Thursday, December 31, 2015

Tech Mahindra: Joining the big league

Are you looking for a good long term bet in the IT space? Then Tech Mahindra should be your choice. The large deal pipeline in the enterprise segment, especially BFSI and manufacturing, the likely revival in IT spends in the telecom space and growing opportunities in network management services work in favour of the stock.

Margins should also improve given the company’s focus on cutting costs and improving utilisation levels. As the newly-acquired companies also integrate with it, the operating leverage should further buttress margins.

In the September quarter, the company’s performance was in line with expectations.

Revenue in dollar terms crossed the $1-billion mark in the quarter, up 2.2 per cent sequentially. This performance was buttressed by growth in the enterprise segment — largely technology, media and entertainment.

Operating profit margin improved 160 basis points over the June quarter and stood at 16.6 per cent, thanks to tailwinds from rupee depreciation, lower visa costs and improved utilisation.

Utilisation rate stood at 79 per cent versus 75 per cent in the first quarter. Total contract value of new deal wins was $300 million. For the first six months of 2015-16, the company reported sales growth of 21 per cent in rupee terms. Profits grew 8 per cent, dragged by the new acquisitions.

On expected earnings of 2016-17, the stock trades at about 12 times at its current price of ₹518. The big four Indian IT majors trade at an average of 16 times one-year forward earnings.

Uncertainties surrounding Tech Mahindra’s new acquisitions look already priced in the stock. So, investors who can hold for at least two years, can buy now.

Growing diversification

Tech Mahindra got into the league of the top five IT services company in India after acquiring the troubled Satyam Computers. The acquisition not only drove up revenues, but also gave Tech Mahindra capabilities in ERP solutions and infrastructure management. It also gained a foothold in the financial services, logistics, transport and life sciences space.

Originally, Tech Mahindra was largely a player in the telecom space, being a company started by a JV between British Telecom and Mahindra & Mahindra group. Today, however, about 50 per cent of the company’s revenue comes from non-telecom business.

To further diversify from the concentration in the telecom segment, it acquired Sofgen, a Geneva-based IT consulting company that specialises in commercial and retail banking solutions, in January this year. Tech Mahindra has gained access to 150 clients in the BFSI space through this acquisition and also a pie of the global private banking segment in Europe.

However, Sofgen is yet to be fully integrated with the company and is currently margin-dilutive. Tech Mahindra also recently announced acquisition of a 60 per cent stake in Pininfarina, a well-known Italian engineering company that has designed cars for Ferrari and Rolls Royce.

The company could complements Tech Mahindra’s capabilities in the automotive space and helps the latter expand into Italy and Germany. But again, given that Pininfarina is making losses at the net level, it may also weigh on margins initially.

It will take at least a year for the new acquisitions to start paying for Tech Mahindra and for it to take advantage of the cross-selling possibilities.

Telecom is promising

Tech Mahindra’s strong positioning in the telecom space is however, an advantage. In 2015, BT acquired EE, Hutchison acquired O2 and Verison acquired AOL — all three acquiring companies are clients of Tech Mahindra.

As the companies integrate their businesses, and draw out new budgets, their IT spends may go up and benefit Tech Mahindra.

Also, given the company’s domain expertise and proven delivery capabilities in network management services (helps communication service providers improve their reach and service capabilities) , and the growing opportunities in the space, the company should do well.

The US-based wireless engineering services company, Lightbridge Communications (LCC), which Tech Mahindra acquired in November 2014, should be of great help here.

Margins to expand

The company has many big clients, such as AT&T, and a reach of about 50 countries globally, including the US. Though currently the focus is to cut costs at LCC and improve its margins, slowly it will throw open big opportunities for Tech Mahindra.

The company may see margins improve, going ahead, as it pulls all levers. One, as the integration process is completed and the acquired entities start to contribute meaningfully, margins will expand.

Two, with the company increasing its focus on improving employee utilisation and better onshore-offshore mix, it will help margins.

Currently, offshore is just 38 per cent of revenue for Tech Mahindra against 40-45 per cent for other large-cap companies.

Last week, Tech Mahindra announced the launch of it own automation platform — AQT.

Slowly, as the company’s many projects embrace this platform, productivity will improve, helping profitability.

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