Tech Mahindra HOLD -Suspect margin sustainability :: ICICI Sec

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Tech Mahindra HOLD
Maintained
Suspect margin sustainability Rs785- Traget
Reason for report: Q2FY11 results review and earnings revision



Tech Mahindra’s (TechM) Q2FY11 revenue performance was in line – revenues
(excluding pass-through) grew 5.4% QoQ (cross-currency benefit ~1.5%) to
US$265mn (I-Sec: US$264mn); EBITDA improved with margin (excluding passthrough)
at 21.7% (up 290bps QoQ) despite headwind in the form of wage
inflation. Forex contributed materially to the margin gain in Q2FY11 but we expect
it to turn into a headwind besides high attrition, lower headroom in utilisation rate
and onsite wage inflation going forward. A 600bps QoQ rise in utilisation rate to
75% along with one of the industry-leading attrition rates (30% annualised for IT
Services, up from 27% QoQ) will negate any major productivity gains hereon.
Even the quality of revenue growth is deteriorating as: i) 65% of Q2FY11
incremental sales (excluding pass-through) was from markets outside US/Europe
(where margins are lower) and ii) US$63.5mn pass-through revenues will entail
finance lease receivables over 3.5 years and hence, will impact cashflows. We
prefer HCL Technologies to TechM besides our top picks, Infosys and Tata
Consultancy Services. Maintain HOLD
􀁦 Maintain HOLD. We raise TechM’s FY11E and FY12E EBITDA estimates 7.9% and
3.7% respectively on better-than-expected Q2FY11 margin (excluding passthrough).
However, reckoning in a 30% downgrade in Mahindra Satyam’s (Satyam)
FY11E EPS post our last update on TechM, we downgrade TechM’s FY11E EPS
4.1%. With lower downgrade of ~9% in Satyam’s FY12E recurring EPS and
expected lower tax rate estimates for TechM, we upgrade TechM’s FY12E EPS
4.8%. Our revised target price of Rs785 is based on sum of the parts: i) Rs458 for
TechM (ex-Satyam) on target EV/E of ~8x and ii) Rs326/TechM share through
Satyam (Rs85/Satyam share) – target EV/E of ~8x Satyam’s FY12E recurring
EBITDA. Our target EV/E for TechM and Satyam is at a ~50% discount to Infosys’.
􀁦 Growth continues to be challenging in core markets of Europe at just 0.3%
CQGR in the past six quarters (0.6% compounded decline in BT revenues over the
period). Despite +3% pound appreciation versus the US dollar, Q2FY11 growth was
sluggish in Europe at just 2.2% (top client likely declined 0.6% in constant currency).
As regards opportunities in Europe, the management is concerned over the low deal
pipeline though it was optimistic on the US, which grew just 2.1% QoQ in Q2FY11.
􀁦 Margin headroom lower hereon due to: i) likely unfavourable forex movements, ii)
high attrition rate (30% annualised for IT Services), which limits any major upside in
utilisation rate, iii) pricing unlikely to be a tailwind given high client concentration and
macro challenges in some of the top five clients, iv) likely accelerated growth outside
the US and Europe, where margins are likely to be lower due to higher investments
and increased component of low-margin system integration work and v) wage
inflation due in Q3FY11 (for onsite employees).