Analysis: Tech Mahindra: Positives priced in

Tech Mahindra beat Street estimates for the December 2012 quarter on topline as well as operating margin fronts, on the bank of strong inorganic growth and higher operational efficiencies. Going forward, the company's prospects remain healthy as it gains from improving deal wins, current pipeline as well as the expected merger with Mahindra Satyam.

The stock, however, has outperformed both BSE Sensex and BSE IT indices over the past year as the Street started discounting the improving profitability and potential synergies post the merger. On Thursday as well, the stock closed up 1% at Rs 990 as against a flattish Sensex on strong results. At current levels, it trades at FY14 estimated price/earnings ratio of 9.6 times and appears to price in key positives.

Thus, while most analysts are positive on Tech Mahindra's future prospects, upsides from current levels seem to be capped given the 12-month consensus price target of Rs 1,096.

“We continue to remain positive on Tech Mahindra with a target price of Rs 1,200. We believe clarity on merger process and beats to consensus expectations will be the key triggers for valuation re-rating”, says Rumit Dugar, IT analyst at Religare Capital Markets.

Tech Mahindra's consolidated net profit fell by 7% sequentially and came in lower thanks to the one-time payment of Rs 294 crore by Mahindra Satyam to settle legal claims of Abardeen, who was a key investor in the erstwhile Satyam Computer (now Mahindra Satyam). Notably, such legal claims are nearing an end, which means little negative surprises going ahead.

This one-time expense eclipsed the strong performance on the topline and operating margin fronts. The topline growth of nearly 10% was driven by Hutchison and Comviva acquisitions, surpassing Street expectations. But given that Hutchison and Comviva earn relatively lower margins, the expansion in EBITDA margins by 30 basis points sequentially to 21% is commendable. The gains came from higher employee utilisation rate (up 200 basis points) and lower headcount.

On the other hand, even as BT revenues (29% revenue contribution) continued to fall (down 3.3% sequentially), non-BT clients registered organic growth of 2%. Interestingly, though the company management expects BT revenues to shrink further, they remain fairly confident on ramp up in non-BT business. Strong deal pipeline (signed five deals having combined worth of $100 million) and reducing BT dependence are key positives of the performance in the quarter. Rising attrition rate (up 200 basis points sequentially to 18%), peaking out utilisation rate though were the key negatives.

However, the gains in margins from hereon is unlikely to be significant, believe analysts. “We believe that easy part of margin gains is behind us. As per management, bulk of the synergy benefits is already realised. Utilisation levels and general and administration cost rationalisation have limited room now. We expect margins (ex-currency) to be in a narrow band over FY13-15”, says Surendra Goyal, IT analyst at Citigroup.

Going ahead, the management believes that the telecom sector (accounts for 96% of standalone revenues; including Mahindra Satyam it is 50%) is likely to remain under pressure in the medium term and does not expect any pick up in discretionary spends. Nevertheless, in the near-term, it hopes to witness higher traction in transformational business in view of telecom companies' need to cut costs. This along with a healthy deal pipeline though makes the management confident of sustaining growth rates over the next 6-8 quarters.