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Tech Mahindra Limited - Views on News from Equitymaster

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Tech Mahindra Limited
Aug 1, 2006

Tech Mahindra is a leading software services provider to theglobal telecom industry. It operates in the telecom service provider as well as telecom equipment manufacturer spaces.

Issue Summary
  • Size: Rs 4,015 m to Rs 4,652 m

  • Offer Price: Rs 315 to Rs 365 per share

  • Shares on offer: 12.7 m*

  • Bid/Issue opens on: August 1, 2006

  • Bid/Issue closes on: August 4, 2006

  • Minimum subscription: 16 shares

* Includes 1,158,790 equity shares reserved for eligible employees

Issue Structure
  Book Building Portion
  QIBs Non-Institutional
Investors
Retail
Investors
No. of shares * 6,952,326 1,158,721 3,476,163
% of total size ** 60% 10% 30%
Minimum Bid/Application size Over Rs 100,000 and
in multiples of 16 shares
Over Rs 100,000 and
in multiples of 16 shares
16 shares and in
multiples of 16 shares
Maximum Bid/Application size Not exceeding the issue size Not exceeding the issue size Rs 100,000
*1,158,790 shares are reserved for the employees of the company.
** Proportion of shares excluding those reserved for employees.

Objects of the issue
  1. To enhance the infrastructure through which the company delivers IT services and solutions to its clients,

  2. To achieve the benefits of stock exchange listing, and

  3. To meet issue-related expenses.

Background

Business
Tech Mahindra (TM) is an IT services company providing software solutions to the global telecommunication industry. The company was incorporated in Mumbai on October 24, 1986 as Mahindra-British Telecom Limited, and subsequently, on February 3, 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.

TM is a mid-sized software company that provides a variety of services, such as 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 (CAGRs) of 22.6% and 12.6% respectively between FY02 and FY06.

Promoters

Mahindra & Mahindra Limited (M&M), India's leading tractor and utility vehicle major, was incorporated in 1945 as a private limited company and converted into a public limited company in 1955. The company employs 30,000 people and has 6 manufacturing facilities spread over 500,000 sq. metres. The company also has diversified interests in financial services, telecommunications, real estate and auto ancillaries.

British Telecommunications plc (BT), a wholly owned subsidiary of BT Group plc, was incorporated in England and Wales in April 1984 as a successor to the statutory corporation British Telecommunications. It was originally wholly owned by the UK Government, which sold its stake between November 1984 and July 1993 in three public offerings. BT's principal activities include networked IT services, local, national and international telecom services and broadband and Internet products and services.

Sector
The global telecom industry can be broadly divided into 2 major segments - telecom service providers (TSPs) and telecom equipment manufacturers (TEMs). In the TSP industry, historically, companies were generally state-owned monopolies, and the sector witnessed a high level of regulation. However, the sector has undergone a transformation, with governments liberalizing the sector to increase competition, particularly in the area of fixed-line services. In addition to this, the global rollout of mobile services has also led to increased transformation of the global TSP industry. As per Datamonitor (industry research firm), while the global fixed-line services market is expected to grow at a compounded rate (CAGR) of 4.6% to reach the size of around US$ 696 bn by 2009 (US$ 556 bn in 2004), the global wireless telecom services market is expected to grow at a CAGR of 11.8% to hit US$ 970 bn by 2009 (US$ 554 bn in 2004).

On the other hand, the global telecom equipment manufacturer (TEM) market has grown at a CAGR of 1.7% from 2002 to 2004 to hit US$ 299 bn, and is expected to grow at a CAGR of 3.1% to hit US$ 348 bn by 2009. Between 2000 and 2002, the global downturn in the equipment market led to TEMs being adversely impacted, since TSPs had already overbuilt capacity in anticipation of growth that did not materialise. As a result, the supply glut led to a significant slow-down in incremental demand for telecom equipment. Post-2002, however, favourable developments in the TSP market led to a revival of demand for 'next-generation' equipment.

Future growth drivers for the industry are:

TSPs

  1. Increasing competition globally, resulting in a greater number of corporations needing to use technology to become more efficient,

  2. Large investments in 'next-generation' networks,

  3. A shift to higher value-add services like data (video, wireless messaging, conferencing services),

  4. Investments by global TSPs in upgrading their networks to data-intensive 3G wireless networks, and

  5. An evolution from pure voice-based offerings by TSPs to 'converged networks' and the 'quadruple play' of voice, video, data and content.

TEMs

  1. Higher investments in research and development (R&D) in order to be able to satisfy incremental demand for 'next-generation' equipment,

  2. Requirements by TEMs for the maintenance of existing product lines as well as for seamlessly moving towards new product lines, and

  3. Investments in the design of increasingly advanced mobile handsets, which serve as the platform for advanced data and content services offered by TSPs.

Thus, all the above factors mean that IT strategy in general, and outsourcing in particular, will be key elements in enabling these firms to migrate to 'next-generation' networks. This will enable TSPs to free up cash flows to grow their businesses. On the other hand, as regards the TEM market, increased expenditure on product development and R&D is the key to their growth, and will enable them to cater to the increasing demand for 3G network equipment. Thus, outsourcing in the form of product development and R&D services will enable them to meet market requirements more effectively, which is a key opportunity for Indian IT services firms providing these services.

Reasons to apply

Domain expertise: TM is a software services company focusing exclusively on providing software solutions to the global telecommunications industry (TSPs and TEMs). The company was initially formed to provide application development and testing services to British telecom major, British Telecommunications. This was the initial period where TM developed expertise in the telecom domain. Since then, the company has evolved significantly, and now provides a range of services, from ADM, testing, product engineering and lifecycle management, consulting and managed services to its clients. This has led to increasing engagements with its customers and has led to a shift in its perception, from just a non-strategic offshore services provider of development services, to a strategic partner involved in major business decisions of its clients. Given the fact that the global telecom industry is subject to rapid technological change, this domain expertise will stand the company in good stead going forward.

Relationships with major TSPs and TEMs: Over the years, TM has developed key strategic relationships with major telecom companies, both in the TSP as well as TEM markets. While TM's largest client is BT (59% of revenues in 1QFY07), the company has also developed relationships with companies like AT&T and Alcatel. The fact that the company has been able to increase its business with these companies is testimony to its client mining abilities. This has been brought about by a strong focus on expanding its service offerings, which is vital if it is to become more relevant to its clients in planning their IT strategy.

An example here is BT. From an offshore supplier of development and testing services, the company now works with BT in planning and executing its business strategy. TM is involved in BT's 21st Century Network ('21CN') project, the largest transformational initiative undertaken by it, which involves the development of a converged network capable of carrying both voice and data. Thus, the fact that BT has involved TM in a project of such vital importance is testimony to its growing importance to the British telecom major.

Reasons not to apply

High client concentration: Given the fact that TM was originally started as a software development and testing services provider to BT, the proportion of revenues that the company derives from BT, by far its largest customer, is very high. In 1QFY07, TM derived as much as 59% of its total revenue from BT. This has, however, reduced significantly, from 83% in 1QFY05. Since then, with each quarter, the dependence on BT as a source of revenue has reduced steadily. Nonetheless, the fact that the company still derives 59% of its revenues from BT is a considerable source of risk, and the fact that in all likelihood, billing rates could also be lower for BT business, is an important factor that potential investors must consider.

Even in terms of the 'Top-10' clients, TM derived as much as 92% of its revenues from these clients in 4QFY06. This has reduced only marginally, from 94% in 1QFY05. Thus, the fact that TM is so highly dependent on just a few clients for the lion's share of its business does make it vulnerable to any cutbacks on spending from these clients.

Volatility risk due to focus: TM is a company that provides software services to global telecom companies. This results in an increased risk profile for the company, given its focus on the telecom sector. Unlike larger peers like Wipro and HCL Technologies, which have a significant presence in the telecom sector but are more diversified in terms of their presence across other industry verticals, TM's focus on the telecom sector could lead to volatility in its performances. This is particularly true of companies with a focus on the telecom sector, given the fact that it is subject to rapid technological changes and a greater amount of volatility. While TM has managed to grow its topline each year since FY02 without any significant volatility, it should be mentioned that in FY04, the company's operating margins fell from 31.5% to just 10.8%, and consequently, the net profit declined by 60.9% YoY. Thus, such factors tend to impact a mid-sized company like TM more than a top-tier software service company, which has greater scale and diversification across a greater number of industry verticals.

Financials
(Rs m) FY02 FY03 FY04 FY05 FY06 1QFY07
Total Sales 5,492 6,214 7,417 9,456 12,427 5,871
Other Income 114 204 133 85 326 32
Total Expenditure 3,529 4,259 6,619 8,106 9,748 4,594
EBIDTA 1,963 1,956 798 1,350 2,679 1,278
EBIDTA margin (%) 35.7% 31.5% 10.8% 14.3% 21.6% 21.8%
Depreciation 443 228 227 321 397 108
Profit Before Tax 1,634 1,931 705 1,115 2,607 1,202
Tax 358 301 83 91 268 144
Net Profit before minority interest and extr. items 1,277 1,630 622 1,024 2,339 1,058
Minority interest - - - - 0 0
Extraordinary items - 1 15 0 15 8
Excess/(short) tax provision of earlier years (14) - 38 - - -
Profit after tax, minority interest and extr. items 1,263 1,631 675 1,024 2,354 1,066
Adjustments on account of restatements 199 (1) (38) - - -
Net profit as restated 1,462 1,630 637 1,024 2,354 1,066
No. of shares (m) 101.1 101.1 101.2 101.5 103.4 115.9
Fully diluted and annualised EPS (Rs)* 12.6 14.1 5.5 8.8 20.3 36.8
* The EPS for all the years is calculated on the expanded equity capital post the issue, and the EPS for 1QFY07 is annualised.

Comparative valuation and comments
On an annualised 1QFY07 EPS basis, and on the diluted equity capital post the issue,, the issue is priced at a P/E multiple of 9.9 times at the higher end of the price band, and 8.6 times at the lower end. These figures appear to be quite reasonable when compared to its major peers operating in a similar business.

We have compared TM with Sasken Communication Technologies, another company focussing exclusively on the telecom vertical, and Subex Azure, a company whose major business is providing niche software products to the global telecom sector. TM's valuations are lower than both these companies, despite being significantly larger in size. We believe that amongst the two companies, Sasken is a better comparison with TM since most of its revenues come from services.

If we take the operating parameters of these companies, TM comfortably outperforms Sasken on all fronts - be it topline, margins and revenues per employee. Subex, on the other hand, edges out TM across most operating parameters, mainly due to its product-led business strategy. In terms of revenues per employee, Subex outperforms TM by a factor of 2, again primarily due to its product-led strategy, which is not linear in nature, unlike a services business. We believe that Subex should get some premium over TM due to its differentiated product-based strategy.

Peer comparison: Reasonable pricing
(FY06) TM Sasken Subex Azure
Net sales (Rs m) 12,427 3,081 1,814
Operating profit margins (%) 21.6% 15.6% 27.7%
Net profit margins (%) 18.9% 7.4% 20.9%
Diluted EPS (Rs)* 20.3 8.9 17.5
Price to earnings ratio (x)* 18.0 30.6 23.9
Price to book value (x)* 6.9 1.8 5.0
Price to sales (x)* 3.4 2.3 5.0
Revenues per employee (Rs m)** 1.8 1.3 3.6
* All these figures are calculated based on the number of equity shares post the issue and at the higher end of the price band (Rs 365).
** Subex Azure's employee base of 500 considered post Subex's acquisition of Azure.

On the balance, we believe that the issue appears reasonably priced. The company should get valuations similar to most mid-sized software companies. Given the company's ever-improving client diversification initiatives, its foray into the TEM space in a more comprehensive manner and possible future acquisitions to drive growth, we believe that investors with a high-risk appetite for mid-sized niche software companies can 'APPLY' to the issue.

We will put up a detailed anlaysis of the IPO shortly.

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