Street positive on Tech Mahindra's 310 million Euro acquisition

The deal will boost its digital and engineering R&D capabilities in BFSI space

To bolster its digital engineering capabilities, expand in East Europe and enhance its presence in the insurance segment, Tier-1 IT major Tech Mahindra (TechM) announced a 310 million Euro ($353 million/Rs 2,632 crore) acquisition. The Europe-based Com Tec Co IT (CTC) with development centres in Latvia and Belarus offers digital engineering and outsourced product development services for global clients in the insurance vertical.

Analysts at Sharekhan believe that the acquisition will scale-up Tech Mahindra’s insurance business by acquiring deep-domain expertise, provide access to advanced capability, and bring synergy through cross-sell opportunities. Strong growth and high margins commanded by CTC is expected to help the company be margin accretive on a consolidated basis, they add.

The company will also invest 20 million Euros for minority stakes of 25 per cent each in two InsurTech platforms (SWIFT Technologies and Surance). TechM has an option of acquiring another 20 per cent stake in the next two years.  

While the CTC deal is positive, the stock shed over 3.5 per cent in trade on Tuesday. A reason for the same could be premium valuation though the street has mixed views on this. For the CTC transaction, TechM paid four times the CTC’s CY2021 sales. While 210 million Euros will be paid upfront, the rest of the payment will earn outs and synergy-linked payouts.

Say Mukul Garg and Raj Prakash Bhanushali of Motilal Oswal Research, “Given its presence in the high growth digital and product development, along with high operating margin, the CTC acquisition is attractive for TechM at 3.8 times trailing enterprise value to sales and mid-teen enterprise value to operating profit.”

While CTC enjoys industry leading margins, it has a limited sales force and talent bandwidth. This will mean that TechM will have to invest in boosting the sales force and scaling up operations. Adjusting for this investment, we reckon the valuation implies a significant premium to TechM and in the vicinity of quality Indian IT services midcaps, say analysts at Edelweiss Research.

The other concern is on the pace of acquisitions (this is the tenth acquisition in FY22) and cash utilisation. TechM has spent $880 million on mergers and acquisitions year-to-date FY22 or 75 per cent of FY21 operating cash flows. Say analysts at Kotak Institutional Equities, “ TechM is leaning even more towards 'buy' whereas investors prefer 'build'; acquisitions of Allyis to boost client profile is a good example. We note that one of the important elements of re-rating was improved discipline on cash utilisation; this will come under scrutiny with the recent pace of acquisitions.”

The acquisitions are less than 2 per cent of TechM’s revenues and have thus not led to any significant change in earnings estimates. Most brokerages however are positive on the company with key triggers being the opportunities from 5G rollout and improving margin trajectory. At the current price, the stock is trading at 22 times its FY23 earnings estimates. Investors should await Q3 earnings management commentary on demand as well as margins before considering the stock.