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Tech Mahindra: Testing times - Views on News from Equitymaster

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Tech Mahindra: Testing times
Jul 23, 2007

Performance summary
  • Topline remains flat on QoQ basis, largely due to appreciation of rupee against the US dollar.

  • Operating margins contract by 3.3% QoQ due to increase in onsite share of revenues and appreciating rupee.

  • PAT margin contracts by 3% QoQ (excluding extraordinary items).

  • Adds 4 clients in 1QFY08; number of clients giving revenues of over US$ 25 m crosses 3.

  • Headcount crosses 21,000 mark; attrition at around 19%.

Consolidated financial performance: A snapshot…
(Rs m) 4QFY07 1QFY08 Change
Sales 8,745 8,763 0.2%
Expenditure 6,527 6,830 4.6%
Operating profit (EBDIT) 2,218 1,933 -12.8%
Operating profit margin (%) 25.4% 22.1%  
Other income 154 131 -14.7%
Depreciation 158 168 6.1%
Interest 49 15 -69.4%
Profit before tax 2,165 1,882 -13.1%
Tax 204 183 -10.5%
Extraordinary items (5,249) -  
Minority interest (1) 3  
Profit after tax/(loss) (3,289) 1,703 151.8%
Net profit margin (%) -37.6% 19.4%  
No. of shares (m) 121.3 131.8  
Diluted earnings per share (Rs)*   51.3  
P/E ratio (x)*   27.7  
*trailing twelve months

What is the company’s business?
Tech Mahindra is a mid-size Indian IT services company providing software solutions to the global telecommunication industry. 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. (BT), a leading global telecom services company. Tech Mahindra provides services like application development and maintenance, 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). BT is Tech Mahindra’s largest client and has a long-standing relationship of nearly 18 years with the company. The company 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 net profits at compounded rates of 40% and 37% respectively between FY02 and FY07.

What has driven performance in 1QFY08?
BPO steals the show: Tech Mahindra recorded a topline growth of 7% QoQ in dollar terms which was driven by all-round increase in volume growth and billing rates. However, appreciation of the rupee against the US dollar led top the topline remaining at almost the last quarter’s levels. In terms of business segment, BPO was clearly the winner recording a growth of 52% QoQ. The BPO business of Tech Mahindra began operations in 3QFY07 and the company is ramping this up in a much bigger way although it contributes only 2% of the company’s revenues. The TEM segment also recorded a growth of 21% QoQ and its share in the company’s total revenues now stands close to 4%. The company’s flagship vertical, TSP showed a 2% QoQ decline in sales. In terms of geographies, the UK continues to be the most dominant region with 74% share of Tech Mahindra’s totals sales in 1QFY08. The share of the US in consolidated revenues also increased marginally making the receivable more susceptible to currency appreciation.

On the client side, the number of client who now contributed to revenues of more than US$ 25 m crossed 3 in 1QFY08. The company added 1 client each giving revenues of more than US$ 15 m and US$ 5 m and the number of active clients now stands at 87 (up from 83 in 4QFY07). On the employee front, the company added a net of 1,397 employees and the total headcount now stands at 21,146.

Wage hike and rupee appreciation dents margins: Tech Mahindra’s operating margins dropped by 3.3% QoQ in 1QFY08, largely due to wage hikes of 15% affected during the quarter as also due to appreciation of the rupee. In terms of margins by segment, the PBIT margins of BPO and TEM segment has improved but the margins TSP segment has recorded a drop of 5.7%. Margins were also impacted owing to a change in service delivery, as share of onsite revenue increased from 39% in 4QFY07 to 43% in 1QFY08.

Segment-wise details (Standalone)
Revenues (Rs m) 4QFY07 % share 1QFY08 % share Change
Telecom Service Provider (TSP) 7,875 93.5% 7,730 91.7% -1.8%
Telecom Equipment Manufacturer (TEM) 252 3.0% 305 3.6% 21.0%
BPO Services 101 1.2% 153 1.8% 51.5%
Others 194 2.3% 243 2.9% 25.3%
Total 8,422   8,431   0.1%
PBIT (Rs m) 4QFY07 PBIT margins 1QFY08 PBIT margins Change
Telecom Service Provider 3,375 42.9% 2,874 37.2% -14.8%
Telecom Equipment Manufacturer 25 9.9% 82 26.9% 228.0%
BPO Services 1 1.0% 60 39.2% -
Others 24 12.4% 82 33.7% 241.7%
Total 3,425 40.7% 3,098 36.7% -9.5%

Change in hedge accounting impacts bottomline:Tech Mahindra’s net profits declined by 13% on QoQ basis mainly because the company transferred US$ 11 m of other income to reserves which will be booked in the next quarter in accordance with the new standards of forex accounting. The effective tax rate on PBT level has however remained stable at 9.7%.

What to expect?
At the current price of Rs 1,420, the stock is trading at a multiple of 27.7 times its trailing twelve months earnings. While we see the winning of large size deals (like the US$ 1 bn deal from BT last fiscal) as positives for a mid size player like Tech Mahindra, we believe that any issues on the scalability front might impact business prospects going forward. Also, considering that the company has high attrition rates in times when its larger peers are catching up fast in the telecom vertical, needs to be given due weight. We shall soon initiate our research coverage on the company.

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