TCS a good deal but investors should wait

Growth, margin recovery expected by 4th quarter but valuations high

Investors were enthused with Tata Consultancy Services (TCS) despite its June quarter (Q1) numbers falling short of estimates. The stock closed 0.8 per cent up on Friday amid a weak market and despite a pricey valuation of 27x its FY21 estimated earnings.

In Q1, while revenue inched up 0.4 per cent YOY to ~38,322 crore (aided by currency movement), profit before tax declined by 10.7 per cent YOY to ~9,504 crore. These missed estimates of ~38,865 crore and ~9,999 crore, respectively. On a constant currency (CC) basis, revenue declined by 6.3 per cent YOY.

A weak top line performance reflected on operating margin, which contracted 150 bps sequentially and 60 bps YOY to 23.6 per cent. Covid-led disruptions spoiled the Q1 showing.

However, the management said: “We probably bottomed out in Q1… and from here we should be on the growth path.” It also highlighted that technology was a key enabler of customers’ recovery journey, their growth, and transformation. It now expects the December quarter rupee revenue and margins to match its year-ago level.

Analysts believe TCS will be a key beneficiary of the pandemic-driven business opportunities, and that its balance sheet strength and diversified businesses encapsulate its strong growth moat. Its strength in the digital space will also aid growth.

Amit Chandra of HDFC Securities says: “In light of the pandemic, digital and automation have seen seeing strong traction, which bodes well for TCS. Thus, the possibility of further expansion in valuation cannot be completely overruled, justifying the Street’s reaction.”

Yet, some analysts are cautious and believe the current valuation is a major hurdle. “While the peak of Covid-led uncertainty may be behind, near-term shocks related to demand, pricing, and collections cannot be ruled out,” analysts at Motilal Oswal Securities (MOSL) said, adding that rich multiples leave a limited upside for the stock.

Total contract value of $6.9 billion in Q1 was up 21 per cent YOY, albeit aided by the closure of large deals initiated in the March quarter.

Most of TCS’ verticals and geographies reported a decline in revenue. BFSI (banking, financial services and insurance) as well as retail and CPG (combined revenue contribution 45 per cent) contracted 5 per cent and 13 per cent YOY, respectively, in CC terms.

Growth in health and life sciences was in line with the rise reported by Accenture for March-may 2020. However, unlike Indian IT majors, Accenture has higher exposure to these segments, which lifted its CC revenue growth to 1.3 per cent.

The September quarter numbers and commentary, therefore, will be crucial. Any miss could hurt investor sentiment.