Buy Tech Mahindra – 3QFY2011 Result Update - Angel Broking

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Tech Mahindra – 3QFY2011 Result Update

Angel Broking maintains a Buy on Tech Mahindra with a Target Price of Rs. 799.

Muted revenue growth: For 3QFY2011, Tech Mahindra reported revenue growth

of 1.6% qoq to US $268.9mn (excluding the impact of US $63.8mn of one-time

pass through revenue in 2QFY2011). Growth was muted on account of flat

volumes in non-BT accounts due to cyclically weak quarter.

Margins dip: During the quarter, the company’s EBITDA margin dipped by 111bp

qoq to 20.6% (excluding the one-off item in 2QFY2011) because of wage hike of

~3% given to overseas employees and stronger INR against USD taking away

gains due to better utilisations and SG&A efficiency.

Outlook and valuation: Management is witnessing sluggishness in demand

revival for IT spending from its TSP clients and foresees them to return to spending

only in 2HCY2011. However, the company expects its second top client AT&T to

record strong growth. Thus, we expect growth in non-BT accounts to be nominal

at 4% CQGR over 3QFY2011–4QFY2012E, with BT revenue expected to be flat.

At the margin front, headwinds of wage inflation and INR appreciation are

expected to result in a dip in EBITDA margins, settling at 19.5% and 19.2% for

FY2011 and FY2012, respectively. However, PAT is expected to hold up as the

deep in-the-money hedges of £270mn and US $780mn with participation rates

at 1.71 USD/GBP and 48.1 INR/USD are expected to boost forex gains for the

company. We value Tech Mahindra on an SOTP basis, with a standalone target

multiple of 10x FY2012E PAT of `740cr (i.e. at a steep 60% discount to Infosys’

target v/s historical avg. of 45%) and add the value of the company’s stake in

Mahindra Satyam, with a holding discount of 20% to the CMP. Thus, we maintain

Buy on the stock with a Target Price of `799.

Muted revenue growth

For 3QFY2011, Tech Mahindra reported disappointing set of numbers. The USD

revenue came in at US $268.9mn (v/s our expectation of US $276.7mn), up

merely 1.6% qoq due to flat volume growth qoq. In INR terms, revenue came in at

`1,211cr (v/s our expectation of `1,241cr), a decline of 1.9% qoq due to INR

appreciation of 3.5% qoq against USD.

Revenue growth was primarily driven by BT-accounts, which grew by 3.0% qoq

with revenue coming at US $118.3mn (£74mn). The company expects BT account

to remain stable at a quarterly run rate of US $118mn.

Non-BT accounts grew merely by 0.7% qoq to US $150.6mn due to laggard

growth in system integration work, which the company does in emerging markets.

Excluding the emerging market, non-BT accounts grew by 4.0% qoq. In constant

currency terms, revenue growth was flattish for non-BT accounts.

The top 2–5 clients’ growth was flat, with revenue growing by mere 1.7% qoq. Real

growth came in from the top 6–10 clients, which posted modest 5.3% qoq growth

Utilisations enhance

During the quarter, utilisation level increased by 130bp qoq to 76.3% from 75%,

which slightly aided margins. The company added 2,753 gross and 201 net

employees. Most of the hiring was done to back fill the spirally moving attrition,

which currently stands at 30% (annualised). However, on LTM basis, the attrition

rate was much lower. The net addition number for software professionals stood at

224, taking the total employee base to 24,673 employees, while there was no net

employee addition in the BPO segment. Sales and support employee base

witnessed reduction of 23 employees to 1,046 employees.

Margins dip

Increased utilisation level aided operating margins, but the negative impact of

forex fluctuation, onshore wage hike and low growth in the telecom equipment

manufacturer (TEM) business faded away the margin gain, which declined qoq.

In 3QFY2011, gross margin declined by 156bp qoq to 34.9%. On the operating

front, EBITDA and EBIT margins declined by 111bp and 117bp qoq to 20.6% and

17.8%, respectively. EBITDA margin for telecom service provider (TSP) clients

improved by 585bp qoq to 35.2% qoq, while it declined significantly by 946bp

qoq to 24.9% for TEM clients. The BPO business posted a 48bp qoq decline in

EBITDA margin to 43.1%.

During the quarter, reported PAT grew by whopping 18.1% qoq to `205.5cr v/s

our expectation of `169.2cr due to robust other income of `52.1cr (including forex

gain of US $8mn) against `8.3cr in 2QFY2011. The company derived forex gains

due to favourable in-the-money hedges.

Client pyramid

Tech Mahindra added two new clients in this quarter, out of which one client was

added in the US $1mn–2mn bracket. A client from the US $5mn–10mn bracket

moved to the higher US 10mn–15mn bracket. However, one client each from

the US $20mn–25mn and US $5mn–10mn bracket moved to the

US $15mn–20mn and US $2mn–5mn bracket, respectively. The active client base

of the company increased to 126 in 3QFY2011 from 124 in 2QFY2011.

Outlook and valuation

Management is witnessing sluggishness in demand revival for IT spending from its

TSP clients and foresees them to return back to spending only in 2HCY2011.

However, the company expects its second top client AT&T to record strong growth.

Thus, we expect growth in overall non-BT accounts to be nominal at 4% CQGR

over 3QFY2011–4QFY2012E, with BT revenue expected to be flat at US $118mn.

At the margin front, headwinds of wage inflation and INR appreciation are

expected to result in a dip in EBITDA margins, settling at 19.5% and 19.2% for

FY2011 and FY2012, respectively. However, PAT is expected to hold up as the

deep in-the-money hedges of £270mn and US $780mn with participation rates of

1.71 USD/GBP and 48.1 INR/USD are expected to boost forex gains (assuming

USD/INR of 45.4 and 44.4 for FY2011 and FY2012) for the company.

We value Tech Mahindra on an SOTP basis, giving a standalone target multiple of

10x FY2012E PAT of `740cr (i.e. at a steep 60% discount to Infosys’ target due to

its undiversified business resulting in underperformance) and further adding the

value of the company’s stake in Mahindra Satyam, with a holding discount of 20%

to the CMP. Thus, we maintain Buy on the stock with a Target Price of `799.