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Tech Mahindra: BPO leads the way - Views on News from Equitymaster

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Tech Mahindra: BPO leads the way

Oct 22, 2007

Performance summary
  • Topline grows by 2% QoQ during 2QFY08, driven by improvement in both volumes and realisations.

  • Operating margins stable at 22%. However, on a half-yearly basis, these have declined by almost 1.8%.

  • Bottomline expands by 7% QoQ during 2QFY08, largely due to higher other income (up 90% QoQ).

  • Adds 9 client in 2QFY08 including 3 clients in excess of US$ 5 m in revenues.

  • Headcount crosses 23,000 mark.

(Rs m) 1QFY08 2QFY08 Change 1HFY07 1HFY08 Change
Sales 8,763 8,976 2.4% 12,847 17,739 38.1%
Expenditure 6,830 7,004 2.5% 9,786 13,834 41.4%
Operating profit (EBDIT) 1,933 1,972 2.0% 3,061 3,905 27.6%
Operating profit margin (%) 22.1% 22.0%   23.8% 22.0%  
Other income 131 249 89.5% (46) 380  
Interest 15 26 78.1% - 41  
Depreciation 168 193 14.9% 221 361 63.3%
Profit before tax 1,882 2,002 6.4% 2,794 3,884 39.0%
Tax 183 187 2.2% 312 369 18.5%
Minority interest (3) (2)   - (5)  
Extraordinary Items - -   339 -  
Profit after tax/(loss) 1,703 1,817 6.7% 2,822 3,519 24.7%
Net profit margin (%) 19.4% 20.2%   22.0% 19.8%  
No. of shares (m)       131 131  
Diluted earnings per share (Rs)*#         52.1  
P/E ratio (x)*#         24.7  
* On a trailing 12-months basis
# Adjusted for extraordinary items during 4QFY07

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 20 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 2QFY08?
TSP, BPO lead topline growth: Tech Mahindra recorded a 2% QoQ growth in topline during 2QFY08. This was driven by improvement in both volumes and billing rates. The major highlight of the quarter was 73% QoQ growth in the BPO segment. Although the business was initiated in 3QFY07, it already contributes to more than 3% of the company’s standalone revenues. The company’s flagship Telecom Service Provider (TSP) segment recorded a 2% QoQ growth in line with the consolidated topline and contributed to 92% of the total revenues.

Where the company is really lagging is the Telecom Equipment Manufacturer (TEM) segment. The progress of this segment over the last 4 quarter has been a roller coaster ride and its share in company’s revenues has come down to under 3%. In 2QFY08, the TEM segment recorded a 28% QoQ decline in revenues. The entire last year was challenging for the equipment manufacturing side due to mergers and consolidations in this segment and this could be viewed in the company’s numbers. While the challenges are not completely over, the TEM segment could start moving in next two to three quarters. On the BT deal front, the management has indicated of increased visibility from the same. Currently, while 700 people have already been deployed for the BT deal, the number could go up to 1,200 by the end of FY08.

Segment-wise details (Standalone)
Revenues (Rs m) 1QFY08 % share 2QFY08 % share Change
Telecom Service Provider (TSP) 7,730 91.7% 7,901 91.9% 2.2%
Telecom Equipment Manufacturer (TEM) 305 3.6% 220 2.6% -27.9%
BPO Services 153 1.8% 265 3.1% 73.2%
Others 243 2.9% 207 2.4% -14.8%
Total 8,431   8,593   1.9%
PBIT (Rs m) 1QFY08 PBIT margins 2QFY08 PBIT margins Change
Telecom Service Provider 2,874 37.2% 2,910 36.8% 1.3%
Telecom Equipment Manufacturer 82 26.9% 34 15.5% -58.5%
BPO Services 60 39.2% 84 31.7% 40.0%
Others 82 33.7% 59 28.5% -28.0%
Total 3,098 36.7% 3,087 35.9% -0.4%

On the geographic distribution of revenues, Europe is the most dominant region for Tech Mahindra and contributed to 75% of total revenues during 2QFY08. The revenues from this segment grew at 4% QoQ while US which, contributes to 19% of revenues grew at 2% on QoQ basis. The company over the last six quarters has managed to increase its share of onsite revenues from 34% in 1QFY07 to 45% in 2QFY08. While this is a positive development on the topline front as higher onsite revenues increases the total topline, the margins could suffer going forward, as higher onsite contribution is generally negative for profitability.

Operating margins remains stable: Tech Mahindra’s operating margins remained stable at 22% in 2QFY08. While the company has managed to maintain its operating margins in this quarter, on a half-yearly comparison, the same have declined by 1.8%. This is a cause of concern for the company which has been client centric and vertical centric for some time now. The company is also not able to increase its utilisation levels and in the current quarter it actually dropped by 4% and has come down to 63%. Now this is a worrying factor as the larger players have been able to increase their utilisation levels considerably in 2QFY08 to boost there operating margins in wake of currency appreciation. While there has not been any major change in direct costs and SG&A on QoQ basis, on a half-yearly basis, direct costs have gone up considerably which has led to decline in operating margins.

Other income boosts bottomline: Tech Mahindra’s bottomline increased by 7% QoQ during 2QFY08 mainly due to 90% QoQ increase in other income. A decline of 0.4% QoQ in effective taxes also expanded the bottomline.

What to expect?
At the current price of 1,285, the stock is trading at a multiple of 13.6 times our estimated FY10 earnings. In the medium term, the major challenges for the company will be to maintain profitability and increase utilisation levels. In the long run, while there are certain positives in being the largest player in the high-entry barrier telecom domain we believe that going forward Tech Mahindra will have to derisk its business model in terms of client concentration and business vertical concentration. We maintain our view on the stock from a long-term perspective.

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