post-results commentary. Gopinathan told analysts that TCS plans to participate aggressively when it spots a demand opportunity. This may mean a hit on margins in the interim, with the hope that cost optimization happens over the life cycle of the project.

While this doesn’t necessarily mean TCS was willing to take pricing cuts and sacrifice margins to win volumes, it does mean that margins can be under pressure in the near term.

Of course, this shouldn’t be something investors should be unduly worried about. In any case, investors prefer growth and momentum over fat margins.

The problem, however, is that investors have been pricing in growth at high margins. TCS trades at about 20 times one-year forward earnings estimates, and some analysts are still working with a rupee-dollar rate of 72. This means earnings estimates may need to be cut both to reflect lower margin assumptions and a stronger rupee.

The good news is that the prognosis on demand remains strong. TCS won deals worth $5.9 billion last quarter, higher than the $4.9 billion worth deal wins in each of the preceding quarters. The key BFSI (banking, financial services and insurance) vertical continued with its growth recovery, and management commentary suggests the momentum should continue. Compared to the lacklustre growth a year ago, investors might just be grateful that the elephant is still dancing.

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