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Merger Update on Tech Mahindra and Mahindra Satyam with anAccumulate recommendation on Tech Mahindra for a Target Price of `750 (12 months).

Merger announced

The Board of Directors of Tech Mahindra (Tech M) and Mahindra Satyam (Satyam) have approved the merger of both the companies along with their wholly owned subsidiaries, Venturbay Consultants Pvt. Ltd., C&S System Technologies Pvt. Ltd., CanvasM Technologies Ltd. and Mahindra Logisoft Business Solutions Ltd. The swap ratio approved by the board of both the companies is 2:17, i.e., 2 shares of Tech M (face value of `10 each) for every 17 shares of Satyam (face value of`2 each). The merger process could take up to nine months to complete and will be effective from April 1, 2011.

Shareholding pattern: On a pro forma basis, Mahindra Group will own 26.3% in the combined entity, British Telecom (BT) will own 12.8%, 10.4% will be held as treasury stock, 34.4% will be held by public shareholders of Mahindra Satyam and the balance 16.1% will be held by public shareholders of Tech M. The intention of creating a treasury stock is to allow the company greater liquidity when needed. This, especially in the matter of acquisitions, is on the agenda of both the companies. Tech M will issue 10.34cr new shares, thereby increasing its outstanding shares to 23.08cr and its equity capital to `230.8cr.

Well-diversified revenue mix: The combined entity will have revenue run-rate of US$2.4bn+ – this size will enable the company to participate in larger deals and improve deal win rates. The combined entity will have a broader service offering. As of now, Tech M’s entire revenue comes from the telecom vertical, which has been shrinking over the past couple of years. After the merger, contribution from telecom would come down to sub-50% (47-48%). The combined entity will have a broad-based play across industries such as manufacturing, BFSI, telecom, technology, media and entertainment, retail, transport and logistics and lifesciences and healthcare.

Geography wise, the revenue portfolio will be well balanced with a diversified global footprint that would boast of contribution from Americas at 42%, Europe at 35% and emerging markets at 23%. Also, Tech M’s dependence on BT, its top client, would come down considerably as the combined entity would derive ~17% of its revenue from BT, while Tech M currently derives 35% of its revenue from BT. The combined entity would have 75,000 employees, across 54 countries, and over 350 customers. Post the merger, the entity would have net cash surplus of `1,600cr-1,800cr.

Outlook and valuation: The benefits of the combined entity will start being reflected only after few quarters of the merger’s completion. The combined entity is expected to post a 10.7% CAGR over FY2011-13E, with growth of 8.9% yoy in FY2013. PAT of Tech M and Satyam is expected to be at `674cr and `900cr for FY2013, respectively. Considering the new share count, the consolidated EPS comes in at `68.2. We value Tech M at 11x FY2013E EPS of `68.2 (23% discount to HCL Tech’s target multiple of 13.5x due risks such as: 1) Tech M still generates 17% of its revenue from one client, which is high; 2) 47% of its revenue comes from the telecom vertical, which is still elevated; and 3) Tech M needs to scale up revenue from high-growth services like infrastructure management and consulting and package implementation). We maintain or Accumulate view on the stock with a target price of `750.

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Tech Mahindra and Mahindra Satyam