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Morningstar | TCS Revenue Surges on Foreign Exchange Effect; Digital and BFSI Encouraging; Shares at a Premium

TCS’ second-quarter headline numbers were very strong with revenue growth surging on a year-over-year basis. However, digging deeper, the firm’s dazzling reported results were flattered by a significant foreign exchange effect. With the rupee depreciating sharply against all major currencies, the difference between reported and constant currency revenue growth was 20.7% and 11.5%, respectively, leading to a foreign exchange effect of 9.2%. Nevertheless, we are encouraged by TCS’ quarterly results and see good underlying growth trends. The company’s digital business was a highlight, accounting for 28.1% of total revenue in the quarter (up from 19.7% in the prior year) and growing 60% year over year. We believe TCS has a good position in the digital transformation market, and we remain confident in the firm’s ability to attract and retain clients. We see cloud advisory & migration, cyber security, process automation, and IoT & analytics services as some key areas of digital strength. After adjusting our model for the stronger foreign exchange tailwinds and a slightly better margin profile, we raise our fair value estimate to INR 1,480 per share from INR 1,385, while maintaining our narrow economic moat rating. With shares trading at a premium, we’d seek a wider margin of safety before investing new capital in the name.

For the quarter, reported revenue rose 20.7% year over year to INR 369 billion (increased 11.5% in constant currency). Last quarter, TCS noted a recovery in the important banking, financial services & insurance, or BFSI, business (31.2% of total revenue), and we continued to see an acceleration in this industry during the quarter, which is an encouraging sign for TCS and the overall health of the IT services sector.

Another important metric was TCS’ growth in large clients, which indicates the company’s ability to expand its footprint in key clients. To that end, TCS added four new clients sequentially to its $100 million bucket and now counts 44 clients in this range. Finally, management mentioned that pricing had remained stable, and we see TCS’ ability to grow its digital practice revenue as helping on this front as it is higher margin relative to more traditional service lines.

TCS’ quarterly operating margin expanded 140 basis points year over year to 26.5%. Disciplined spending helped slightly with the expansion, but the depreciation of the rupee was by far the biggest margin expansion contributor. We expect TCS’ full-year operating margin to be approximately 26% and forecast a mid-20s operating margin over the medium term, in line with historic norms and management’s goals.