Jefferies rates Tech Mahindra ‘Buy’, says growth likely to accelerate

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Published: December 12, 2016 6:44:02 AM

With most FY16 issues behind it and valuations below peers, Tech M provides good protection against any macro slowdown/issue

Three quarters of steady ex-LCC revenue growth with recovery in telecom and continuing momentum in enterprise vertical should sustain revenue revival in 2H17 and beyond. LCC too has bottomed out. While margin recovery has been slower than expected, one-offs have impacted with revival imminent here too. With company specific issues now behind us and valuations well below peers, Tech M provides downside protection from macro as well as good visibility for upside.

Revenue growth trajectory continues to improve

Tech M has now delivered three quarters of steady organic revenue growth ex-LCC. Much of Tech M’s growth issues in FY16 were limited to the top telecom accounts which have stabilised and are likely to grow from here on while non telecom (enterprise) segment has shown acceleration. LCC too has bottomed out now (annualised revenue run rate of $300 million). We believe that most issues for the company in FY16 are now past, growth should accelerate from here on with visibility aided by strong deal win momentum.

Margin recovery is imminent too

While the company’s margin decline has stabilised, recovery has been slower than expected over the past two quarters. This has also been hampered by one-offs in the last quarter (-130 bps impact) and cross currency impact

(-40bps). Going forward, margin increase would be driven by pyramid improvement (2,700 trainees added in 2Q17), increasing utilisation due to automation, some low margin contracts coming to an end and strong 2H seasonality in the Comviva business.

Well-positioned in both telecom and enterprise for the long run

We believe Tech M is well positioned to benefit from any cyclical recovery in telecom due to solid engagements with global operators (best in class telecom offering) even as sector issues of consolidation and technology transitions are mostly complete. Enterprise segment too has shown a pick-up driven by two major verticals, manufacturing and financial services, where deal wins have been robust in recent quarters.

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Valuation/Risks

We continue to value Tech M at 14x multiple applied to FY18E EPS (10% premium to 5-year average). Trading at the low end of peer group and with most company specific issues now behind it, Tech M provides good protection against any potential macro slowdown/issue with revenue and margin revival likely to drive upside. Maintain Buy. Risks: Weakening macro, higher competition, unfavourable cross currency moves, stronger INR.

Target Investment Thesis

Growth pangs in FY16 were limited to the Telecom vertical and Top-5 accounts and are now behind it. Non-telecom verticals have sustained at industry leading growth. Deals wins have improved steadily. Margins to revive at a gradual pace even as expectations remain low. Mar 17e/18e EPS: Rs33.7/41.7; Target Multiple: 14x; Target Price Rs580.

Upside scenario: Macro environment improves with discretionary spending coming back. Tech Mahindra also shows strong traction in the telecom and non-telecom business. Revenue growth at >12% CAGR (USD terms) over FY16-19E. Margin to revive to 16% at Ebit level. Mar 17e/18e EPS: R38/47; Target Multiple: 15x; Target Price R700.

Downside scenario: Macro environment deteriorates and snowballs into a crisis-like situation. Revenue growth estimate of <8% CAGR (USD terms) over FY16-19E. Margin stabilises at 12-13% at Ebit level. Mar 17e/18e EPS: Rs31/38; Target Multiple: 10x; Target Price Rs 380.

Other considerations: The Indian IT industry is export-oriented; as a result, the fortunes of the sector are heavily dependent on global macroeconomic conditions. We have assumed that the current stability will continue for some more time; however, we have not assumed a crisis-like situation (as seen in 2008). In addition, the reported numbers are impacted by the exchange rates (especially USD/GBP/EUR).

Catalysts: Telecom vertical to revive from here on. However, non-telecom business to continue growing at industry leading level. Near term margins might see slower than expected revival due to competition and integration of acquisitions. Acquisitions led strategy to continue. Margin revival and resilience over the longer term to be driven by growth and internal levers.

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