Tech Mahindra: Margin pressures ahead

With subdued organic revenue growth, prospects appear muted

The Tech Mahindra stock made a new 52-week low on Monday, as the company said it might witness sequential revenue and Ebitda (earnings before interest, depreciation and amortisation) margin decline in the June quarter. The company cited weakness in mobility and organic businesses as key headwinds to revenue growth. Soft demand in telecom vertical (55 per cent of overall revenues) is a key reason for Tech Mahindra's muted prospects. Notably, Tech Mahindra has not bagged a large deal in this vertical in Q4'FY15, even though it has outpaced peers in this segment. Analysts believe sluggishness in this sector will catch up with Tech Mahindra which means, going ahead, this vertical's revenue growth will be similar to that of peers. The enterprise vertical (35 per cent of revenues), which is likely to grow in line with the sector, would act as a stabilising factor.

While integration of low-margin acquisitions -- Sofgen and LCC -- could pull down Tech Mahindra's Ebitda (earnings before interest, tax, depreciation and amortisation) margin in the medium term (about 1-1.5 years), higher visa costs (about $9-12 million in Q1) will put further pressure on margins in the June quarter. The company will focus on maintaining margins via levers such as utilisation rate and overall operational efficiencies. Notably, Tech Mahindra's employee utilisation (excluding trainees) stood at 74 per cent in the March 2015 quarter versus 79 per cent to 85 per cent of large peers.

After this announcement, brokerages have trimmed their FY16 and FY17 earnings estimates by 5-10 per cent each and are building about 10 per cent growth in dollar revenues in FY16, a 250-300 basis points Ebitda margin fall and flattish earnings. Even as management remains confident of recovery starting Q3FY16, analysts expect it to improve only in FY17. Dollar revenue growth is pegged at 13-14 per cent, Ebitda margin expansion of 100-150 basis points and 20 per cent earnings growth in FY17, albeit on a lower base.

The actual impact of a default by Greece will be dependent on a company's exposure to the euro currency. Harit Shah of HDFC Securities, says, "Higher exposure to British pound (15 per cent of FY15 revenues versus 11 per cent contribution by euro) could limit translation losses."

The Tech Mahindra scrip trades at 14 times FY16 estimated earnings, closer to its historical average one year forward price/earnings of 15 times. However, analysts remain divided. While some believe the scrip captures the negatives adequately and have a buy rating, others say it will remain under pressure in the near term and do not rule out further downsides.