Return of predictability in operations and financial performance is likely to be rewarded through multiple re-rating; ‘Add’ maintained.
We hosted Manoj Bhat, CFO of Tech Mahindra recently. TM reiterated telecom business growth potential of 5-7% in FY20 without 5G contribution and 8-10% growth potential in enterprise backed by stable to improving margins. The 5G opportunity can be large with revenue flow uptick in FY21. We believe that predictability is returning to operations and financial performance, something that was missing in the past three years. This will likely be rewarded through better multiples. Reiterate Add rating.
Predictability returning to operations
The Tech Mahindra stock has traded at material discount to peers in the past three years due to multiple reasons—a couple of poor acquisitions, weak growth in telecom partly due to rationalisation of acquired portfolio, margin volatility and compression and a poor payout ratio. However, a lot has changed in the past three years including focus on profitable growth, tightening of operations, investments in automation and digital competencies, better cash conversion and increase in the payout ratio. Telecom will likely start growing as the impact of portfolio rationalisation fades and will be fully absorbed in the base numbers of FY19e. However, these improvements have not reflected in better multiples with the stock trading at 12.5X FY2020e earnings. Herein lies an opportunity of buying acceleration in overall revenue growth with stable to improving profitability and 5G option value.
Telecom—potential to grow 5-7% in FY20e without 5G upside
Telecom deals have seen an uptick, courtesy of upgrade in systems and a few discretionary programmes to ensure that networks are 5G ready. Large deals signed by TM in September, 2018 quarter of $300 mn were a mix of deals that were in the pipeline for a long time and discretionary 5G readiness type of deals. TM believes that the telecom business can grow by 5-7% in FY20. Growth in the past three years has been lower due to legacy issues, rationalisation of LCC revenues and unprofitable network business and price cuts. These headwinds have abated and will reflect in better growth starting FY20.
Early investments position the company well for 5G opportunity
5G is a large opportunity for which the company is well-positioned due to—(i) investments in network capability through LCC, (ii) investments in platforms and IP and (iii) investments in partnerships to develop an eco-system play, viz. Intel, Rakuten, stake in Altio Star, among others. This positions it well to capitalise on the 5G opportunity across networks and IT services. Rollout of 5G network will be gradual with revenue flow that will pick up in FY21e.
Ebit margin in FY20e will at least match FY19e levels
TM believes that the recent operational improvements are sustainable and expects FY20e Ebit margin to at least match FY19e levels. Further improvement in operational margins in 2HFY19 is possible with the traditional seasonal strength in the telecom vertical. Ebit margin drivers from here are—(i) pyramid management and increase in offshore component in the overall revenue mix that can aid margins by 100 bps, (ii) the company believes it can retain part of the benefits of automation and (iii) further rationalisation of unprofitable revenue mix.