Tech giant soars 30 per cent despite an earnings slump

The Indian Silicon Valley has been grappling with cross-Atlantic headwinds for nearly a year now. High-interest rates and rising inflation have forced major sectors in the US to cut their spending, and most Indian IT players are feeling the heat. But Tech Mahindra , India's sixth-largest IT company by market cap, might just have taken the hardest hit.

In the nine months ending December 2023, its operating profit declined by a whopping 55 per cent YoY. In fact, its profit after tax (PAT) has declined for four consecutive quarters, and its operating profit margin has shrunk to its lowest level in 10 years.

Surprisingly, however, the market remains euphoric about the stock. Its share price has grown nearly 30 per cent in the past 12 months (as of February 2, 2024).

The glaring disparity between share price and financial performance poses several questions. Does the hive mind of the market know something individual investors don't? Also, why is Tech Mahindra the worst hit by these industry-wide headwinds?

We may not have a concrete answer for the first. But the latter can be explored.

Telecom turmoil

The US and European telecom and media industry has historically been a key revenue source for Tech Mahindra. For the uninitiated, Tech Mahindra provides networking solutions to US telecom companies. These include network design, network infrastructure building, cloud services, data centre management, etc. In the nine months ending December 2023, the industry accounted for 37 per cent of the company's revenue.

It may not come as a surprise to many, but the US telecom sector, akin to its Indian counterpart, is notorious for its high capital requirements and debt levels. The media companies share similar traits. OTTs are largely unprofitable, leading to high levels of debt.

Now, consider the fact that borrowing became considerably more expensive in 2023 due to Fed rate hikes, and the picture becomes clear. The telecom sector faced severe cash crunches and had to cut down on spending, and the victim was Tech Mahindra. Revenue from telecom and media went down 14 per cent YoY in the first nine months of FY24.

Paying the price for inorganic growth

Tech Mahindra has often taken the inorganic route to growth through acquisitions. In the last decade, it spent around Rs 8,500 crore on acquisitions.

And to a large extent, these acquisitions have played out well. It has allowed the company to expand its core telecom and media segment and also diversify its service offerings. For example, back in 2014, telecom and media services accounted for 80 per cent of its revenue. Fast forward to today, a reasonable chunk of its revenue comes from catering to manufacturing, and banking and financial services (BFSI) companies. In the first nine months of FY24, business from manufacturing and BSFI players accounted for around 18 and 16 per cent of its revenue, respectively.

However, investors are wary of inorganic growth for a reason. Acquisitions come with their own set of challenges. These include higher cash outflows, the trouble of integrating the additional businesses and, most importantly, higher goodwill.

Goodwill is essentially the premium you pay over the fair value of a company's assets. It can be viewed as the price you pay for the company's brand reputation, customer relationships, etc. It's like paying more for a Gucci bag than it's really worth just because it's Gucci. And there lies the problem.

Reputation can decline, and customer relationships can deteriorate. As a result, goodwill can go down, which leads to goodwill impairment costs, and that is exactly what happened to Tech Mahindra.

It has incurred goodwill impairment costs of around Rs 1,700 crore since FY20. Consequently, its consolidated operating profit margins have shrank. Its present ten-year median operating profit margin is 16.3 per cent, ten percentage points lower than that of the industry leader, Tata Consultancy Services .

The path ahead

The near-term outlook for Tech Mahindra remains bleak. Most of its clients have scaled back their growth projections and plan to keep a tight lid on IT expenditure. In addition, the company witnessed a decline in clientele in Q3 FY24 as active clients went down from 1,290 to 1,228. Deal wins have also slowed down YoY, declining from $795 million to $381 million. In addition, the telecom segment is expected to remain muted until FY25.

Also, apart from the factors mentioned above, the banking crisis in the US is expected to maintain its pressure on Tech Mahindra's topline.

The silver lining is that Tech Mahindra has recovered from similar muted phases in the past. Also, the manufacturing segment was a bright spot in the rather grey first nine months of FY24, witnessing high single-digit growth.

Will the company make a smart recovery over the long term? That only time can tell. However, our article aims to serve as a reminder that simply chasing price growth can be hazardous. Tech Mahindra's share price growth is at odds with what its books are saying.

Disclaimer: This is not a stock recommendation. Do the due diligence before investing.

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