FY20/21e Ebitda margins go up to 19.1/18.9%; TP revised to Rs 830 owing to global macro uncertainty; valuations very reasonable.
Tech Mahindra (TechM) reported a better than expected Q2FY19 on margin execution and deal intake. Even revenue growth adjusted for the HCI ramp-down was better than expected at 4.2% q-o-q in CC terms with enterprise revenues (ex HCI) increasing by 3.5% q-o-q and Communications revenues by 5% q-o-q. Strong deal intake of $550 mn should ensure revenue growth to remain healthy in the medium term alongwith the benefit from strong Comviva seasonality in H2FY19.
Ebitda margin expansion of 240bps q-o-q was materially ahead of our estimate of 120bps q-o-q. Ebitda margins should increase in H2FY19 as well given further INR depreciation and Comviva seasonality. We reiterate our Buy rating on TechM given Communications recovery being in initial stages, margin stability and inexpensive valuation. We lower target multiple to 14x given elevated uncertainty in the global macro but our target price of Rs 830 still presents an upside of 25% from the CMP (including dividend yield of 3%).
Higher than expected drag from HCI ramp-down
HCI revenues declined by $42 mn q-o-q given completion of certain large implementations (across 6-7 hospitals) over one to two months. Excluding HCI, enterprise revenues increased by 3.5% q-o-q in CC terms. HCI revenues have bottomed out and should witness gradual growth in the next two quarters. Target for annual growth for HCI is still 10% for FY19 though that looks aspirational at this point. Overall enterprise revenues are still expected to grow in the range of 8-10% in CC terms in FY19.
Encouraging early signs of communications recovery
Given a weak start in Q1FY19 when USD revenues had declined by 6.4% q-o-q in the communications segment, FY19 would anyways be a lost year in terms of annual growth. What matters is that sequential momentum in the business is improving and that is likely to sustain in H2FY19 even outside of stronger Comviva seasonality. Not only has the deal intake been strong in the segment in Q2FY19, pipeline is still equally strong. Encouragingly, both revenue execution and deal intake in Q2FY19 in the Communications segment as well as the deal pipeline has been broad-based across geographies.
We would expect revenue growth in the communications segment to be in the range of 5-7% in FY20 with material inflection in 5G spends, if any, to drive an upside. Some of the large deals in the communications segment have been signed with the large client ecosystem (top-5) which are in the early stages of spending on networks to make them 5G ready, creating a line of sight for continued spends from them in the medium-term.
There is no doubt that TechM has disappointed on overall revenue execution in H1FY19 relative to expectations with steeper than expected drags from Comviva seasonality in Q1FY19 and HCI in Q2FY19 being the key drags. Weaker than expected H1FY19 topline obviously impacts FY19 headline growth as well, with USD revenues in FY19 now likely to grow only around 4.5%. However, focus should be on an improving sequential trajectory in the communications segment which should enable a better exit in FY19 and help growth be in the range of 5-7% in the segment in FY20. Likewise, improvement in deal intake and pipeline across the communication and enterprise segments should be seen as a lead indicator of continuity of growth in each segment.
We expect revenue growth to accelerate to 7% in FY20, which would be closer to peer averages. Our core thesis on TechM though was always centered around significant headroom for profitability improvement where execution has been ahead of even our expectations. We see multiple levers for margin sustenance and further improvement though conservatively model 19.1% for FY20 for now.
Valuation is very reasonable at 12.2x FY20e EPS for an FY18-20 EPS CAGR of 14.6%. Maintain Buy.