TCS reported a largely inline quarter with revenue and EPS marginally above consensus (about 0.8 per cent), while EBITDA was 1.5 per cent above. Most verticals and geographies saw sequential growth too. Given this, one could ask the question ‘Have the business fundamentals in the IT sector bottomed out?’ If so, given TCS’ track record of best-in-class execution and history of successfully adapting to multiple tech and non-tech disruptions in the industry, investors can expect TCS to be on a growth path. However, given many factors that contribute to uncertainty at different levels, it would be too early to celebrate if you are a TCS investor. Here are five reasons why Q1 results is not an all-clear signal and investors need to stay cautious.
Lacklustre Growth
For one, on a year-on-year basis, the numbers still look lacklustre. Constant currency (CC) revenue growth at 4.4 per cent remains weak. Key vertical BFSI, which accounts for 32 per cent of revenue, reported flat performance, and key geography North America reported a 1 per cent decline. While CEO Krithivasan re-iterated that he believes FY25 will be better than FY24, it does not set a high bar given the fact that FY24 CC revenue growth was a weak 3.4 per cent.
Two, at a trailing PE of 30 times the TCS stock is still priced as though it is a mid-teens percentage growth stock, compared to its current low single-digit growth. During the years FY17 and FY18 when TCS reported similar low-single-digit percentage revenue growth during the industry shift from legacy to cloud/digital business, TCS traded in the PE range of 16 to 23 times. So at current valuation, any better-than-expected performance is already priced in.
Three, the long-term disruptive impact of IT on the business of IT services companies like TCS is still unclear. According to Krithivasan, people generally tend to over-estimate the near-term positive impact of disruptive technologies, while they under-estimate the long-term positive impact. This reflects his belief that AI benefits for TCS are more likely to flow in the medium to long term. From this, the indications are clear there is unlikely to be any meaningful uplift to TCS business or financials from AI.
With regard to long term, yes, there is a strong case to be made that TCS can benefit from AI, as it did from the cloud digitisation theme and related disruptions in the previous decade. However, as mentioned above, the reason, investors benefitted from the successful adaptations of the company to technological evolution was that the company then was priced for the uncertainty unlike now, where it is more than priced to perfection with regard to potential gains from AI.
Slowdown risks
Four, the US recession threat still looms for Indian IT services companies. A fiery debate is still on, as to whether a recession has been delayed or derailed. It may be imprudent to conclude that a US soft-landing is certain, just as it was to conclude in early 2023 that a recession was certain. So far in 2024, the Q1 US GDP at 1.6 per cent and estimates for around similar growth in Q2, reflect a slowdown compared to 2023 quarterly GDP growth in the range of 2-4.9 per cent. How this trends will remain a crucial barometer for the FY25 performance of TCS, given the company derives around 52 per cent of revenue from the region.
Five, Accenture and TCS are globally the industry bellwethers for IT services and consulting. Their financial, share performance and valuations tend to track each other. Yet, what is worth noting is that a clear divergence has been emerging recently. This is something that we pointed out in our bl.portfolio edition dated April 30 (Accenture sets the tone for IT stocks from here). Their share performance and valuation have been taking a divergent trend. Over the last one year, while Accenture shares are down 4 per cent, TCS shares are up 20 per cent. In the last five years, the earnings CAGR for Accenture, at 10 per cent, has been marginally better than that of TCS at 9 per cent. While in the current FY, TCS is expected to marginally outpace Accenture, given history and Accenture’s higher share in consulting/AI revenues, TCS’ current 20 per cent premium valuation is something to take note of. For most investors focused on Indian stocks, why does this matter? It’s because over a period of time, this differential is likely to get bridged by Accenture shares outperforming TCS shares. This makes TCS relatively a less attractive stock for global investors, or Indian investors too who are willing to invest in international stocks. The other way to look at it is – global investors are not showing as much enthusiasm on IT services/consulting stocks as Indian investors. Wondering why this is the case might help address some blind spots.