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Well placed to ride out macro headwinds

Supply-led drag on margins to moderate in H2 FY23

* TCS reported revenue of USD6.7b in 1QFY23, up 3.5%/1.3% QoQ in constant currency (CC)/USD terms, in-line with our estimates. Revenue in 1QFY23 was led by Retail & CPG, while regional markets remain a drag. It reported deal TCV of USD8.2b (flat YoY, book-to-bill ratio at 1.2x), in-line with its historical trajectory, although down 27% from its 4QFY22 record booking.

* Q1 EBIT margin was at multi-year low, as it dipped 190bp QoQ to 23.1% (vs. our estimate of 23.9%) due to elevated supply side pressure. Wage hike in Q1 negatively impacted EBIT margins by 150bp. Elevated attrition, all time high subcontractor cost and resumption of travel expenses also impacted margins during the quarter. Lower other income also resulted in lower Net Profit, down 4% QoQ to INR95b.

* As expected, management commentary on the demand environment and deal pipeline remained intact with no visible impact of weakening macro environment, although they remain watchful. Despite intact commentary, they indicated that the US will do better than Europe, due to client concerns over the slowdown. In our view, this is an initial sign of industry commentary turning more realistic vs the current view of no impact on tech spends. We are factoring in TCS revenue growth of 10.2% YoY in CC terms in FY23 (vs 15.5% in Q1), as the growth moderates in H2 FY23.

* The drop in margins was higher than our expectation, led by elevated salary hikes and subcontractor expenses. Given elevated attrition and TCS focus on growth, we expect EBIT margin in FY23 to decline 110bps YoY to 24.2% (vs 26-28% medium-term guidance). Moreover, with an exit margin guidance of 25%, FY24 EBIT margin should also remain below target guidance (MOFSLe of 25%) despite a favorable pricing environment. In addition, TCS should start seeing some benefit in overall cost in FY23 with a fresher hiring of 100K in FY22.

* Q1 LTM attrition rose 230bp QoQ to 19.7%. The management indicated that attrition will remain elevated in 2Q, before normalizing from 3Q. TCS generated FCF of INR 101b in 1Q, leading to total cash and investments at the end of quarter at INR 528b. It also gave a dividend of INR 8/share.

* We have tweaked our FY23/FY24 EPS by ~4% to account for lower margins. We expect a USD revenue CAGR of 9.3% over FY22-24 and INR EPS CAGR of 13.1% during the same period. Our TP of INR3,730 implies 28x FY24E EPS, with a 14% upside potential. We maintain our Buy rating on the stock.

In-line topline performance but miss margin on high employee cost

* Revenue (CC) grew 3.5% QoQ, INR EBIT/INR PAT rose 5% YoY each in 1QFY23.

* EBIT margin of 23.1% (down 190bps QoQ) was below our estimate of 23.9%

* It added 14k associates (the lowest net adds in the last seven quarters), although it was on an all-time high Q4 base.

* TCS announced a dividend of INR8/share.

Key highlights from the management commentary

* TCS continues to see a strong demand environment, with clients maintaining spend in Cloud adoption, operating model transformation and vendor consolidation.

* Management indicated a good visibility on the pipeline over the next few months. It is not witnessing any budget cuts or deferments in client spend, although some European clients have expressed concerns on macro-economic demand. It expects North America to lead the growth in FY23.

* TCS expects margins to improve sequentially for the remaining quarters of FY23, leading to flat YoY margins by Q4.

Valuation and view

* Increase in interest rates, slow economic growth, and elevated geo-political tensions have impacted the macro environment and raised concerns over IT spends.

* Given TCS’ size, order book, and exposure to long duration orders, and portfolio, it is well positioned to withstand the weakening macro environment and ride on the anticipated industry growth.

8 TCS has consistently maintained its market leadership position and shown bestin-class execution. It allows the company to maintain its industry-leading margin and demonstrate superior return ratios.

* We maintain our positive stance on TCS. Our TP of INR3,730 implies 28x FY24E EPS, with a 14% upside potential. We reiterate our Buy rating.

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