Tata Consultancy Services is the IT sector’s bellwether, and this week the market watched its Q2FY22 earnings announcement closely. In anticipation of TCS’ results on Friday, most IT services companies’ stocks were trading higher, but stocks dropped as news trickled in that TCS’ dollar sequential dollar revenue growth was less than 3% for the second consecutive quarter.

Investors made their disappointment clear, and the Nifty IT index fell nearly 4.2% in the next two trading sessions. But on Wednesday, ahead of Infosys’ and Wipro’s results, the index was trading in the green.

TCS’ stock however is down nearly 8% from Friday’s close, and this must make investors wonder what was in the numbers that left the street miffed. Is it really as bad as it seems?

A decent quarter, but Europe revenues slow

Although the company’s management and the press release focused on the strong YoY revenue growth in Q2FY22, analysts and investors pointed out in the company’s earnings conference call that Q2FY22 was a weak quarter which resulted in a low base. Consequently, the year-on-year revenue growth looks impressive.

One of the primary reasons TCS’ dollar revenues grew at the same pace in Q2FY22 as Q1FY22 was because of slow revenue growth in Europe. This was due to the offshoring of certain projects, which led to lower revenue from the region. There was also a large project that ended during the quarter, which led to lower revenues, the management said.

Apart from Europe, the Asia Pacific region saw revenues fall marginally, while all the other regions saw higher revenues sequentially. India, which was impacted by lockdowns across many states during Q1FY22, grew 14% QoQ in dollar terms.

However, revenues grew across all of TCS’ verticals with demand seen from varied clients across various industries. The retail & CPG and technology and services verticals grew the fastest in Q2FY22 at 4.3% and 5.3% QoQ, respectively.

Employee attrition and higher salaries hit margins and profits

What could be worrying investors is the company’s costs, especially employee and subcontracting costs going up. In Q2FY22, employee costs rose 2.9% QoQ to Rs 26,649 crore, while subcontracting costs rose 7.4% to Rs 4,190 crore. This hemmed in TCS’ profits in the quarter. However, despite this impact, the company was within touching distance of Rs 10,000 crore quarterly profit.

A concern for TCS is the huge spike in attrition, which on a trailing twelve-month basis is nearly 12%. This is the first time in four quarters that TCS’ employee attrition was reported in double digits. The higher employee costs are going to bite due to a shortage in employees with the right skills across the technology space. This is often referred to as “supply-side” constraints, which is essentially a company having to pay more than it normally would to hire talent laterally. This has impacted margins.

To serve its various projects the company has hired many people laterally and has already hired 43,000 freshers in FY22. The company says that it will continue to invest in talent to build a pipeline of staff that can be deployed as and when projects get underway. This way, it can continue to serve the demand surge it has seen over the past few quarters across various industries and geographies, including Europe.

Apart from the large migration to cloud services that the company’s customers need in order to survive post-pandemic, there are many clients who are now investing in upgrading their processes to transform into a digital business. This is coming from all sectors like healthcare, lifesciences, utilities, and manufacturing companies, among others.

Deal wins have left the street wanting more

Being TCS, the company sets the expectation for the rest of the IT services industry. In Q1FY21, the company bagged deals with a total contract value of $8.6 billion, which included a very large deal. Excluding this, the TCV rose around 25% in YoY terms.

What dampened investors’ exuberance, however, was the sequentially lower deal win from Q1FY22. The company said there are enough deals in the pipeline, which is a result of a robust demand environment for technology services.

But H2 of any financial year is usually a weak period. Last year the company and the industry turned this truism on their head by posting $12.1 billion in revenues in H2FY21. The management said that this ensured the company would be almost at the same level in revenues as H2FY21. In FY22, TCS has already posted revenues of $12.5 billion. Even if the company posts flat revenue growth in H2FY22, it will still grow at a little over 12%. This would lead it to post revenues of $25 billion in FY22.

It is quite possible that the company posts higher growth in H2FY22. Even at $25 billion, at nearly 20% net margin, this would mean a $5 billion net profits for FY22. If the company is able to manage its “supply-side” issues and ramp-up projects, with operating leverage, this profit number can only go higher.

Whether the street agrees or not, this is more than just a probability. For investors though, it will be interesting to see if the management’s decision to invest ahead of demand coming on stream will pay off. When growth picks up, the expectation is that profits and cash flows will also grow. But the unknown factor here is employee costs. There is a huge rush to snap up talent with the right skills. This is leading to a rise in costs across the industry. And TCS is no longer immune to this phenomenon, at least for the next three quarters.