TCS margins decline amid higher third-party costs as BSNL project peaks

TCS was hit by about 60 bps as a result of the BSNL deal.

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Tata Consultancy Services (TCS) has reported a 60 basis points sequential decline in operating margin at 24.1 percent in the September quarter due to higher third-party expenses incurred following a large transformation deal with Bharat Sanchar Nigam Limited (BSNL).

“The headwinds were in form of the higher third-party expenses on account of a large transformational project and that project is running at its peak. We had incremental investment in talent and infra,” chief executive officer K Krithivasan told analysts in a post-earnings call on October 10.

The third-party impact that the CEO is taking about can be gauged from the fact that TCS’ cost of equipment and software licences went up a whopping 600 percent to Rs 3,230 crore in the second quarter from Rs 462 crore in the year-ago period.

Analysts had expected margins of IT companies to be hit due to pass-through revenues, similar to the previous quarter.

Pass-through revenue, or sale from third-party items, refers to income that is collected on behalf of a client and typically arises when IT firms include costs such as software licences and cloud services in their billing.

“Yes, they are doing pass-through also probably with the BSNL deal, that is one reason for the fall in margins. It also fell because of high subcontractor cost, third-party equipment and the BSNL deal,” Pareekh Jain, Founder and CEO, EIIRTrend, said.

As a result of the BSNL deal, TCS was hit by about 60 basis points (bps), and 70 bps on account of incremental investment in talent and infrastructure. Currency tailwinds and one-offs from Q1 partially offset this.

“During the transformation programme, we do not expect the (profitability) dynamics to change considerably,” Krithivasan said.

TCS has reiterated that the objective of the BSNL deal is on "nation-building," aligning with the company’s strategic approach to government projects, which is more than just profit margins.

Also read: TCS taps emerging markets to fuel growth as US, Europe demand remains muted

The BSNL deal

A consortium led by TCS bagged an order valued at over Rs 15,000 crore (around $1.8 billion) from BSNL to deploy 4G networks across India.

TCS is overseeing the deployment of 1 lakh sites to upgrade the state-run telecom operator’s 4G network infrastructure.

“We are around the halfway mark on that (deployment),” Krithivasan said. The company said there is still a long way to go, as various milestones from manufacturing to installation and final acceptance remain.

In Q2, TCS missed analysts’ expectations on most operational parameters, reflective of the tepid demand environment.

Net profit fell 1.1 percent sequentially to Rs 11,909 crore, while the operating margin declined 60 basis points at 24.1 percent, missing Street expectations on both metrics. India’s largest IT service firm’s revenue rose to Rs 64,259 crore, a marginal beat on expectations driven primarily by the BSNL deal ramp-up.

Some segments saw positive movement but the communication & media unit was particularly affected due to the BSNL project, falling over 10 percent.Also read: TCS expects growth rebound in Q4 FY25 after a seasonally weak Q3

Challenges in Q3

Despite the near-term pressure, TCS is committed to maintaining long-term margins in the 26-28 percent range.

The company expects margin tailwinds in the fourth quarter as the BSNL project and associated third-party costs begin to taper. However, the third quarter is projected to be another challenging period before the expected improvement.

"We have been calling out the third-party expenses incrementally going up. So, once it starts tapering Q3, Q4 or Q1 (FY25), that should reflect on both the revenue and margin," the company said.