RBS: Hold Tech Mahindra --Running a tight ship; Rs650 target

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Tech Mahindra
Running a tight ship
We believe Tech Mahindra's high revenue concentration from few clients, its
focus on the telecom vertical and the difficulties in turning around Satyam will
lead to lower revenue and EBITDA growth than peers. Hence, a major positive rerating
is unlikely. We initiate coverage with a Hold rating

Business risk still high

Continuing pressure on volumes and pricing at TECHM’s top client (British Telecom (BT)

which accounts for about 44% of TECHM’s revenues) and high dependence on its top 2-5

clients (cumulatively contribute 28% of TECHM’s revenues) indicate TECHM’s weakening

revenue growth visibility. Our analysis indicates revenue and earnings growth for most of its

top-five clients (72% of revenues) and telecom operators in the US/Europe are likely to be

muted. We believe revenue growth, excluding the top-five clients and US/Europe, will require

higher investments, which will likely affect margins.

Margin challenges also increasing

Besides challenges relating to revenue growth, we expect TECHM’s margins to remain

muted due to: 1) a high attrition rate (30% annualised for IT Services), limiting any major

upside in its utilisation rate; 2) pricing unlikely to be a tailwind, given high client concentration

and macro challenges among some of the top-five clients; 3) likely accelerated growth

outside the US/Europe and top-five clients, where margins are likely to be lower due to

required additional investment and high proportion of low-margin system integration work.

We initiate with a Hold rating

We initiate with a Hold recommendation and sum-of-the-parts (SOTP) based target price of

Rs650, comprising: 1) Rs466 for TECHM (excluding Satyam) based on target PE of c11x

FY13F diluted adjusted EPS (excluding Satyam); and 2) Rs184 per TECHM share, through

Satyam, based on a target EV/EBITDA of 5.8x FY13F for Satyam’s recurring EBITDA

(EV/EBITDA is a better multiple for valuing Satyam, given the high volatility on items below

EBITDA). At our target price, TECHM is valued at 11x FY13F diluted adjusted EPS (including

Satyam), a c50% discount to the Indian IT industry benchmark Infosys.

The basics

Catalysts for share price performance

We expect key near-term catalysts to be:

􀀟 CY11F IT budget finalisation (which we expect to be positive) and the renewal of large

outsourcing deals (over the next eight quarters, starting 4QCY10). We believe TECHM will

struggle to achieve industry-average growth in FY12, due to low growth opportunities from its

top-five clients and single vertical (telecom) focus.

􀀟 Cognizant’s guidance for CY11 (in February 2011) and Infosys’s guidance for FY12 in April

2011. While building in its typical conservatism, we expect Infosys to take a more confident

stance on FY12 guidance. However, considering various micro risks specific to TECHM, we

expect it to face many revenue growth challenges.

􀀟 The likely underperformance of the telecom vertical (which contributes 100% of TECHM’s

revenues) vs other verticals due to low earnings growth of clients within telecom vertical.

􀀟 Likely negative surprises in TECHM’s margin performance.

Earnings momentum

􀀟 We believe that due to its high client concentration and focus only on the telecom vertical,

TECHM will underperform its peers in revenue and EBITDA terms.

􀀟 We expect TECHM’s EPS growth to be lower than its peers’ considering organic business

risks, relatively high headwinds on margins and the difficult task of turning around Satyam.

􀀟 Our forecast assumes USD revenue, INR EBITDA and INR EPS FY11-FY13 CAGR of 12%,

6% and 8%, respectively. Excluding amortisation of deferred revenues, we expect INRadjusted

EBITDA and INR-adjusted EPS FY11-FY13 CAGR of 7% and 10%.

Valuation and target price

We initiate with a Hold rating and Rs650 SOTP-based target price, which comprises: 1) Rs466 for

TECHM (excluding Satyam), based on a target FY13F P/E of 11x on diluted adjusted EPS

(excluding Satyam); and 2) Rs184 per TECHM share through Satyam, based on a target

EV/EBITDA of 5.8x FY13F, Satyam’s recurring EBITDA. At our target price, TECHM is valued at

11x FY13F diluted adjusted EPS (including Satyam), a c50% discount to the Indian IT industry

benchmark Infosys.

How we differ from consensus

Bloomberg estimates may not be comparable with our estimates, considering the ambiguity

relating to the inclusion of profits from associates, including Satyam. Our normalised EPS

estimates consider recurring profits from associates, including Satyam (accounting for 20-25% of

normalised EPS). Also, the treatment of amortisation of revenue receipts from the top client in

consensus estimates is not clear, in our view. Our adjusted EPS excludes this amortisation.

Risks to central scenario

􀀟 Higher-than-expected revenue growth among its top-five clients and any major volume ramp

up in the telecom vertical for Indian IT services.

􀀟 The potential merger of Tech Mahindra and Satyam - risk related to the merger ratio and the

resulting impact on stock price.

􀀟 Higher-than-expected economic revival in Western economies will likely benefit TECHM and

other vendors. However, any acceleration in Europe’s economic recovery will benefit TECHM

more than its peers considering higher revenue contribution of >50% from Europe for TECHM.

􀀟 Currency volatility, specially any sharp depreciation of the INR vs the GBP and the EUR, will

benefit TECHM more than its peers considering its higher invoicing in GBP and EUR.

Business risk still high

We believe the business risk to TECHM (excluding Satyam) remains high, with low growth

opportunities in telecom (100% of revenues) and the top-five clients accounting for about

72% of revenues). Hence, we expect its revenue growth to remain muted going forward.

Continuing pressure on volumes and pricing at TECHM’s top client BT (contributing about 44% to

TECHM’s revenues in 3Q11 and business risk through high client concentration beyond BT,

indicate TECHM’s weakening revenue growth visibility. Our analysis indicates that revenue and

earnings growth for most of TECHM’s top-five clients (72% of revenues) and telecom operators in

the US/Europe are likely to be muted in the medium term. We expect revenue growth, excluding

top-five clients and US/Europe, will require greater investment, which will likely affect margins.

Growth challenges to continue from BT

Revenues from core BT spend to remain under pressure

Over the years TECHM has partnered BT across business segments, including Retail, Wholesale,

Open Reach and BT Global Services (BTGS). The first three segments are treated as core BT

work segments and BTGS is an enterprise services arm for BT’s enterprise clients.

Given the recessionary pressure and progress in 21CN layout (an internet protocol-based network

fit for the 21st century) already behind in a big way, core BT spend reduced materially after FY08,

impacting most of BT’s outsourcing vendors, including TECHM. Therefore, growth opportunities

within core BT for TECHM are likely to be limited. Hence, we believe with TECHM’s highest wallet

share coming through increased penetration of core BT spend and likely reduced capex

requirements in the coming years (relating to core work), this part of the BT business for TECHM

is likely to remain under pressure.

Revenue ramp up from Barcelona deal lagging

With growth opportunities tapering in core BT since late 2006, TECHM started pursuing

outsourcing spend in BTGS (BTGS’s annualised 2QFY11 revenues were about £8bn), providing

IT and hardware services to BT’s enterprise customers. In early 2007, TECHM won the largest

outsourcing contract by any Indian vendor from BT, called Barcelona, worth about £500m and

spread over five years. In return, TECHM paid BT Rs5.25bn as upfront savings resulting from

outsourcing this contract to TECHM. With scope and pricing restructuring of Barcelona in

3QFY10, the revenue run rate from this contract is unlikely to increase. Therefore, for TECHM, the

revenue growth opportunity of this deal will likely be muted going forward.

Revenue from Andes deal largely discretionary in nature

In 2QFY09A, TECHM was awarded another contract worth £350m, called Andes. TECHM paid

Rs4.40bn to BT in 4QFY08 for exclusivity of deal discussion and savings as a result of BT

outsourcing this deal to TECHM. As the Andes deal is transformational in nature, it is likely to be

discretionary with revenues expected to decline post the ramp-up phase. 1QFY10 was the first full

quarter of ramping up of this deal for TECHM. We believe that the deal’s ramp-up is mostly

complete.

Most deals with BT group are being restructured

With recessionary pressure on BT significantly impacting its earnings, the company has started

restructuring its contract with TECHM in terms of scope and pricing effective 3QFY10. With

significant changes in scope and pricing of many BT deals (including Strada, Barcelona and

Andes), TECHM has received £126m from BT as restructuring fees. Management claims these

fees are unrelated to the upfront payment to BT when TECHM won the Barcelona and Andes

deals (together constituting the same amount as restructuring fees received by TECHM from BT).

TECHM is amortising these restructuring fees over 19-20 quarters, effective from 1QFY10.

The company treated upfront payments made to BT as one-time expenses in the FY07 and FY08

audited financial statements. However it is amortising the receipt of restructuring fees over 19-20

quarters (starting 1QFY10). Hence, to reflect a more correct picture in terms of cash flows as well

as recurring earnings, we exclude the amortisation of restructuring fees (post tax) over 19-20

quarters, effective 1QFY10, from our normalised EPS estimates while arriving at our fair value for

TECHM.

Other top clients – growth acceleration difficult with high penetration

Besides top client BT, TECHM has established long-term relationships with AT&T, Telefonica O2,

Alcatel and Motorola – its other top clients. The company has been successful in mining these

relationships and has master service agreements with them, providing long-term revenue visibility.

This has led to the risk of high client-concentration shifting from the top client (still high at 44% in

3QFY11 vs 80% in FY05) to the top 2-5 clients (28% in 3QFY11 and 7% in FY05) – with the top

five clients accounting for 72% of revenue in 3QFY11. Based on 3QFY11 financials, the average

annualised revenue run rate from the top 2-5 clients has now increased to about US$75m per

client, from US$4m per client in FY05A. The revenue run rate for the second top client, according

to us, has risen to >US$125m at present, indicating that the current revenue run rate from the top

3-5 clients is at >US$45m per client

Macro concerns behind, but telecom to underperform

Considering 1) strong correlations (as shown in Charts 1 and 2 within our sector arguments) in

revenue growth of Indian IT companies with operating profits of S&P500 companies; and 2) our

findings relating to likely higher growth in BFSI/Retail/Manufacturing for Indian IT as discussed

earlier in our sector argument, we have done a second level check for lead growth indicators

within some of the major verticals of Indian IT. We have extended the growth analysis to compare

the revenue/earnings growth of top global companies by industry (source: Bloomberg) to get

some lead indicators regarding growth opportunities for Indian IT in some of the major verticals.

Our analysis of the telecom service provider (TSP) vertical indicates that revenue and EBITDA

growth of the top global TSPs in CY07/CY08 was higher than in other verticals. However, revenue

and EBITDA growth are likely to be modest through CY10-12 (a post-recessionary period), but we

see much higher growth in other verticals including BFSI, Retail and Manufacturing (analysis

restricted to the auto sector). Telecom, being a defensive vertical, is unlikely to provide any major

positive or negative surprise relative to other sectors during booms and recessions. Therefore, we

believe each telecom IT services vendor’s growth is largely dependent on its clients relationship

and maturity and the extent of outsourcing/offshoring within its clients. Considering the high client

concentration of TECHM with most top five clients, muted growth prospects in Top client BT, and

high competitive pressure within top 2-5 clients, growth opportunities are likely to remain muted

for TECHM in FY11F-FY13F

Growth within TECHM’s top 2-5 clients may come through higher offshoring (not yet visible

despite the relationships being four to five years old) and an increase in demand for application

modification post the converged network layout and managed services. However, while

addressing growth outside BT, we believe competitive pressures are likely to be intense.

Therefore, TECHM’s overall growth within its top five clients (which still contribute c72% of

revenues) is likely to be muted beyond FY10. Therefore, we believe TECHM has to invest in

growing its non-top five clients, whose revenue contribution is just 28%. (Its top 6-10 clients

contribute c9% of revenues).

However, a revival in telecom capex cycle from CY11 onwards could deliver positive surprises for

IT services vendors in that vertical as telecom clients’ operating expenditure would start to

increase, albeit with lag to capex growth. We believe that in this scenario, TECHM would benefit

given its strong footprint. However, we believe any such benefit would be limited outside its top

client (BT, still c44% of revenues) considering its major capex growth cycle has past. Following

any major revival in telecom capex (outside the top client), we would expect TECHM to face

significant competition from the other large Indian vendors (whose revenue in the telecom vertical

is also high).

TECHM needs to invest in markets (ex-US/Europe) and in new services

TECHM’s revenues outside the US and Europe are cUS$150m (based on 3QFY11A annualised

revenue run rate) vs its peers’ (TCS, Infosys and Wipro) at US$700m-1,500m. TECHM’s

penetration in telecom markets outside the US and Europe may not be lower than its peers, but

competition in any such markets is likely to be intense given the likely higher growth in telecom

vertical in these markets (versus US/Europe) for the Indian IT industry. Typically, margins in

emerging markets are lower.

Besides the above, TECHM is a late entrant in BPO and IMS segments. We do not doubt

TECHM’s prowess in client mining through BPO/ITO/managed services, but the competition has

already scaled up its offerings in BPO/ITO/managed services for telecom clients. Within managed

services, clients are aggressively demanding upfront cost savings, including taking over

employees and assets, especially in telecom. Indian vendors, including TECHM, have been

reluctant to take over employees and assets till now. Therefore, we expect TECHM will have to

invest more in these offerings to increase its penetration.

Margin challenges also increasing

Besides the big challenges to revenue growth discussed earlier, TECHM’s margin visibility

is lower than its peers’ given its supply side issues, lower pricing power and higher

investment in sales and marketing.

Besides challenges relating to revenue growth, we expect TECHM’s margin to remain muted due

to: 1) a high attrition rate (30% annualised for IT Services), limiting any major upside in its

utilisation rate; 2) pricing unlikely to be a tailwind, given high client concentration and macro

challenges among some of the top-five clients; 3) likely accelerated growth outside the US/Europe

and top-five clients, where margins are likely to be lower due to required additional investment

and high proportion of low-margin system integration work.

Initiate with Hold rating

We initiate on TECHM with a Hold rating given its high business risks and the likely

underperformance in EBITDA and EPS growth (both ex-Satyam) vs peers, as well as the

difficult task of turning around Satyam. Hence, we believe a positive re-rating is unlikely.

Our target price for TECHM is based on an SOTP valuation. We value TECHM (ex-Satyam) on a

P/E discount to our target multiple for Infosys. We value Satyam based on an EV/EBITDA

discount to Infosys. We believe that EV/EBITDA is better method to value Satyam considering the

volatility of items below the EBITDA line, including various pending litigations and their impact on

cash flow, other income, tax provisions and hence on EPS.

While arriving at our target price for TECHM, we are excluding the amortisation of revenue

receipts from our EBITDA and normalised EPS calculation as discussed earlier. In the following

table we show our adjusted EBITDA and adjusted normalised EPS calculations.

We initiate with a Hold rating

We initiate with a Hold rating and Rs650 target price based on our SOTP: 1) Rs466 for TECHM

(excluding Satyam) based on a target PE of c11x FY13F diluted adjusted EPS (excluding

Satyam);and 2) Rs184 per TECHM share through Satyam based on a target EV/EBITDA of 5.8x

FY13F Satyam’s recurring EBITDA (EV/EBITDA is a better multiple for valuing Satyam given high

volatility on items below EBITDA). At our target price, TECHM is valued at 11x FY13F diluted

adjusted EPS (including Satyam), a c50% discount to the Indian IT industry benchmark Infosys.

Our target PE multiple for valuing TECHM (excluding Satyam and based on EPS excluding

amortisation of one time revenue receipt as discussed earlier) is at c50% discount to our fair

multiple for Infosys which we believe is fair considering much higher business risk, much lower

EBITDA margins and significantly lower cash flow generation. Our target EV/EBITDA multiple for

valuing Satyam is at a c60% discount to our fair valuation for Infosys, which we believe is

reasonable considering much lower revenue growth visibility, higher business risk, much lower

EBITDA margins and significantly lower cash flow generation.

Management indicated TECHM-Satyam merger will be prioritised

We believe post re-statement of Satyam’s accounts and largely cleaned-up balance sheet,

Mahindra & Mahindra’s management will consider merging Tech Mahindra (TECHM) and Satyam.

As per the management, such an announcement is likely in the short-medium term. Our estimates

(at the current market price of TECHM and Satyam) value Mahindra group’s stake in TECHM

(excluding TECHM’s stake in Satyam) at >US$520m and in Satyam at >US$300m. Further, we

believe that the brand identity will also be taken into account while merging the two. However with

lot of challenges relating to Satyam’s steady state of financials as discussed above we believe

that ambiguity relating to merger ratio would remain high.

Management team

Mahindra and Mahindra Group (M&M Group) of India together with UK’s British Telecom Group

(BT Group) are the promoter owners of the Tech Mahindra (TECHM) with their combined equity

stake of 72.8%. M&M Group owns 48.2%, while BT Group owns 24.5% and the balance stake of

around 0.1% is held by the Mahindra BT Investment Company Mauritius. Besides BT Group’s

equity stake in TECHM, BT is the largest client of TECHM with revenue concentration of c44%

(while others including top 2-4 clients contribute 28% of the revenues). TECHM’s day-to-day

operations are run by a team of professionals under the leadership of Mr Vineet Nayyar, who is

the Vice Chairman, Managing Director and CEO of TECHM. To diversify beyond the telecom

vertical (which contributes almost 100% of TECHM’s revenues), TECHM group acquired a 42.7%

equity stake in Satyam Computers in July 2009 which resulted into a significant decline in the net

cash balances of TECHM as well as dividend payments.