Positives well captured in Tech Mahindra's valuations

A preferred pick for most brokerages due to the positive outlook, upsides from Satyam merger & strategic acquisitions

The Tech Mahindra (TechM) scrip has outperformed both the BSE Sensex and BSE IT indices in the recent past. The stock currently trades at 14.3 times FY15 estimated earnings, 35 per cent above its five-year average one-year forward price/earnings (P/E) multiple of 10.5 times. The company’s strong deal pipeline, healthy balance sheet (cash kitty of nearly Rs 3,000 crore), growth across both telecom and enterprise businesses make it a preferred pick of most brokerages. Of the 13 analysts polled by Bloomberg in December so far, 10 have a ‘Buy’ rating, two have ‘Hold’ and one has a ‘Sell’ rating on the scrip. Their average target price stands at Rs 1,796 a share, indicating a downside of about two per cent from current levels. Hence, investors should wait for a correction before investing in this scrip.  

The TechM stock has re-rated significantly over the past year on account of the merger with Satyam. The stock has been factoring gains such as margin improvement and revenue growth due to the merger. The company’s Ebitda margin has expanded from 16.7 per cent in FY12 to 23.3 per cent in the September quarter. The company’s revenues are expected to grow by 28-30 per cent in this financial year, while net profit growth is pegged at 35-37 per cent. The stock now trades at a premium to its closest peer HCL Technologies (12 times FY15 estimated earnings) which is larger in terms of revenues as well as margins. Analysts believe upsides appear to be capped due to the high valuations.

“We believe a major part of P/E re-rating has been done at Tech Mahindra. Further incremental returns could be generated by the company if it delivers earnings per share upgrades aided by higher revenue growth (as compared to Street estimates) or Ebitda margin beats or inorganic growth initiatives,” says Madhu Babu, IT analyst at HDFC Securities.

Telecom, manufacturing key growth drivers
Revenues from its key client, BT, are expected to fall further, as about 33 per cent of its business is up for re-bidding this December. The management believes this business will continue to witness weakness in the next few quarters. Notably, despite a slowdown in BT, TechM’s telecom business (47 per cent of revenues, enterprise segment accounts for the rest) has grown well. It has put up sequential growth of four-five per cent in its non-BT telecom business over the past two quarters. Within the enterprise segment, TechM’s focus on ramping up its manufacturing (19 per cent of revenues) and Banking, Financial services and Insurance (BFSI) verticals seems to be paying off well. The two verticals were part of the erstwhile Satyam. The enterprise segment  has grown six-eight per cent sequentially over the past few quarters.

The company’s recent merger of Mahindra Engineering Services will strengthen TechM’s position in the auto and aerospace verticals. This merger will give TechM access to large clients such as Honda, GM, Audi, Daimler, Caterpillar and Aston Martin, among others, and provide opportunity to cross sell its IT and infrastructure services. “Though the merger looks a bit expensive, we believe this is justified, given improved growth prospects with the TechM brand, higher margins and strong cash flows," says Vishal Agarwal, analyst at Jefferies India.

Outlook
The Tech Mahindra management aims to achieve $5 billion in annual revenues by FY15, against $3 billion currently. The company’s strong presence in Europe and strong deal pipeline are its key positives. It has successfully done four acquisitions this year (excluding Satyam) which are expected to drive revenue momentum for the company. The key risks remain further pressure on BT revenues, rupee volatility and an unexpected slowdown in demand.