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Tech Mahindra: No more a child's play!

Jan 23, 2007

Introduction to results
Tech Mahindra recently announced its results for the third quarter and nine-months ended December 2006. For 3QFY07, while revenues grew by 10% QoQ, net profits were up 17% QoQ. Higher net profit growth was on the back of expansion in operating margins, which was powered by change in business mix and reduction in personnel and other expenses. But for the effect of appreciation of the Indian rupee against the US dollar, the growth in topline and expansion in operating margins would have been higher.

Consolidated financial performance: A snapshot…
(Rs m) 2QFY07 3QFY07 Change 9mFY06 9mFY07 Change
Sales 6,977 7,698 10.3% 8,215 20,546 150.1%
Expenditure 5,207 5,625 8.0% 6,516 15,398 136.3%
Operating profit (EBDIT) 1,770 2,073 17.1% 1,699 5,148 203.0%
Operating profit margin (%) 25.4% 26.9%   20.7% 25.1%  
Other income (57) (32)   213 (77) -136.2%
Depreciation 113 137 21.2% 287 357 24.4%
Interest - 12   - 12  
Profit before tax 1,600 1,892 18.3% 1,625 4,702 189.4%
Tax 169 224 32.5% 162 537  
Profit after tax/(loss) 1,431 1,668 16.6% 1,463 4,165 184.7%
Excess provision for tax written back 339 -   - 339  
Profit after tax/(loss)(after tax provision) 1,770 1,668   1,463 4,504  
Net profit margin (%) 20.5% 21.7%   17.8% 20.3%  
No. of shares (m)         116.2  
Diluted earnings per share (Rs)*         43.5  
P/E ratio (x)*         40.4  
* On a trailing 12-month basis

What is the company's business?
Tech Mahindra (TM) is a mid-size Indian IT services company providing software solutions to the global telecommunication industry. The company was incorporated in 1986 as Mahindra-British Telecom Limited, and subsequently, in February 2006, was re-christened as Tech Mahindra Limited. The company was formed as a joint venture between Mahindra & Mahindra (M&M), India's leading tractor and utility vehicle manufacturer, and British Telecommunications Plc., a leading global telecom services company. The company provides services like application development and maintenance (ADM), solution integration, product engineering and lifecycle management, testing, consulting and managed services to global telecom companies. The company's major focus areas are telecom service providers (TSPs) and telecom equipment manufacturers (TEMs). British Telecommunications (BT) is TM's largest client and has a long-standing relationship of nearly 18 years with the company. TM serves clients in over 40 countries, in geographies such as the UK, continental Europe, North America and the Asia-Pacific region. The company has grown its revenues and profits at compounded rates of 23% and 13% respectively between FY02 and FY06.

What has driven performance in 3QFY07?
TSPs led the way: The strong sequential growth in Tech Mahindra's topline during 3QFY07 was largely due to robust performance from the company's TSP business (96% of total revenues), which grew sales by 10% QoQ. In this business, Tech Mahindra is associated with building and maintaining the network of Hutch in Indonesia and also performing similar tasks with the Caribbean major, Digicel. On the TEM front, revenues grew by 59% QoQ, though on a lower base in 2QFY07. Considering the growth in the telecom sector in India, these two verticals are likely to rake in strong growth in the future. The company started its BPO service offering during the quarter. As of the quarter end, it had more than 1,500 people delivering BPO services for various clients.

Segment-wise details (Standalone)
Revenues (Rs m) 2QFY07 % share 3QFY07 % share Change
Telecom Service Provider (TSP) 6,140 95.7% 6,772 94.5% 10.3%
Telecom Equipment Manufacturer (TEM) 110 1.7% 175 2.4% 59.1%
BPO Services - 0.0% 39 0.5%  
Others 164 2.6% 183 2.6% 11.6%
Total 6,414   7,169   11.8%
PBIT (Rs m) 2QFY07 PBIT margins 3QFY07 PBIT margins Change
Telecom Service Provider 2,486 40.5% 2,630 38.8% 5.8%
Telecom Equipment Manufacturer 26 23.6% 57 32.6% 119.2%
BPO Services -   (16) -41.0%  
Others 43 26.2% 81 44.3% 88.4%
Total 2,555 39.8% 2,752 38.4% 7.7%

Notably, the company had recently won one of the largest deals in the history of the Indian IT industry, when it signed a 5-year US$ 1 bn deal to support British Telecom's (BT) growth of managed services to business customers globally. The revenue generation from this deal is in addition to the existing services that the company already provides to BT where it fulfills the latter's internal IT needs. BT still contributes to around 65% of TM's total revenues.

TM added a net of 8 clients during the quarter, taking its active clientele to 78 at the end of December 2006. On the manpower front, the company added a net of 2,604 employees during the quarter, thus taking its total headcount to 17,774. However, utilisation rate declined from 69% in 2QFY07 to 67% in 3QFY07. As indicated by the company, this decline is due to advance hiring for the US$ 1 bn BT deal that is expected to commence in 1QFY08. The attrition rate stood at 22% during the quarter. This includes the employees leaving during training period, employees leaving the organization within three months, voluntary and involuntary resignation. Though the company endorses this as its major concern, the management has indicated that just giving salary hikes has not helped in controlling attrition. The management has also indicated of a wage hike of 15% to 18% effective next financial year.

Lower costs aid margins: TM's employee costs, as a percentage of revenues, declined from 39.7% of consolidated sales in 2QFY07 to 37.8% in 3QFY07, thus aiding the expansion in operating margins on a sequential basis. However, the margins expansion would have been better but for the appreciation in the Indian rupee against the US dollar and lower utilisation rates. Even the increase in onsite component of revenues seems to have pared the margin expansion to an extent.

What to expect?
At the current price of Rs 1,760, the stock is trading at a multiple of 40.4 times its trailing 12-month earnings. Numbers from the BT deal will start showing up from 1QFY08 onwards. In the initial phase of the deal, however, the business will be in the investment mode and the company will set up four global delivery centers in India, China, Eastern Europe and Latin America. The management has indicated that the deal will add to the bottomline from FY09 onwards. The BT deal has buoyed sentiment towards the stock, as seen from the sharp run up in the past few weeks. However, investors need to recognise the scalability challenges that such large deals get along with them. While TM has displayed its ability to grow strongly in the past, the playing field is getting more competitive by the day. Also, as the competition for talent intensifies among software companies, getting quality brains to execute business in the future might indeed be a tough task for TM.

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