TCS Expects To Recoup Margin As AI Investments Taper, Bench Strength Gets Deployed

TCS top management expects to gain back operating margin during the next few quarters as their AI investments slow down and the bench they created in anticipation of demand gets utilized on projects. K Krithivasan, CEO & MD of TCS, stated this in an interview with NDTV Profit following the release of their second-quarter results.

Krithivasan did not provide a timeline for the recovery. "I do not wish to set a timeline", Krithivasan stated, but the 26-28% margin range "will remain our guiding range and we will attempt to attain it." TCS' Q2 Ebit (earnings before interest and tax) margin of 23.98% fell short of the Street's estimate of 24.38%, while net profit increased by 4.38% to Rs 13,934 crore on revenue of Rs 73,188 crore. In constant currency terms, which removes the effects of foreign exchange rate fluctuations, growth was at 0.5%, meeting expectations.

Krithivasan stated that the reduction in margin was due to AI spending on collaborations, acquisitions, and top-tier talent, some of whom were hired for immediate projects, and some in advance of anticipated demand. Hiring has created a bench that Krithivasan believes will ultimately benefit the company. "The bench strength that we have developed will be utilized, and that will ultimately serve as a margin advantage for us", Krithivasan stated. TCS added a net of 4,258 employees in the second quarter, marking its third consecutive quarter of net additions, with the majority of new hires possessing new-age skills.

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The bench is also intended to reduce reliance on third-party subcontractors. Fees paid to independent contractors increased from approximately 6.5% of revenue in Q1 to over 7% of revenue in Q2. Krithivasan stated that this represents a temporary shortage of skilled labor in geographical areas where TCS does not possess sufficient staff, and that historically TCS has relied less heavily on subcontractors than its competitors.

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AI continues to drive the majority of growth for TCS. Annualized AI revenue exceeded $3.1 billion, representing more than 10% of total revenue and an increase of 19% from Q1. Management stated that the investments made to achieve their objective of being the world's largest AI-led technology services company, announced last year, are providing a return on investment, and that AI work yields substantially higher margins than the company's average margin. AI-led projects typically run for three to six months and constitute a smaller portion of the overall project pipeline, whereas traditional services and transformation deals typically run for multiple years. Customers are being provided commitments based on outcomes, but pricing models continue to be traditional.

Krithivasan stated that there is no withdrawal of discretionary spending by customers, however, there is a condition associated with this statement. "Customers are not withdrawing from discretionary spending. Customers are prepared to spend as long as they perceive the benefits of doing so within a relatively short timeframe", he stated. What customers are reconsidering are long-term projects that require four to five years to become profitable.

Aarthi Subramanian, President & COO of TCS, concurred with Krithivasan regarding spending being tied to returns. "Discretionary spending is directly related to the value you generate for your organization. Therefore, you are not spending for technology alone", she stated, adding that it could change if the macroeconomic climate improves.

International revenue grew by 1.2% during the quarter, while Indian revenue declined by approximately 10% due to certain programs not being recognized as revenue. Krithivasan characterized India as a volatile market and stated that revenue will materialize "eventually." North American revenue grew by only 0.4%, but Krithivasan indicated that TCS observes indications of a robust recovery emerging. During the earnings conference call, management indicated that work performed by state-owned telecommunications provider BSNL (Bharat Sanchar Nigam Limited) could potentially mitigate some of the negative effects during the upcoming two quarters.

What Brokerages Make Of TCS Q2

Top brokerages generally considered the quarter to be satisfactory but differed on their opinions regarding the outlook for TCS, with two reducing their target prices.

Citi maintained Sell and reduced its target price to Rs 1,840, warning of impending margin pressures. It stated that FY27 margins are likely to be lower than previous statements made by the company and anticipates that TCS will continue to experience slow single-digit revenue growth trajectory, which it believes will exert pressure on TCS' stock price and multiple valuation metrics.

Jefferies maintained Underperform with a target price of Rs 1,800, citing unremarkable growth and escalating margin pressures. Jefferies indicated that growth in the United Kingdom surprised positively; however, growth was weak across other major geographical areas. Jefferies projects that TCS will experience annual earnings per share growth of only 4% during FY27-29.

Kotak Securities maintained Add and decreased its target price to Rs 2,320. Kotak Securities stated that the quarter was satisfactory with reasonable growth occurring in overseas operations; however, relatively few deal wins disappointed somewhat. Kotak Securities indicated that while AI revenue growth is accelerating, it is difficult to extrapolate; moreover, growth-oriented investments negatively impact TCS' margin profile.

JPMorgan maintained Overweight with a target price of Rs 2,300, also characterizing growth and margin as satisfactory. JPMorgan noted management's intention to enhance margins during the latter half of FY24; however, JPMorgan cautioned that this will hinge upon how growth develops in light of seasonal declines.

I read Krithivasan's answers to the margin, bench and timeline questions as being made by him because they match his speaking style. Please verify all four against the audio and lightly trim stutters as well. The titles come from TCS' 2025 appointments list K Krithivasan as Chief Executive Officer and Managing Director and Aarthi Subramanian as Executive Director, President and Chief Operating Officer, please confirm that they still hold these positions.

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