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Only For The Patient Investor

To profit from Tech Mahindra's innate strengths, buy on declines and hold on for the long-term

The top IT companies have shown exceptional resilience over the past two years despite multiple negative factors like flat volume growth, sharp correction in pricing, and rupee appreciation. Analysts generally take Cognizant's performance as the precursor for Indian IT companies. Cognizant's results indicate that the demand environment for IT services is improving, and more significantly, the guidance for CY2010 is “at least” 20 per cent revenue growth. This is very much in line with Infosys' conservative revenue guidance of 16-17 per cent. According to an analyst at BNP Paribas Securities, there is adequate evidence of recovery in corporate spending on IT.

Indian IT showed a lot of resilience during the last crisis. But if the recent crisis in Greece takes the form of a contagion, then Indian IT could once again come under pressure. According to a note by India Infoline, margins of Indian IT companies are likely to come down due to increased hiring and wage hikes across the board. Moreover, adverse currency movements like rupee appreciation and strengthening of the US dollar against the British pound and the euro will also contribute to shrinking margins.

The company
Tech Mahindra is India's leading tier II IT company. It provides IT services and solutions to telecom service providers (TSP) and telecom equipment manufacturers (TEM). The TSP segment contributes close to 85 per cent of the company's total revenue. The company was initially formed as a joint venture between Mahindra & Mahindra and the BT Group under the name Mahindra-British Telecom. It was only in 2006 that it assumed its current name.

Strengths and weaknesses
Relationship with BT. This relationship started in 1988. Over the years Tech Mahindra has evolved from being just an offshore supplier of telecom applications into a key strategic partner. Though over the years Tech Mahindra has added new clients, BT still contributes around 46 per cent of its revenue. According to Srishti Anand, IT analyst at ICICIdirect.com, a brokerage firm, “The large long-term end-to-end transformational deals that Tech Mahindra bagged from BT and its role as a strategic transformational partner to it was once considered its competitive strength. But with the global telecom industry underperforming, this boon has now turned into a bane.” Though being concentrated on one client gives it stable revenue visibility, it also raises Tech Mahindra's company-specific risk.

High client penetration. Tech Mahindra has cultivated long-term relationships with top clients like AT&T, Telefonica O2, Alcatel and Motorola. It has got Master Service Agreements with all these clients, enabling it to have long-term revenue visibility. But according to a recent note from ICICIdirect.com, capex growth for most of the top five clients is likely to be muted over the coming years. Hence, while Tech Mahindra will offer stability, you are unlikely to get positive surprises.

AT&T post liquidation. AT&T, Tech Mahindra's number two client, contributes around 15 per cent to its revenue. The strategic partnership between the two included awarding of options with the completion of certain revenue milestones. In March 2010, AT&T exercised its options and converted them into equity shares. But it has since then sold its stake in the open market, which raises questions about the depth of the business relationship between the two.

Promise of developing economies. While the Western telecom markets have become stagnant, emerging markets like India and the Middle East are poised for growth. Says Srishti: “Tech Mahindra has in-built capabilities to service TSPs which can be leveraged in these markets. Both Tech Mahindra and Wipro are likely gear themselves up to compete against giants like IBM in this space.” Tech Mahindra has already won contracts from new entrants like Etisalat, S Tel, and Videocon.

Geographic risk. Around 56 per cent of its business comes from Europe's troubled economies. Due to the crisis brewing there, there has been a significant slowdown in the decision cycle. Says Srishti: “The management has a vision to increase its wallet share from non-BT accounts over time, hence now it has started focusing on growth geographies like India, Middle East and Asia Pacific.” But in the near to medium term Tech Mahindra will face strong margin pressures due to the weakening of the pound and the euro.

Integrating Satyam. Tech Mahindra intends to fully integrate Satyam with itself and become a full service provider. This should help it scale up faster giving it access to new geographies, new clients and a diversified service mix, positioning it in the top tier of Indian IT companies. But Srishti points out that Satyam's turnaround will take considerable time to yield dividends for Tech Mahindra.

Valuation
The BT business has now reached a steady state revenue run rate of £70-72 million after the entire restructuring exercise at BT (de-growing by 18 per cent YoY). The non-BT accounts (54 per cent contribution) that proved to be the company's saviour in FY10 (growing by 23 per cent YoY) are expected to continue to be the growth drivers. Srishti expects Tech Mahindra will clock in revenues at 12 per cent CAGR over FY10-FY12 on account of strong 5.5 per cent CQGR (cumulative quarterly growth rate) in non-BT accounts over the next eight quarters and flat performance in BT. Also net profitability is expected to grow at 9.5 per cent CAGR over the same period on account of operational improvements. In the near term (i.e. FY11), though, he expects margins to come under pressure on account of volatile currency, highly competitive wage inflation environment, and limited cutback possibility on selling, general and administrative expenses. But by FY12 margins are expected to rebound once the share of non-BT accounts becomes dominant and utilisation heads northward. Currently the stock is trading at 9.5 times FY12E EPS, while analysts value the stock at 13-14 times FY12E.

Should you buy?
A recent note from Prabhudas Lilladher says that the stock price factors in the negatives and there is a lack of positive triggers. They further add that the company is operating in a more challenging environment that its peers.

According to Srishti, “The stock has corrected too much but is in sync with market discounting. At current price the stock looks good fundamentally to buy. But if the market as a whole is expected to have further downside one can wait for further decline.”

The PEG ratio (taking five-year historic EPS) of the stock stands at 0.27 compared to industry average of 0.63. You could buy the stock on decline, but should hold it for at least five years to be able to weather the near- and medium-term problems in the European markets.

Financials  CY2006  CY2009  3Y CAGR  FY10
Sales (Rs cr) 1,197 4,358 53.83 4,484
Net profit (Rs cr) 220 987 64.88 743
Operating margin (%) 10.93 17.33  5.33
Borrowings (Rs cr)^ 0 0  
Return on Net worth (%)^ 40.17 61  
^Data for financial year