Institutional Equity Research Initiating Coverage | 20 July 2020
India IT Services - Structural Growth Story, Medium-term Outlook Remain Intact We request for your valuable vote and support Key Sectoral Tailwinds: Medium-term demand outlook for IT services sector remains attractive Resilient operating model and defensive balance sheet limit potential downside due to adverse macro environment Click Image for Video COVID-19 impacted Travel & Hospitality (T&H) vertical the most; financial services and Presentation other verticals remain largely stable Limited impact of temporary suspension of H-1B visa on operating margin Potential inorganic opportunities of captive units to help IT players to gain market Research Analyst: share Suyog Kulkarni, ACA, CFA Contact : (022) 4303 4000 / 9890966735 1. Indian Information Technology-Business Process Management (IT-BPM) industry, which Email : [email protected] is US$191bn in size, enjoys the lion’s share (~55%) in the global IT outsourcing market. 2. Historical analysis suggests that demand for IT services grows at 1.3x of GDP and consumption of software as a percentage of GDP is on the rise which is encouraging. 3. Indian IT companies are likely to continue to gain market share on the back of strong talent base, long-standing customer relationship, proven track record and best-in-class Coverage Summary practices. Company Rating CMP 2 Yr TP Upside (Rs) (Rs) (%) 4. We expect temporary suspension of H-1B visa by the US is likely to have limited impact on EBIT margin of Indian IT companies, as they have already reduced visa dependency Mphasis BUY 999 1,200 20 L&T and have 50%-60% local workforce currently. BUY 2,269 2,550 12 Infotech 5. Indian IT companies are likely to benefit from potential captive monetization efforts by Mindtree SELL 1,020 900 (12) global enterprises in the medium-term. 6. Resilient operating model (low capex, high variable cost structure) and defensive balance sheet (strong free cash flow) limit potential downside due to adverse macro Price Performance environment. Mkt. Cap. Absolute Perfromance Company (Rsbn) 1 M 3 M 12 M COVID-19 Impact: While the industry consultants expect global IT services demand to witness Mphasis 186 16.4 33.4 7.1 higher single-digit decline in CY20, we expect the Indian IT-BPM industry to witness low single- L&T digit decline in FY21. Our analysis of compilation of end market commentary of key IT companies 398 20.9 57.0 44.9 Infotech indicates that travel, hospitality and transport vertical are likely to witness the highest negative impact. Retail (non-essential), Energy (low oil prices) and Manufacturing vertical would also Mindtree 168 12.5 35.5 52.9 witness some pressure. On the other side, while the banking and financial services is showing sign of stability, telecom, technology and healthcare verticals have witnessed significant growth. We Initiate Coverage on Mphasis & L&T InfoTech with BUY Mphasis: Mphasis deserves multiple rerating considering the industry leading FY20-FY23E CAGR of 8.6% in direct core business (65% of revenue in FY23E), stable EBIT margin and attractive dividend yield of 5%. Mphasis is trading at 21% discount to peer group vs 3 year average of 9%. We initiate coverage on Mphasis with BUY and a 2-Year Target Price of Rs1,200, (based on a PE of 15.8x of FY23 earnings). L&T InfoTech (LTI): We believe LTI should continue to warrant premium valuation vis-à-vis peers on the back of its consistent industry-leading growth backed by execution focused stable management, diversified client base, robust new logo addition and client mining efforts.We initiate coverage on LTI with BUY and a 2-Year Target Price of R2,550 (based on a PE of 20.5x of FY23 earnings). We Initiate Coverage on Mindtree with SELL Mindtree: We believe risk-reward is unfavorable due to its high exposure to T&H vertical, disproportionate dependence on top clients and limited clarity on medium-term margin trajectory. We initiate coverage on Mindtree with SELL and a 2-Year Target Price of Rs900 (based on a PE of 14.5x based on FY23 earnings).
We have made changes to our Recommendation and Target Price. Please refer to Page no. 77 at the end of the report. 1 Table of Contents
Content Page No.
Sector Section 1-13 f (I)ndia (T)oday- IT industry birds eye view...... 1 f Sector At a Glance - Key Charts...... 2 f Key Sectoral Dynamics - At a Glance ...... 3-13
Company Section 14-36
Mphasis 15-32 Key Charts...... 21 Investment Rationale...... 22-31 Outlook & Valuation...... 32 Key Financials ...... 33-34 Company Background ...... 35-36
L&T Infotech 37-58 Key Charts...... 43 Investment Rationale...... 44-53 Outlook & Valuation...... 54 Key Financials ...... 55-56 Company Background ...... 57-58
Mindtree 59-76 Key Charts...... 65 Rationale for SELL Recommendation ...... 66-71 Outlook & Valuation...... 72 Key Financials ...... 73-74 Company Background ...... 75-76
2 (I)ndia (T)oday- IT Industry Bird's Eye View
India IT industry comprises ~20% of global IT spend India IT industry service line break-up
Source: Rsec Research, NASSCOM Source: RSec Research, NASSCOM
Brief Overview of Industry: In FY20, Indian IT-BPM industry generated US$191bn revenue (75% from export) and employed >4.3mn people. Indian IT industry provides IT services, Engineering R&D, products and Business Process Management services. Geography-wise, the USA contributes around two third of India IT revenue followed by Europe and Rest of World (ROW). Indian IT industry, which flourished during Y2K crisis ,has grown from US$4bn in 1999 to current level of US$191bn and accounts for ~55% of global outsourcing market.
f Strong Medium-term Growth Visibility: Indian Information Technology-Business Process Management (IT-BPM) industry, which is US$191bn in size, enjoys the lion’s share (~55%) in the global IT outsourcing market. Our analysis suggests that demand for IT services remain intact, as consumption of software/services – as a percentage of GDP – is on the rise. India IT industry is likely to continue to gain market share on the back of strong talent base and proven track record. f Limited Impact of H-1B Visa Suspension: We expect temporary suspension of H-1B visa by the US is Key Sectoral Theme likely to have limited impact on EBIT margin of Indian IT companies, as they have already reduced visa dependency and have 50%-60% local workforce currently. f Captive Monetization – Medium-term Opportunity: Indian IT companies are likely to benefit from potential captive monetization efforts by global enterprises in the medium-term. Currently, India has >1,400 captive units, out of which ~40% has <500 employees. f Defensive Business Profile:Resilient operating model (low capex, high variable cost structure) and defensive balance sheet (strong free cash flow) limit potential downside due to adverse macro environment.
f Talent scarcity in key offshore markets: Inability to provide digital talent (Data Analytics, Customer Experience, Cloud, Cyber) to key customers in a cost effective manner. f Failure to step up ecosystem partnerships/alliances: Indian IT industry has been working closely Key Risks with various software developers and other ecosystem partner. Failure to step up partnerships with new age software providers and ecosystem partners (cloud vendors, virtualization partners etc) may impair client relevancy. f Political/ regulatory risks: Protectionist policies regarding movement of people/off-shoring / privacy policies are one of the key growth hindrances
1 Sector At a Glance
Key Charts f Historically, software consumption has maintained a secular Exhibit 1: Software investments as a percentage of GDP is on consistent rise trend across business cycles. Since 1960, US software investments – as a percentage of GDP have been increasing consistently. f Since 2007, global IT services grew at 1.3x of global GDP growth.
Source: Federal Reserve Economic Data f Indian IT companies are likely to continue to gain market share Exhibit 2: India IT Industry contributes 18.5% of global IT spend on the back of strong talent base and proven track record.
Source: Rsec Research, NASSCOM
f Indian IT companies have consistently reduced dependency on Exhibit 3: Indian IT companies have increased localization efforts H-1B visa and developed strong local and nearshore workforce. Company Localization % in US TCS 50.0%+ Infosys 61.0%* Wipro 70.0%+ HCLT 67.70% Mindtree ~50.0%
Source: Industry; RSec Research; Note: *Americas: It includes US, Canada and Mexico f Low tech unemployment suggests robust tech demand amidst Exhibit 4: Technology unemployment remains well below national COVID pandemic. unemployment...
16% 14% 12% 10% 8% 6% 4% 2% 0% 2019 2019 2019 2019 2019 2019 2019 2019 2019 2019 2019 2019 2020 2020 2020 2020 2020 2020 ------1 7 - 6 5 4 3 2 9 8 1 11 - 6 5 4 3 2 10 12
US Tech Unemployement US Unemployment
Source: Industry; RSec Research
2 Key Sectoral Dynamics - At a Glance
We are optimistic on the IT-BPM industry on the back of the following indicators: Medium-term Demand Outlook Continues to Remain Intact Indian IT-BPM industry continues to Gain Market Share Limited Impact of Temporary H-1B Visa Suspension Potential Acquisition Opportunities of Captive Units to Increase Market Share IT Industry Enjoys Defensive Balance Sheet & High Variable Cost
I. Medium-term Demand Outlook Continues to Remain Intact IT services/software demand in the medium-term depends on two factors: (1) level of economic activity; and (2) pace of innovation/introduction of new technology/business model changes. Currently, though the level of economic activity remained subdued due to COVID-19 pandemic, we believe there is a higher propensity among enterprises to adopt newer business models and induct digital technologies. Historically, software consumption has maintained a secular trend across business cycles. Since 1960, US software investments – as a percentage of GDP (global IT services demand is related to global GDP) – have been increasing consistently. Since 2007, global IT services grew at 1.3x of global GDP growth. As the technology spends are largely discretionary, global IT services demand shows higher standard deviation at the time of economic contraction/expansion (for example: at the time of Global Financial Crisis (GFC), IT services demand fell more than 2x of contraction in global GDP).
Exhibit 5: Software investments as a percentage of GDP is on Exhibit 6: Global IT services grew at 1.3x of global GDP growth consistent rise
Source: Federal Reserve Economic Data Source: RSec Research, Federal Reserve Economic Data
3 II. India IT-BPM industry Continue to Gain Market Share The size of Indian IT-BPM industry continues to clock 9.7% CAGR since FY08 (pre-GFC level). Additionally, its share in global IT spends more than doubled from 8.4% in FY08 to 18.5% in FY20. Notably, significant part of India’s IT-BPM industry’s growth story was its consistency since its inception, which suggests that it was able to adapt at each level of technology transition. Currently, revenue from next generation services contributes >30% to he US$191bn domestic IT-BPM industry. We expect Indian IT-BPM industry to continue gaining market share driven by: (1) proven track record of managing large transformational deals; (2) availability of strong engineering talent in India; (3) long-standing customer relationship; and (4) best-in-class methods and practices.
Exhibit 7: India IT Industry accounts for 18.5% to global IT spend Exhibit 8: India IT industry service line break-up
Source: RSec Research, NASSCOM Source: RSec Research, NASSCOM
ISG Sees Sharp Initial Impact; TCS & Accenture both Highlighted Pressure from Clients in Highly Impacted Sectors For Q3CY20, Information Services Group (ISG) has guided 11% YoY decline in Annual Contract Value (ACV) from managed services. ISG expects rebound in demand from 2HCY20 but for CY20, ACV is expected to decline by 7.5%. Recent commentary from IT companies suggests step up in client interactions and demand boost in collaboration tools, workforce virtualization and cyber services. Post Covid-19, we believe enterprises are likely to accelerate digital transformation plan. For 3QFY20 (March-May), Accenture reported revenue growth of 1.3% YoY in local currency with stable operating margin. New bookings stood at US$11bn (+6% YoY). Management commentary suggests that both demand and cost are holding up. Accenture highlighted pressure from clients in highly impacted industries (20% of revenue) - Travel, Retail, Energy, Hi-Tech including Aerospace and Defense and Industrials reported high single-digit decline, whereas 50% of revenue came from 7 industries that were less impacted by COVID-19 pandemic, and in aggregate grew by high single-digit with double-digit growth in Software & Platforms and Life-Sciences & Public Service. Tata Consultancy Services (TCS) also indicated in its 1QFY21 release that T&H vertical in general and Airlines in particular are yet to bottom out. TCS expects recovery in T&H vertical in FY22.
4 Exhibit 9: Commentaries from Indian IT companies suggests relatively stable outlook Comments Accenture f About 50% of revenue came from 7 industries that were less impacted by the pandemic, and in aggregate its revenue grew by high single- digit with double-digit growth in software and platforms, Life-Sciences & Public Service. f Pressure from clients in high impacted industries (20% of revenue); travel, retail, energy, hi-tech including aerospace and defense and industrials reported high single digit decline. f Revenue from North America grew by 2% in local currency terms driven by double-digit growth in public service, life sciences and software and platforms, and high single-digit growth in banking and capital markets. Growth is offset by decline in chemicals and natural resources and high-tech. f Revenue from Europe declined by 2% in local currency terms. Double-digit growth witnessed by four industries, including software and platforms, chemical and natural resources, health and life sciences. Growth was offset by decline in consumer goods retail and travel, high- tech and banking capital markets. Europe was driven by high single-digit growth in Italy and mid single-digit growth in Germany, offset by continued decline in the UK as well as decline in Spain and France. f It witnessed improved demand in IT modernization, cloud migration and cloud-based data and innovative business. TCS f BFSI revenue declined by 4.9% largely due to the pandemic-related softness in the UK and Canada and residual supply-side issues from early April. Other than that, BFSI revenues held up relatively well in other markets. f The Retail cluster took the biggest hit, de-growing by 12.9% due to virtual shuttering of many retail segments as well as the Travel, Transportation & Hospitality (TTH) sub-vertical. A few sub-segments like grocery, and pharmacy retail and CPG performed well during the quarter. f Communications & Media de-grew by 3.6% impacted by media sub-vertical, which was affected by cancellation of major sporting and entertainment events and the resultant impact on advertising revenue. f Manufacturing declined by 7.1% with most production coming to a grinding halt. Technology & Services de-grew by 4%. Virtually all markets declined in 1Q with the exception of Europe, which grew by 2.7%. Cognizant f BFSI revenue declined by 1.3%. Much of the revenue leakage was due to the supply side impact arising out of delays in or inability to activate remote access for some of the offshore teams due to regulatory concerns. f Retail grew by 4.2% despite a sharp hit in Travel, Transportation and Hospitality (TTH) sub-vertical, while Life Sciences and Healthcare continued to grow by a strong 16.2%. f Communications and Media business continued to do well, growing by 9.3%, while Manufacturing and Technology & Services grew by 7% and 3.5%, respectively. f Geography wise, Europe continued to outperform, growing by 11.9%, while the UK grew by 5.4%. North America was flattish at 0.2%. Among the emerging markets, Latin America and APAC grew by 3.9% and 3.5%, respectively, while MEA grew by 1.3% and India declined by 1.9%. Infosys f Despite the COVID related challenges, Infosys registered 1.5% YoY revenue growth in constant currency terms in 1QFY21. f Financial Services, Hi-Tech, Life Sciences and Healthcare segments witnessed positive growth on YoY basis, while Communications, Manufacturing and Energy Utilities, Resources and Services segments were flattish. Retail segment saw weakness on expected lines. f After an initial drop in early part of 1QFY21, Financial Services witnessed faster recovery in business volume and deals during the quarter, especially in US and APAC banking. Strength in the vertical was also driven by high level of remote enablement for the employees in different geographies. f The company saw some softness in Capital Markets and Cards & Payment sectors. f Retail segment remains under pressure with the clients in non-grocery, apparel, lifestyle and fashion, restaurants, logistics sub-segment seeing demand contraction and supply chain disruptions. f Performance in Communications segment stabilized on sequential basis, although the clients, especially in media and entertainment industry, are under pressure due to weaker advertisement spent and cancellation of events. f Energy, Utilities, Resources and Services vertical is seeing pressure due to lower activity in Energy and Resources segment. However, the company has been winning deals in this segment, while a continued strong pipeline makes it hopeful on the future prospects, despite near- term volatility. f In Manufacturing, the company has seen weak sequential performance due to disruptions in demand, production and supply chain, which is expected to continue for some time. Auto and aero sectors are majorly impacted with factory closures, delays and cancellations in aircraft purchases and so on. Wipro f Demand environment is driven by what Wipro calls as 3 Cs i.e. Cloud, Collaboration and Cyber. f Despite witnessing a tough 1QFY21 across sectors, the company is seeing some stability in consumer business, tech business and communication business units. For others, it will watch it closely as to how the traction unfolds during the course of 2QFy21. f In Banking space, the banks are spending less due to uncertainties as they want to protect their balance sheet. There are lots of discussions on run side of business where the company made heavy investment.
Source: RSec Research
5 Dodd-Frank Act Stress Test Suggests Limited Systemic Risk under Extreme Scenario Last month, the US Federal Reserve released annual Dodd-Frank Act Stress Test (DFAST 2020) for 33 large US banks. The stress test analysis suggests that firms under supervision period (1QCY20 to 1QCY22) would experience substantial losses under severely adverse supervisory stress scenario but on aggregate, the banks are likely to maintain minimum CET 1 capital levels well above minimum regulatory requirement. DFAST 2020 also suggests that losses would increase in case of ‘W shaped’ recovery. We consider outcome of DFAST 2020 is encouraging and expect limited impact to large banks technology spending outlook.
Exhibit 10: Dodd-Frank Act Stress Test Suggests Limited Systemic Risk under Extreme Scenario
Source: ISG
Exhibit 11: Scenario Assumptions Scenarios Peak Peak-to-trough Lowest 10-year unemployment GDP change treasuries rate Severally adverse 10.0% -8.5% 0.7% V- Shaped recovery 19.5% -10.0% 0.8% U-Shaped recovery 15.6% -13.8% 0.6% W-Shaped recovery 16.0% -12.4% 0.5% Source: Federal Reserve
6 III. Limited Impact of Temporary H-1B Visa Suspension Recently, the US entering to President Donald Trump issued a presidential proclamation, which temporarily blocks foreign workers entering to the US on H-1B visas and L-1 visas (intercompany transfers in response to high US unemployment rate (11.1%). The Trump Administration expects this move will open up 525,000 jobs for U.S. workers. Notably, rejection rate of H-1B petitions for new employment has already gone up to 30% in 2020 from 6% in 2015. In response to restrictive visa regime, Indian IT companies have already reduced their H-1B dependency and have stepped up localization efforts. Currently, most Indian IT companies have 50-60%+ local employees in their US workforce. Additionally, they have been consistently stepping up nearshore offices (Mexico & Canada). Post H-1B visa suspension, Indian IT companies need to rely on subcontractors/local talent pyramid for onsite work force expansion.
We expect temporary suspension of H-1B visas is likely to have limited impact (to the tune of 20-50bps) on EBIT margin of the Indian IT companies. We think future of US legal immigration policy in general and H-1B Visa suspension in particular will be dependent on US unemployment rate and US presidential election. Our analysis of Democratic presidential nominee Joe Biden’s legal immigration plan suggests comparatively dovish tone vs. the current administration. Consistent Drop in Visa Approval Rate with Escalation in Denial Rate In 2017, Trump administration issued ‘Buy American and Hire American executive order’ under which the administration pledged to reform high-skilled immigration program to “create higher wages and employment rates for workers in the United States.” Since then there is a consistent increase visa denials, as denial rate for H-1B initial applications soared to ~30% at 1H2020 from 6.3% in 2015. US Citizenship and Immigration Services (USCIS) have stepped up Request for Evidence (RFE) of H-1B visa petitions which increased processing time as well the cost.
Exhibit 12: H1-B visa approvals have declined since 2015 Exhibit 13. …with step up in visa denials
Source: United States Citizenship and Immigration Services Source: United States Citizenship and Immigration Services
Exhibit 14: Large Indian IT companies have reduced visa applications
Source: United States Citizenship and Immigration Services
7 Indian IT Companies Stepped up Localization Efforts in Response Indian IT companies responded higher visa denials by stepping up localization efforts. Since 2017, Infosys added >10,000 local people in its US workforce. TCS, Wipro and HCLT have also significantly increased their localization efforts. Our analysis suggests that most Indian IT companies have ~50%-60% local workforce in the US. Additionally, Indian IT companies have stepped up hiring in nearshore centers in Mexico and Canada. Furthermore, they stepped up subcontracting/flexi hiring. Currently, subcontracting – as percentage of sales for key IT services companies remains in the range of 6%-13.9%. Successful localization efforts in onsite delivery model is expected to protect delivery capabilities of Indian IT companies during the period of temporary H-1B visa suspension. Higher local workforce in key revenue geographies provides higher stability in the long-run.
Exhibit 15: Indian IT companies have increased localization efforts Exhibit 16: Subcontractors constitute ~6-13.9% of sales
Company Localization % in US
TCS 50.0%+
Infosys 61.0%*
Wipro 70.0%+
HCLT 67.70%
Mindtree ~50.0%
Note: *Americas: It includes US, Canada and Mexico
Source: RSec Research Source: RSec Research US Tech Services Unemployment Rate Remains Low vs. Elevated National Average COVID-19 outbreak led to sharp slump in economic activities worldwide. In just few months, the US employment rate soared to >11.1% from 3.8% in Feb’20. According to Computing Technology Industry Association (CompTIA), unemployment rate for technology occupants remains low at 4.3% in comparison to elevated national average. Interestingly, technology companies reduced their workforce in May’20, but non-tech employers across the US increased hiring of technology professionals. According to CompTIA, during past three years, tech services and custom software sector accounted for >75% of job gains in the tech industry. Talent demand in the field of IT infrastructure modernization, systems, data and cyber security is likely to remain robust. CompTiA study also reveals that out of the current 263 thousand job postings, around 30%+ are for software and application developers. Current tech unemployment level is well below the level of 6.5% in GFC (2008-09) and dot com bubble (2000), which indicates that tech demand is still holding up compared to other verticals.
Exhibit 17: Technology unemployment remains well below national Exhibit 18: New IT job postings recovered in US unemployment…
16% 380 14% 360 340 12% 320 10% 300 8% 280 6% 260 4% 240 2% 220 0% 200 7 - 7 - 1 1 8 9 11 - 2 3 4 5 6 8 9 11 - 2 3 4 5 6 12 10 12 10 ------2019 2020 2019 2018 2019 2019 2019 2019 2019 2019 2019 2018 2018 2020 2020 2020 2020 2020 - - - - 2019 2018 2019 2019 2018 2018 2019 2019 2019 2019 2019 2019 2019 2019 2019 2019 2019 2019 2020 2020 2020 2020 2020 2020 ------1 7 - 3 4 5 6 2 8 9 1 11 - 3 4 5 6 2 10 12
US Tech Unemployement US Unemployment IT Occupants job postings (Thousands)
Source: Rsec research, US Labour Department, CompTiA Source: RSec Research 8 Our deep dive on key customers earnings capability and credit rating We analyzed' key 20 'US clients of Indian It companies on the basis of their H-1B visa applications during Oct-18 to Sept-19. We also analyzed revenue/EPS growth trajectory of each of the key customer with change of credit ratings during COVID pandemic if any to determine customer portfolio resiliency. Our analysis suggests relatively stable credit quality of key US customer portfolio of both Mphasis and LTI. Additionally, we highlight credit rating deterioration of key customers of Mindtree, which is majority in Travel and Hospitality and financial services vertical. LTI: 1) LTI’s pool of key 10 customers predominantly comprises of clients from diversified sectors i.e. Banking, Insurance, Energy, Telecom & Media and Manufacturing, which we believe reduces vertical concentration risk. 2) Our analysis suggests stable credit quality of key 10 customers (above investment grade), which directs to strong customer portfolio resiliency. 3) Major chunk of EPS decline in Top-10 customer comes from select manufacturing customers. 4) Consensus EPS (CY19-CY22) of banks and insurers is largely stable, whereas, telecom and pharma companies are expected to continue stable EPS growth
Mphasis: 1) Mphasis’ key 10 customers comprise of financial services providers and insurers. 2) Stable credit quality of key 10 customers indicates strong customer resiliency. 3) Major chunk of EPS decline in key 10 clients comes from technology companies – DXC/HP – which is undergoing restructuring efforts (for whom Mphasis works as a subcontractor/ partner).
Mindtree: 1) Mindtree’s key 10 clients (by visa applications) comprise of players from Technology, CPG, Financial Services, and T&H domain. 2) Despite decline in credit quality of 4 out of key 10 clients are still investment grade or above, which indicate risk of further credit rating downgrades in T&H vertical. 3) Majority EPS decline comes from T&H vertical.
Exhibit 19: LTI - Applications for Oct 2018-September 2019 Revenue CAGR EPS CAGR Current Credit rating Top 20 Clients (on the basis CY19-22E CY19-22E Credit rating (Dec 2019) of applications) US bank -0.2% 3.1% A3 A3 Insurance 2.8% 3.4% A2 A2 Energy -2.6% -7.4% Aa2 Aa2 CPG 3.7% 4.3% Aaa Aaa Insurance 3.7% 6.7% Baa1 Baa1 Telecom 6.3% 12.3% Aa1 Aa1 Technology -0.2% 2.9% A1 A1 Manufacturing -1.0% -16.8% Baa1 Baa1 Media & Entertainment 0.0% -4.5% Baa2 Baa2 CPG 2.9% 7.4% Aa3 Aa3
Automotive -5.4% -6.7% A- A Manufacturing 3.0% 9.0% Baa2 Energy -0.8% -2.2% A3 A3 Pharma 11.4% 9.2% B1 B3 Insurance 3.7% 6.7% Baa1 Baa1 Technology NA NA Media & Entertainment -2.1% NA
US bank 19.3% 0.9% A3 A2
Manufacturing -4.9% -13.4% B2 B2 HEVC -1.1% 8.4% Baa2 Baa2
Source: USC IS; RSec Research
9 Exhibit 20: Mphasis - Visa applications (H-1B) from key clients during Oct-18 to Sept-19 Revenue EPS growth Credit rating Credit rating growth as on as of Key Customers CY19-22E CY19-22E today Dec/2019 Financial Services 0.1% 0.0% A2 A2 Financial Services -3.0% -10.9% A2 A2 Logistics 1.4% -7.7% Baa2 Baa2 Technology -3.6% -3.6% Baa2 Baa2 Insurance -1.8% 4.2% Baa1 Baa1 Technology -7.7% -19.8% Baa2 Baa2 Financial Services 11.9% 6.0% Baa1 Baa1 Insurance/ Technology Financial Services -2.5% -5.5% A2 A2 Insurance NA NA NA NA Insurance 4.5% -0.4% A3 A3 Communication -2.7% Ba2 NA Semi conductor 1.1% 1.4% Private Co. - Insurance software NA NA NA NA US Airlines -5.6% -25.4% Ba2 Ba2 Financial Services -1.1% 7.4% Baa2 Baa2 Real eastate 5.2% 2.8% NA NA Pharma 0.7% 3.5% A1 A1 Financial Services firm -9.0% -19.8% A2 A2 MNC Media company 3.0% 20.7% Baa2 Baa2 Source: Rsec research, USCIS
Exhibit 21: Mindtree - Key customers by visa applications during Oct-18-Sept-19 Top 20 key clients- Revenue CAGR EPS CAGR Credit rating as Credit rating at applications CY19-22E (%) CY19-22E (%) of today Dec 2019 Unknown (28% of total) NA NA NA NA Travel & Hospitality -3.4 -10.6 Baa1 A3 Financial Services 1.2 14.7 Baa1 Baa1 Travel & Hospitality -1.1 -6.5 Baa3 Baa2 Financial Services 1.7 2.8 A3 A3 Technology NA NA NA NA CPG 3.2 4.2 A2 A2 Financial Services 5.8 7.6 Baa2 Baa1 Travel & Hospitality -6.4 -14.7 Baa2 Baa3 Insurance -1.8 4.2 Baa1 Baa1 Automotive -1.9 -3 A1 Aa3 CPG 2.9 7.4 Aa3 Aa3 Real estate -1.1 1.3 NA NA Travel & Hospitality -3.2 4.9 B+ BB Professional Services NA NA Other NA 4.9 Manufacturing 0.5 -3.4 Technology/ Other NA NA A+ A+ Retail/Other NA NA University NA NA Source: RSec Research; USCIS
10 Democratic Presidential Nominee Joe Biden’s Stance on Legal Immigration Policy The United States presidential election is scheduled for Tuesday, November 3, 2020. We analyzed Democratic presidential nominee Joe Biden’s stance on immigration plan titled ‘Plan for securing our values as nation of immigrants’, which emphasizes that ‘Immigrants bring tremendous economic, cultural, and social value to their new communities. Even in the cities hit hard by the loss of manufacturing jobs, immigrants are a key driver of entrepreneurship and population growth. Our analysis suggests that Joe Biden’s plan has four relevant features.
1. Linking Number of Visas to Health of US Economy: Biden’s immigration plan suggests that he will increase number of permanent, employment-based immigration and develop a mechanism to temporarily reduce number of visas during time time’s high US unemployment (vs. current annual cap). This is positive for US tech industry as this will automatically link supply to demand. 2. Additional Rural Visas: According to Biden, current disparity in economic growth between U.S. cities, and between rural communities/urban areas, is one of the great imbalances of today’s economy. Biden’s plan suggests additional immigration visas for rural areas to support regions economic development. This is incentive for employers/ rural communities to bridge economic gap. 3. Special Rules to Protect Foreign Workers: Biden’s plan vouch for equal enforcement of rules to protect American and foreign workers alike. 4. Possibility of Expanding Temporary Visas under Certain Conditions: Biden’s plan indicates to create a mechanism to promote high skill visas, which will not be used to disincentivize recruiting US workers in favour of entry-level salaries. Post that Biden will consider expanding limits on high skill visas as well. This proposal may increase visa processing time and scrutiny. Joe Biden’s stance on legal immigration plan is comparatively dovish vs. the current administration. Exhibit 22: Joe Biden’s plan for immigration Comments Employment Visa f Currently, the number of employment-based visas is capped at 140,000 each year. Presidentail nominee, Mr. Biden will work with Congress to increase the number of visas awarded for permanent, employment-based immigration and promote mechanisms to temporarily reduce the number of visas during times of high U.S. unemployment. f He will also exempt cap on PhD programs in STEM fields in the US, who are poised to make some contributions to the world economy. f Biden believes that foreign graduates of a U.S. doctoral program should be given a green card with their degree.
Visa proposals for rural f As presidential nominee, Biden will support a program to allow any county or municipal executive of a large or mid-size county or communities city to file petition for additional immigrant visas to support the region’s economic development strategy, provided employers in those regions certify job availability and that there are no workers to fill them. Rules to protect Foreign f Mr. Biden wants to enforce the rules to protect American and foreign workers alike. The U.S. immigration system must guard workers against economy-wide wage cuts due to exploitation of foreign workers by unscrupulous employers who undercut the system by hiring immigrant workers below the market rate or go outside the immigration system to find workers. f Biden will work with the Congress to ensure that the employers are not taking advantage of immigrant workers and that U.S. citizen workers are not being undercut by employers who don’t play by the rules. f Biden will also work to ensure that the employers have the right tools to certify their workers’ employment status and will restore the focus on abusive employers instead of on the vulnerable workers they are exploiting. Reforms the temporary f High skilled temporary visas should not be used to disincentivize recruiting workers already in the US for in-demand occupations. visa system An immigration system that crowds out high-skilled workers in favor of only entry level wages and skills threatens American innovation and competitiveness. f Biden will work with the Congress to reform temporary visas to establish a wage-based allocation process and establish enforcement mechanisms to ensure they are aligned with the labor market and not used to undermine wages. f Then, he will support expanding the number of high-skilled visas and eliminating the limits on employment-based visas, which creates unacceptably long backlogs. Source: Joebiden.com
11 IV. Potential Acquisition Opportunities of Captive Units to Increase Market Share In last 3-4 years, India’s GIC (Global In-house Capability Center) ecosystem witnessed sustained growth in new captive units. Currently, 40% GICs in India has <500 people. According to recent commentaries from deal advisors/consultants checks/media reports, enterprises have stepped up efforts for captive monetization, specifically where the parent company is under financial stress or captives units, which are not properly managed. During the GFC and afterwards, Indian IT companies consistently remained active in captive monetization space for example TCS acquired Citi captive in FY09-10, Mphasis acquired AIG captive in FY09-10 and Cognizant acquired UBS captive unit. We believe Indian companies to benefit from acquisition opportunities of captive centers, as it provides larger strategic relationship opportunity and increases wallet share.
Exhibit 23: Captive monetization to aid IT companies in gaining market share
Source: ISG
V. IT Industry Enjoys Defensive Balance Sheet & High Variable Cost IT-BPM industry follows a typical business model compared to other industries. Some of these typical features include: limited capital requirement and revenues in USD with INR cost base, which make the industry structurally attractive. Further, robust cash flow generation and strong cash in hand suggest stable and defensive nature of balance sheet, which are the strong positives in light of current macro environment. Additionally, the Indian mid-cap IT companies continue to grow at a higher pace compared to large-cap peer (Infosys and TCS), which suggests that they have successfully managed to differentiate themselves from their large-cap peers. We believe the enterprises continue to see value in adding small and mid-size IT companies in their vendor portfolio due to the following: f Niche Player: Generally, enterprises like to add mid-size IT companies in their vendor portfolio, as they come with some niche technology. Continuous acquisitions in newer technology have helped both L&T Infotech and Mphasis in acquiring new clients. f High Customer Focus: Generally, because of their small size, it is perceived that the mid-cap companies can focus more on clients vs. larger peers. f Diversification of Vendor Profile: Enterprises look forward to diversify their vendor profile and they need mid-size IT companies to manage the vendor pyramid.
12 Exhibit 24: Comparison Sheet Revenue growth (%) EBIT margin (%) PE (x) ROE (%) Stocks Price FY21E FY22E FY23E FY21E FY22E FY23E FY21E FY22E FY23E FY21E FY22E FY23E Covered Stocks LTI 2,115 6.6 11.7 10.4 15.5 16.2 16.4 23.9 20.3 18.0 26.3 26.1 25.3 Mindtree 1,011 1.9 8.3 7.2 12.9 13.1 13.1 22.1 19.9 18.3 23.9 22.7 21.5 Mphasis 916 3.1 9.2 8.0 15.1 15.5 15.6 15.1 13.4 12.1 20.6 21.2 21.4 Covergae Average 3.9 9.7 8.5 14.5 14.9 15.0 20.4 17.9 16.1 23.6 23.3 22.7
Not Covered (Bloomberg Consensus) Infosys 780 1.6 9.0 10.6 20.7 21.5 21.7 20.5 18.2 16.3 23.6 24.6 25.0 TCS 2,221 -0.2 9.6 8.7 24.1 24.9 24.9 26.7 23.6 21.6 34.6 36.2 36.9 Wipro Ltd 222 -1.1 4.7 4.3 15.6 16.2 16.4 14.4 13.1 12.4 15.1 15.3 15.4 HCLT 582 4.2 8.2 8.7 18.9 19.4 19.8 14.4 12.8 11.6 19.8 19.4 19.3 TechMahindra 567 -1.0 8.2 8.7 10.7 12.3 12.7 13.6 11.5 10.0 15.8 17.0 18.1 Hexaware * 343 8.2 10.5 NA 13.2 13.3 NA 13.9 14.2 NA 21.0 21.0 NA NIIT Technology 1,594 7.1 10.3 11.4 12.9 13.8 13.3 20.9 18.0 16.5 18.7 20.2 20.6 Source: Bloomberg; RSec Research
13 COMPANY SECTION
14 Institutional Equity Research CMP* (Rs) 999 Upside/(Downside) (%) 20 Mphasis Bloomberg Ticker MPHL IN BUY IT | India Market Cap. (Rs bn) 186 2 Year Target Price: Rs.1,200 Free Float (%) 44 Initiating Coverage | 20 July 2020 Shares O/S (mn) 186
Strong Core Business Warrants Multiple Rerating
Research Analyst: Key Triggers: Suyog Kulkarni, ACA, CFA Healthy direct core business (65% of FY23E revenue) to drive USD company revenue Contact : (022) 4303 4000 / 9890966735 growth of 9.2%/8% and EPS growth of 12.8%/10.6% in FY22E/FY23E Email : [email protected] Resilient business profile with limited exposure to COVID affected verticals DXC Tech/Hewlett Packard (HP) business likely to remain soft but near-term downside is protected Well-placed to cash in significant transformation opportunities in Blackstone portfolio companies
1. Mphasis (MPHL) – the 7th largest IT service company in India – provides IT, business consultancy and outsourcing services to global corporations in financial services, Share price (%) 1 mth 3 mth 12 mth insurance, telecom, logistics, and technology verticals. Absolute performance 16.4 33.4 7.1 2. Its direct core revenue clocked 13% CAGR over FY17-20 driven by new client addition Relative to Nifty 8.4 15.7 13.1 and market share gain. We expect direct core business (65% of FY23E revenues) to clock 8.6% CAGR over FY20-23E on the back of strong deal win momentum in FY20. Shareholding Pattern (%) Dec'19 Mar'20 3. DXC Technology (DXC US), which has witnessed slump in revenue growth and undergoing Promoter 52.2 56.2 restructuring efforts, is likely to impact growth trajectory of MPHL’s DXC/HP business (20% Public 47.8 43.8 of FY23E revenue). But, the near-term downside remains protected owing to minimum revenue commitment of ~US$300mn till next contract renewal in Sept’ 21. 1 Year Stock Price Performance 4. Higher fixed price contracts, off-shoring and optimization of subcontractor cost are expected to aid in shrugging off pricing pressure in the medium-term. 1160 1080 5. We are enthused by strong balance sheet (US$325mn) and strong free cash flow (FCF) 1000 and dividend yield of US$200mn and ~5%, respectively in FY23E. 920 840 The COVID-19 Impact: Mphasis enabled work from home (WFH) for 99.5% of onsite and 95% 760 of total employees by the end of Mar’20. Whilst COVID-19 pandemic is likely to have short-term 680 disruptions, we expect limited impact on MPHL’s focused verticals i.e. financial services and 600 19 19 19 20 20 20 20 ------
insurance. Thus, we expect sequential growth to return from 2QFY21 onwards. Jul Jul Sep Nov Jan Mar May
Outlook & Valuation Mphasis 1 year share price chart We expect healthy direct core business (65% of FY23E revenue) to drive the company’s USD revenue growth of 9.2%/8% and EPS growth of 12.8%/10.6% in FY22E/FY23E. A robust 16% YoY Note: * CMP as on 17 July 2020 growth in deal win and stable credit quality of the clients limit any downside in the near-term. Currently, the stock trades at 21% discount to its peers (L&T Infotech, Mindtree & Hexaware) compared to historical average discount of 9% due to DXC business overhang. We forecast DXC/ HP business to clock a negative CAGR of 4.6% over FY20-23E. In the medium term, we expect strong growth in direct core business to outweigh concerns over DXC business. Thus, Mphasis deserves multiple rerating considering the industry leading CAGR of 8.6% in direct core business (65% of revenue in FY23E), stable EBIT margin and attractive dividend yield of 5.3%. We assign 15.8x PE on FY23E earnings at par peer group. We initiate coverage on Mphasis with BUY and a 2-Year Target Price of Rs1,200, which implies 20% upside potential from the current level.
Financial Summary (Rs mn) FY19 FY20 FY21E FY22E FY23E Net Sales 77,311 88,436 91,155 99,582 1,07,516 EBIT 9,004 8,144 11,220 11,831 13,135 PAT 10,734 11,424 11,386 12,847 14,214 Diluted EPS (Rs) 55.5 60.8 60.6 68.4 75.7 P/E (x) 18.0 16.4 16.5 14.6 13.2 RoE (%) 18.5 21.3 20.6 21.2 21.4 Dividend Yield (%) 2.7 3.5 3.5 4.0 4.7 Source: Company, RSec Research 15 Our Thesis
f Strong Direct Core business: Mphasis reported strong 13% CAGR in direct core revenues in FY17-20 driven by strong new logo additions and wallet share gains. We expect industry leading growth (FY20-23E 8.7% CAGR) in direct core segment is likely to continue in the medium term on the back of strong deal win momentum in FY20 (+16% YoY).
f DXC/HP business downside remain protected: DXC Technology (DXC US) has witnessed slump in the revenue growth and undergoing restructuring efforts which is likely to impact growth trajectory of Mphasis’s DXC/HP business (27% of FY20 revenues). But, the near term downside remain protected as minimum revenue commitment of ~$300mn available till next contract renewal in Sept' 21.
f Execution focused leadership: Stable top leadership, strong execution experience in legacy and next generation Key Investment Themes projects, decade long customer relationships are the key building blocks of investment argument.Strong balance sheet ($325mn and healthy free cash flows (FY23E $200mn) supported by solid dividend yield (6% FY23E) make the stock compelling investment proposition.
f Outlook & Valuation: We expect healthy direct core business (65% of FY23 revenue) to drive the company’s USD revenue growth of 9.2%/8% and EPS growth of 12.8%/10.6% in FY22/FY23. A robust 16% YoY growth in deal win and stable credit quality of the clients limit any downside in the near-term. Currently, the stock trades at 21% discount to its peers (L&T Infotech, Mindtree & Hexaware) compared to historical average discount of 9% due to DXC business overhang. We initiate coverage on Mphasis with BUY and a 2-Year Target Price of Rs1,200, which implies 20% upside potential from the current level.
f Significant reduction in tech spends by US banks/insurers. f Possibilities of longer-term ban on US H-1B visas may drag operating profit. Key Risks f Vulnerability to client specific events owing to high client concentration. f Appreciation of INR against USD.
16 EPS & Target Price
Source: Company, RSec Research
Price Sensitivity Analysis EPS (Rs) Growth (%) FWD PE 13 14 15 15.8 17 FY17 (-3) 38.0 26.3x 494 532 570 600 646 FY18 (-2) 42.6 12.1% 23.5x 554 596 639 673 724 FY19 (-1) 55.5 30.3% 18.0x 722 777 833 877 944 FY20 (Base Year) 60.8 9.6% 16.4x 791 852 912 961 1,034 FY21 (Year 1) 60.6 -0.3% 16.5x 788 849 910 958 1,031 FY22E (Year 2) 68.4 12.8% 14.6x 889 958 1,026 1,081 1,163 FY23E (Year 3) 75.7 10.6% 13.2x 984 1,060 1,135 1,200 1,287 Soure: RSec Research
17 The COVID-19 Impact f Update on Business Continuity: Mphasis implemented WFH for 99.5% of its onsite and 95% of total employees to by the end of Mar’20. Due to some privacy related constraints, 100% could not be implemented. f Deal Ramp-up Pace in April: As per the management, Apr’20 was a tough month for ramp- up led by logistical issues from client side on employee on-boarding and repurposing the existing employees. A clear picture on deal ramp-up can emerge once the logistical issue is over. f Demand Environment: Mphasis foresees higher near-term challenges in supply side than from demand side. In light of the COVID-led disruptions, the clients have reprioritized budgets, which have short-term impact on discretionary budget. However, the management highlighted that deal pipeline continued to remain strong even during the pandemic period. f Sequential Revenue Growth from 2QFY21 Onwards: Despite short-term impact of COVID-19 pandemic, its focused verticals such as financial services and insurance) are unlikely to have any significant impact. The company expects sequential revenue growth from 2QFY21 onwards. f EBIT Margin: Whilst the management expects to maintain EBIT margin in the range of 15.5%- 17% in FY21, clarity will emerge post 1QFY21 result. f New Dimensions into Enterprise IT Budgets: The COVID-19 pandemic has forced enterprises to defer discretionary spend and focus on IT projects that make their operations cost-effective and flexible. Thus, the key focus areas are likely to be: (1) enhancing digital transaction capacity (digital contract, digital on boarding, application uploads, digital contactless customer experience, re-design and strong leverage of data strategies); and (2) cost takeout approach; and (3) approach to supply chain and omni-channel strategies led by new design. f Opportunities from Vendor Consolidation: There is possibility that the enterprises are likely to focus on strategic sourcing decisions. The management expects long-term decisions around strategic sourcing can provide consolidation opportunities for the vendors.
18 Management Meet – Key Takeaways f Demand Outlook: In the wake of COVID-19 outbreak, Mphasis has witnessed surge in transformation conversations with clients and sharp growth in number of interactions with technology leadership of the customers. The management also emphasized significant demand shift towards transformation services. f Stable Pricing Environment: The management expects limited impact of stable pricing environment on transformational deals. Additionally, it emphasized that maximum pricing pressure can be seen in legacy deals, where the company has low exposure. f Deal Environment: Mphasis recorded strong deal wins in 4QFY20 with large share of transformational deals. While new deal momentum remains good and deal pipeline also remains solid during the pandemic with no decline. The management continues to witness strong traction in financial services and insurance verticals. f Impact on Execution: COVID-led nationwide lockdown impacted new employee addition, which consequently affected execution, as some projects are taking longer time to than earlier. f Direct Core Business: The management expects growth in direct core business is to remain strong on the back of continued growth in new client addition and step up in US$5mn+ and US$10mn+ client buckets. Revenue from Blackstone portfolio companies (which albeit constitutes a small part direct core revenue) grew by around 30%-40% in last two years. Notably, Mphasis has only 1% revenue exposure to airlines vertical, while its exposure to logistics vertical is mostly on B2B side than B2C. f DXC Business: Mphasis’ Master Service Agreement (MSA) is due for renewal in Sept’21. Additionally, Minimum Revenue Commitment (MRC) of US$300nmn is available for consumption till contract renewal, which protects revenue from downside. In case of any revenue shortfall, DXC Technology would indemnify loss of contribution, which will protect margin. Mphasis has long-standing relations with DXC’s clients (from EDS days), which is likely to weigh on future relationship with DXC. f Digital Risk Business: The management is confident that digital risk business (mortgage processing) is likely to benefit from low interest environment in the United States. f Fixed Price, Subcontractor & H-1B Visa: Mphasis receives ~74% of revenue from Time and Material (T&M) contracts (higher than peers from DXC/HP days). As per the management, while temporary suspension of H-1B visa won’t have much impact on onsite delivery, travel restrictions might have higher impact on project execution. Subcontractors cost has increased for all IT companies including Mphasis. f Capital Allocation Policy: The management targets to maintain dividend payout ratio in the excess of 50%, going forward.
19 Comparative Analysis
Mphasis Mindtree Investment View f India's 7th largest IT services company. f India's 8th largest IT services company. f Mphasis to report strong double digit growth f Mindtree is likely to witness softer revenue acceleration Business View in core business with relatively stable margins. driven by high exposure to T&H and top client Attractive valuation with strong 5%+ dividend concentration risk. It's valuation is expensive vs. peers. yield.
Financials (Rs Mn) FY20 FY21E FY22E FY23E FY20 FY21E FY22E FY23E Revenues 88,436 91,155 99,582 1,07,516 77,643 77,933 84,210 91,016 EBIT 14,187 13,790 15,436 16,749 8,144 11,220 11,831 13,135 Adj PAT 11,424 11,386 12,847 14,214 6,309 8,493 9,122 10,233 Growth (%) Revenues 14.4 3.1 9.2 8.0 10.6 0.4 8.1 8.1 EBIT 13.7 -2.8 11.9 8.5 -9.6 37.8 5.4 11.0 Adj PAT 6.4 -0.3 12.8 10.6 -16.3 34.6 7.4 12.2 Margin (%) EBIT 16.0 15.1 15.5 15.6 10.5 14.4 14.0 14.4 Adj PAT 12.9 12.5 12.9 13.2 8.1 10.9 10.8 11.2 Per Share (RS) EPS 60.8 60.6 68.4 75.7 41.7 51.6 55.4 62.1 DPS 35.0 35.0 40.0 47.0 13.0 13.0 17.5 20.0 Book value 310.4 336.3 370.0 406.0 191.6 230.2 268.1 310.2 Valuation (x) P/E 16.4 15.1 13.4 12.1 24.4 19.8 18.4 16.4 EV/EBIT 12.6 12.6 11.0 9.7 19.7 14.0 12.8 11.2 P/BV 3.2 3.0 2.7 2.5 5.3 4.4 3.8 3.3 Div Yield (%) 3.5 3.5 4.0 4.7 1.3 1.3 1.7 2.0 Return Ratio (%) ROCE (%) 18.3 15.4 16.2 16.5 18.1 21.4 19.8 19.5 ROE (%) 21.3 20.6 21.2 21.4 19.1 26.9 24.1 23.2 Source: Company; RSec Research
20 Key Charts f Mphasis clocked a robust 37% CAGR in new generation deal Exhibit 1: Solid deal momentum to enhance mid-term visibility wins in FY17-FY20. f In FY20, ~80% deal wins came in the next generation services, which suggests that Mphasis has successfully transformed its offerings into key areas such as Cloud, DevOps and Data Analytics.
Source: Company; Rsec Research
f Mphasis’ direct core business (65% FY23E) consistently recorded Exhibit 2: Direct core business drives growth double digit growth rate. f Revival of growth is expected in FY22E/FY23E driven by pent up demand and execution of strong orderbook.
Source: Company; Rsec Research
f Client mining efforts and proactive sales have helped Mphasis Exhibit 3: Improved client pyramid suggests client share gain to improve its client pyramid.
f We will closely watch further wallet share gain among US$1mn+ and US$5mn+ client bucket.
Source: Company; Rsec Research f In FY19-FY20, Mphasis added 88 new clients in direct channel, Exhibit 4: New client additions went up 2x which led to new client revenue growth of 73% in FY20. f Growth in new accounts is expected to aid in diversification of revenue base and improve growth visibility in the medium- term.
Source: Company; Rsec Research
21 Investment Rationale
Our investment thesis is based on the following premises: Robust Direct Channel to Aid in Sustaining Growth Limited Near-term Downside in DXC/HP Portfolio Deep Dive of Clients’ Portfolio Suggests Stable Credit Quality Limited Exposure to COVID-19 Impacted Verticals Multiple Operating Levers to Aid EBIT Margin Recovery New Client Addition to De-risk Client Concentration
I. Robust Direct Channel to Aid in Sustaining Growth Mphasis’ direct core business (65% of FY23E revenue) comprises of strategically focused client accounts, which are sourced through direct channels (unlike DXC channel). In FY17-FY20, direct core business witnessed robust 14% revenue CAGR vs. India IT industry CAGR of ~7.5%. We believe Mphasis’ outperformance was largely driven by: f Rapid development and constant renewals of offerings f Proactive deal sourcing f Expanding wallet share among the existing accounts Mphasis’ FY20 new generation deal wins grew by almost 2.6x from FY17 level. It added 88 new clients in FY19-FY20 compared to 33 new clients in FY17-FY18. Additionally, it continued to increase its wallet share in strategic accounts with growth in US$100mn/US$75mn/US$5mn client buckets by 1/2/4. Direct international TCV (Total Contract Value) grew by 15% YoY to US$715mn in FY20. Additionally, Mphasis won ~81% of FY20 TCV in next generation services with 50% increase in US$25mn+ size deals. We believe MPHL’s direct core businesses likely to sustain the industry-leading growth in the medium-term on the back of strong deal win momentum in FY20 and focused client mining efforts. We forecast direct core business to clock 8.7% CAGR over FY20-23E.
Exhibit 5: Solid deal momentum to enhance mid-term visibility Exhibit 6: Direct core business drives revenue
Source: Company; RSec Research Source: RSec Research
A. Focus on Continued Renewal of Services to Aid in New Generation Deal Wins: Globally, enterprises are expanding their capability to deliver software-based services, which needs continuous modernization of legacy applications, back-end processes and support systems. As a transformation partner, MPHL has also enhanced its focus on constant renewals and rapid development services. The company has identified 8 key areas of focus i.e. DevOps, Cloud- native App Dev, Legacy Modernization, Enterprise Automation, Next Gen Data, Application Management, Infra Management and Cyber Security. It has accelerated its efforts on IP led solutions on focused areas with multiple in-house application development, IMS and AI/ automation platforms. Additionally, it is continuously evolving its product offerings with increasing partnerships with multiple Cloud providers (AWS, Azure and Google Cloud) and other ecosystem partners. Mphasis wins ~25% of deals through partner ecosystem. In 2018, Mphasis acquired Stelligent, DevOps solution and Continuous Integration/ Continuous (CI/CD) Delivery provider to strengthen Application portfolio.
22 Exhibit 7: Mphasis has stepped up efforts to constantly renew its offerings Particulars Domain teams Set up of cross functional teams as well domain focused team for early engagement Platforms & IP NextSTEP (application development), InfraGenie (IMS delivery platform), Autocode.AI, DeepINsights, HyperGraph(Customer 360 degree analytics), Infragraph (predictive maintenance) Partnerships AWS (Premier consulting partner), Microsoft (Azure), Google cloud GCP (building POC), Quantel (AI), VMware (Modern Applications, integrations), UiPath (RPA) Acquisitions Stelligent (DevOps 2018) Ecosystem NextGen labs (innovation hubs) & SparkelLabs Source: Rsec Research
B. New Accounts & Blackstone Portfolio Companies fuel Growth: In FY19-FY20, Mphasis added 88 new clients in direct channel, which led to new client revenue growth of 73% in FY20. Growth in new accounts is expected to aid in diversification of revenue base and improve growth visibility in the medium-term. Blackstone Private Equity (Mphasis’ parent company) owns portfolio of US$535bn across multiple verticals i.e. real estate, life sciences and infrastructure companies. We note that Blackstone portfolio companies currently contribute ~5% to MPHL’s revenues. We highlight example of Refinitv and Apria Healthcare (Blackstone Portfolio Companies), wherein Mphasis is expanding its wallet share. We believe Blackstone portfolio companies offer huge potential opportunity in the medium-term given their size and number.
Exhibit 8: New client additions went up 2x … Exhibit 9: …Blackstone Portfolio of US$538bn: Strong Opportunity to add new logos
$bn Structure/vertical
Real Estate 161 Core, Debt
Private Equity fund 175 Life Sciences, Infrastructure
Hedge fund solutions 74 GP stake, Seeding, Commingled
Credit & Insurance 128 Insurance, Stressed/distressed
Total 538
Source: Company; RSec Research Source: Blackstone
C. Proactive Deal Process Aids in Wallet Market Share: Mphasis has institutionalized early engagement sales process and robust account planning. It has set up special tribes who have experts with strong domain knowledge and understanding of clients’ business. These tribes help in sourcing new deal upstream. In last two years, Mphasis has won 80%+ deals driven by proactive deal processes. Proactive sourcing aided in improving win rates in new generation technologies and also in expanding wallet share.
D. Healthy Improvement in Client Pyramid led by Expanding Wallet Share: Mphasis reported continuous improvement in client pyramid driven by expansion of wallet share in large clients and consistent new deal wins. In last 12 quarters, it added 1 client in >US$100M bucket and 2 clients in >US$75M bucket during FY18-20. Notably, it added 4 new clients in >US$5M bucket and 15 clients in >US$1M bucket during the same period.
23 Exhibit 10: Improved client pyramid suggests client share gain
Source: Company; Rsec Research
II. Limited Near-term Downside in DXC/HP Portfolio Mphasis derives around 27% of revenue from DXC/HP business, wherein it works as a subcontractor/partner for several projects. Currently, future revenue trajectory of DXC/HP vertical is the major concern for the investors, as DXC is facing growth challenges as well as undergoing restructuring efforts to trim cost. Additionally, Master Service Agreement (MSA) between Mphasis and DXC is due for renewal in Sept 2021, which suggests possibility of client specific one off risk. As per the management, under the MSA, a minimum ~US$300mn revenue commitment is still guaranteed by DXC, which will be consumed by Mphasis until next renewal. In last couple of years, Mphasis has expanded its relationship with DXC as ‘Transformation Projects Partner’ vs. previously being a mere supplier with higher share in transformation deals, which we expect to increase its relevance to DXC’s customer in the medium-term. There are multiple moving parts, which are likely to impact DXC-Mphasis relationship in future and eventually annual run rate of DXC business, going forward. However, we believe subcontractors/partners have become an important part of IT services ecosystem particular that of onsite delivery system. Further, Mphasis has been working with DXC’s customers throughout the last decade (EDS relationship), which are difficult to replace immediately. We believe slower growth trajectory of DXC Technology‘s underlying business is the biggest headwind for Mphasis in the medium-term.
In Base Case scenario, we assume CAGR of -4.7% in DXC/HP revenue over FY20-23E. In Bull Case the scenario, we assume revenue CAGR of 1.2% over the period of FY20-23E, which will lead to EPS accretion of 2.2%-6.2% to our base case estimate. In Bear Case scenario, we assume revenue CAGR of -8.4% over the period of FY20-23E which will lead to EPS decline of 1.9%-3.5% to our base case estimate.
24 Exhibit 11: DXC/UP bull case FY20 FY21E FY22E FY23E CAGR Bull case Revenues $mn 335 318 328 347 1.2% Revenue growth -5% 3% 6% % of total revenues 27.0% 25.8% 24.2% 23.3% EBIT margin 16.0% 15.0% 15.5% 16.0% EPS impact to base case 2.2% 2.6% 6.1% Base Case Revenues $mn 335 301 303 290 -4.7% Revenue growth -10.1% 0.7% -4.3% % of total revenues 27.0% 24.8% 22.8% 20.2% EBIT margin 16.0% 14.5% 15.0% 14.5% EPS impact to base case 0% 0% 0% Bear case Revenues $mn 335 298 286 258 -8.4% Revenue growth -11% -4% -10% % of total revenues 27.0% 24.6% 21.8% 18.4% EBIT margin 16.0% 13.5% 13.5% 13.0% EPS impact to base case -1.9% -3.3% -3.8% Source: Company, RSec Research
A. Understanding DXC-Mphasis Relationship f HP-Mphasis Relationship – At a Glance: In May 2008, HP acquired Electronic Data Systems (EDS) which was holding company of Mphasis. For next few years, Mphasis operated as independent subsidiary of HP. In 2016, HP sold its majority stake in Mphasis to Blackstone Private Equity. As part of agreement, HP and Blackstone entered into a Master Service Agreement (MSA) for 5 years with additional three automatic renewals of 2 years each. Under the MSA, HP committed minimum revenue of US$990mn over next 5 years (September 2016-2021). Additionally, Mphasis was also included in HP’s preferred partner programme with additional revenue opportunities. f DXC Technology – Merger of CSC & Enterprise Services Business of HP: In 2017, DXC Technology was formed by merger of Computer Science Corporation (CSC) and enterprise services business of HP (former parent of Mphasis). The combined entity had revenue of US$25bn, 6,000+ clients and workforce of ~170,000 people. DXC Technology inherited all the legacy contracts from CSC and HP and that’s how Mphasis’ former HP business tied to DXC Technologies performance. B. Luxoft Acquisition – Not an Immediate Threat despite Some Commonalities In January 2019, DXC acquired Luxoft Holdings for US$2bn. Luxoft has specialization in the areas such as Analytics, UX/UI, Internet of Things (IoT) and Blockchain. Luxoft has also brought strong vertical expertise in key industries including automotive, financial services and healthcare and life sciences. In CY18, Luxoft clocked US$911mn revenue out which 55% came from the European region. The investors were apprehensive that Luxoft may soon take away some subcontracting works from Mphasis. However, as per our analysis, despite some commonalties in capabilities between Luxoft and Mphasis, former’s focus always remains on the European banks and automotive sector. We believe DXC’s primary objective of acquisition was geography (Europe) and vertical expansion (automotive). Our analysis of US clients’ profile of both DXC and Luxoft finds no overlapping of top clients. Therefore, there is low probability in short to medium term that Luxoft would become threat to Mphasis in North America geography.
Exhibit 12: Limited commonalities between Mphasis & Luxoft Digital offerings Vertical expertise Partnerships Analytics & BI Automotive AWS UX/UI Finacial services Microsoft Azure IOT Healthcare LG WebOS Blockchain avalog Embedded software Murex Digital cockpit Appian SourceL RSec Research
25 C. Restructuring Plan of DXC Technology Under new management, DXC Technology is executing restructuring plan to revive growth in three parts to bring back growth in core business with cost optimization. f Focus on Customers: DXC has fixed 25 out of 30 problematic accounts. However, it witnessed US$1bn revenue run off in FY20 due to suboptimal delivery. f Cost Optimization: Cost optimization measures include simplifying management layers and right sizing cost structure to revenue. DXC targets to eliminate ~US$700mn cost on annualized basis (US$550mn in 2021). There is special focus on optimizing real estate and subcontractor cost. f Divestments of Non-core Business: DXC also announced divestment of three business units i.e. (1) Workplace & Mobility; (2) US State and Local Health Human Services; and (3) Horizontal Business Process Services. In Mar’20, Veritas Capital acquired DXC’s healthcare business for US$5bn. On 4Q earnings release, DXC’s management had guided that the company is reviewing divestment plan of Workplace & Mobility business in light of amplified demand for Workplace services in COVID-19 scenario (~US$1bn new deal wins). We expect Mphasis has a low single-digit revenue exposure to DXC’s divested business, which is likely to have limited impact on Mphasis’s revenue trajectory.
Exhibit 13: Mphasis has limited exposure to DXC’s divested business
Source: DXC Technology
D. Proactive Expansion of Relationship with DXC Increases Service Relevance Mphasis has been working with DXC to enhance existing relationship from being an ‘outsourcing supplier’ to ‘service transformation partner. It received 75% of revenue from service transformation and App services in 4QFY20 compared to NIL in FY17. DXC constitutes about 88% of DXC/HP revenue in 4QFY20. For Mphasis, ~US$300mn revenue is pending to be consumed by Sept’21. We expect expanding relationship with DXC is likely to increase service relevance of Mphasis in the long-term.
Exhibit 14: Increasing share of transformation business… Exhibit 15: …with geography expansion in America, UK, RoW
Source: Mphasis, RSec Research Source: Company, RSec Research 26 Exhibit 16: Key summary of moving parts between DXC & Mphasis relationship Key moving parts Impact Comments DXC's cost efficiency plan High f Mphasis' share in DXC's subcontractor cost is only~10%. It has been expanding share in transformation and MRC to protect sharp downside. Divestment of non core No impact f Maphasis has low single digit exposure to DXC's revenue. As workplace business divestment plan is under businesses review, we do not expect any impact on Mphasis's. DXC's efforts on fixing problem High f DXC has fixed 25 out of 30 problem accounts. accounts DXC witnessed $1bn revenue run offs due to suboptimal delivery in FY20. DXC fixing this issue is likely benefit to stable contractors such as Mphasis. Luxoft acquisition Low f There are minimal commonalities between DXC & Luxoft's client portfolios. f DXC's objective to acquire Luxoft was to expand in European geography and amplify capabilities in automotive and healthcare industries. DXC's medium term revenue High f Restructuring efforts at DXC is likely to improve its agility in marketplace. DXC growing at market rate would be growth trajectory biggest positive in long run for Mphasis Mphasis expanding High f In last 2 years, Mphasis expanded its relationship to transformation partner from earlier mere 'supplier'. partnership with DXC Master Service Agreement High f Though renewal is automatic we will closely watch for minimum revenue commitment. renewal Under 2016 MSA, on average there was minimum commitment of $198mn annual revenue run rate to Mphasis. Source: RSec Research
III. Deep Dive on Clients Portfolio Suggests Stable Credit Quality We analyzed Mphasis’ visa application trends from public sources and its end customers in the US geography. We also analyzed revenue/EPS growth trajectory of each top customers with change in credit ratings, if any. Our key findings are given in the following. 1. Mphasis’ key 10 customers comprise of financial services providers and insurers. 2. Stable credit quality of key 10 customer indicates strong customer resiliency. 3. Major chunk of EPS decline in key 10 clients comes from technology companies – DXC/HP – which is undergoing restructuring efforts (for whom Mphasis works as a subcontractor/partner). 4. Primary credit deterioration can be seen in a US airline company, which is not a key 10 client and Mphasis is not also among its key 10 IT vendors. Second credit deterioration can be seen for a communication company, which has been recently merged with T-mobile. 5. Mphasis faces major competition from Cognizant, Capgemini and Mastech Technology and other domestic IT players.
Exhibit 17: Visa applications (H-1B) from key clients during Oct-18 to Sept-19 Revenue EPS growth Credit rating Credit rating growth as on as Of Key Customers CY19-22E CY19-22E today Dec/2019 Financial Services 0.1% 0.0% A2 A2 Financial Services -3.0% -10.9% A2 A2 Logistics 1.4% -7.7% Baa2 Baa2 Technology -3.6% -3.6% Baa2 Baa2 Insurance -1.8% 4.2% Baa1 Baa1 Technology -7.7% -19.8% Baa2 Baa2 Financial Services 11.9% 6.0% Baa1 Baa1 Insurance/ Technology Financial Services -2.5% -5.5% A2 A2 Insurance NA NA NA NA Insurance 4.5% -0.4% A3 A3 Communication -2.7% Ba2 NA Semi conductor 1.1% 1.4% Private Co. - Insurance software NA NA NA NA US Airlines -5.6% -25.4% Ba2 Ba2 Financial Services -1.1% 7.4% Baa2 Baa2 Real eastate 5.2% 2.8% NA NA Pharma 0.7% 3.5% A1 A1 Financial Services firm -9.0% -19.8% A2 A2 MNC Media company 3.0% 20.7% Baa2 Baa2 Source: Rsec research, USCIS 27 Exhibit 18: Visa applications (H-1B) from key clients during Oct-19 to March-20 Top 20 clients Whether Mphasis is in key 10 vendors? Other vendors US bank Yes Cognizant, Virtusa, Photon, TCS US broker Yes Infosys, Mastech, Randstand Technologies, Computer Software Group Logistics company Yes Atos, Wipro, Deloitee, GB Tech Insurance company Yes Cognizant, Capgemini, EY, TCS Technology company Yes Hexaware, Opera Technology US bank Yes Persistent, SVS Technology US bank No Deloitte,Cognizant, Infosys, Kforce, Randstand Technology Yes Deloitte, CSC, Infosys, Kforce, Capgemini Insurance company NA TCS Pharma NA NA Insurance company Yes Accenture, Capgemini, Majesco
Telecom company Yes Accenture, IBM, TCS, UST Global US broker Yes EY, Technomax, Cognizant, EPAM US Airline No Birlasoft, CSC Convesys, Infosys, Mastech Technology, TCS US Airline No DXC, Cognizant, InnoCore Solutions, Abacus, Mastech Digital Insurance NA Cognizant, Infosys, DOTS Technolgoy Semi Conductor NA NA Real estate NA Cognizant, Itech
Public services No CGI technology, Cognizant, Mastech Digital consulting Insurance company NA NA Source; Rsec research, USCIS; `Note: Green highlight suggests new entrants
IV. Limited Exposure to COVID-19 Impacted Verticals COVID-19 has put immense pressure on several verticals such as Travel and Hospitality, Energy (low oil prices), Manufacturing and some part of retail verticals, while Financial Services and Insurance verticals have remained relatively less affected. Mphasis generated ~57% of its FY20 revenue from these verticals, which is one of the highest compared to its peers. Our analysis of commentaries from IT services players also suggests relative stability in these verticals. Emerging industries such as Logistics and Transportation, Manufacturing, Healthcare and Pharma and others contributed around 27% to Mphasis’ revenue in FY20. These industries segment grew by 17% in FY20 led by Logistics & Transportation vertical (30% YoY growth). Mphasis has overall just 1% revenue exposure to Airlines vertical, which is one of the hardest hit segment during the current pandemic.
RSec View: Mphasis has relatively limited exposure to COVID-19 impacted verticals. Additionally, higher revenue exposure to financial services/insurance industry (which is comparatively stable) provides comparatively better near-term visibility in direct core business.
Exhibit 19: Mphasis has high revenue exposure to financial services/ Exhibit 20: Emerging industries revenue exposure vertical insurance vertical
Source: Company; RSec Research Source: Company, RSec Research 28 Low interest Environment is Tailwind to Digital Risk Business: Mphasis acquired ‘Digital risk’ business in 2012 for US$175mn, which works under three business segments: f Managed Services: End-to-end services regarding origination, purchase, sale and securitization support. f Technology Solutions: Platforms i.e. Mortgage loan routing accelerator to loan cycle time. f Risk & Compliance: Provide legal and compliance services (KYC, AML, on boarding though investigations). Digital Risk’s suite is deployed by over blue chip clients across key mortgage constituencies – Originators, Insurers, Issuers and Investors. Digital risks mortgage origination business performance is linked to cost of financing. It reported subdued revenue growth in last few years due to rising interest rate in e US and client-specific issues. We believe interest rates going back to near zero levels to provide structural tailwind to business, as demand for new loans and refinancing to go up.
Exhibit 21: Low interest rate environment is positive for digital risk business
Source: RSec Research
V. Multiple Operating Levers to Aid EBIT Margin Recovery Mphasis reported 16% margin in FY20 (110bps higher from FY17 level) on the back improved operating efficiency led by higher utilization, expanding billing rates on rising digital share and increasing fixed price contracts. In FY20, the company managed to remain in the guided EBIT margin band of 15.5%-17% on the back of strong execution focus. Looking ahead, Mphasis can optimize subcontractor cost, which is 13%of FY20 revenue in case of any onsite revenue run offs. We believe Mphasis has ample margin levers to address pricing pressure and protect EBIT margin. Despite COVID-19 challenges, the management targets to remain in EBIT margin band of 15.5% and 17% which we believe is encouraging, while more visibility is expected in 1QFY21 earnings conference call.
Exhibit 22: Cost optimization efforts and higher digital pricing to aid Exhibit 23: Scope to improve utilization in application services/ in margin recovery in FY21E/FY22E BPO in the medium term
Source: RSec Research Source: RSec Research
29 A. Improved Onsite Billing Rate on Increasing Digital Share: Currently, Mphasis generates more than 50% revenue from new age services, which has helped the company in expanding onsite billing rate by almost 30% in last four years. Onsite billing rate for ITO services also grew by 15% during the same time. Strong growth in onsite billing rate was a key component of margin rebound post FY19, in our view. Offshore billing rate growth remained comparatively softer, as the offshore cost mostly remained in INR.
Exhibit 24: Onsite billing rate improved due to rise of digital revenues Exhibit 25: …whereas offshore billing rate remains stagnant
Source: RSec Research Source: RSec Research
B. Expanding Share of Fixed Price Contracts: Mphasis has proactively improved the share of fixed price contract revenues by 900bps since FY16. Additionally, around 15% of time and material (T&M) contract also come from fixed contract bucket. The company has relatively lower fixed price revenue share (26%) vs. peers (>50%). We believe there is a large scope in the medium-term to improve the share of fixed price contract, which will lead to improved operating efficiency.
Exhibit 26: Share of fixed price contracts are on the rise
Source: Business Today
VI. New Client Addition to De-risk Client Concentration Top-10 clients (mostly banks and insurance companies) contributed ~60% to Mphasis’ FY20 revenue, making the company vulnerable to client-specific events. In order to ward off this structural weakness, It has been focusing on new client addition and ramping-up US$5mn+/ US$10mn+ client bucket. The company has also been focusing on to increase its European presence, which led to 13.8% growth in European business in FY20 (ahead of its average growth of 10.9%). Strong new client addition and a robust 17% YoY growth in emerging industries in FY20 suggest proactive efforts by the management to de-risk vertical as well as top-10 client concentration.
30 Exhibit 27: New client additions to help in de-risking Mphasis’s top- Exhibit 28: America accounts for ~60-70% revenue of key IT 10 client concentration companies
Source: RSec Research Source: RSec Research
Mphasis looks attractive on dividend yield screen Mphasis screens well on dividend yield in comparison to other IT companies on the back of higher dividend payout ratio and strong FCF generation. We believe Mphasis is likely to continue with 50%+ payout ratio in the medium term.
Exhibit 29: India IT dividend yield comparison
Source: Rsec Research, Bloomberg
31 Outlook & Valuation
Looking ahead, we expect the company’s healthy direct core business (65% of FY23 revenue) to outweigh concerns around DXC business and drive USD revenue growth of 9.2%/8% and EPS growth of 12.8%/10.6% in FY22/FY23. Robust deal wins in FY20 (up 16% YoY) and stable credit quality of client portfolio limits near-term downside. Currently, the stock trades at 20% discount to peer set (L&T Infotech, MIndtree & Hexaware) vs. historical average discount of 9% owing to DXC business overhang. We forecast DXC/HP business (20% of FY23E) to witness negative 4.6% CAGR over FY20-23E. Mphasis deserves multiple rerating considering industry leading CAGR of 8.6% in direct core business, EBIT margin and attractive dividend yield of 5.3% (FY23E). We assign 15.8x PE on FY23 earnings at par with peer group. We initiate coverage on Mphasis with BUY and a 2-Year Target Price of Rs1,200, which implies 20% upside from the current level.
Exhibit 30: Mphasis Band Chart Exhibit 31: Due to DXC concerns, Mphasis’ 1-Yr fwd PE is trading at 20% discount to peer set
Source: Company; RSec Research Source: Company, RSec Research
Exhibit 32: Reverse DCF analysis suggests slender growth margin exceptions, we believe stock warrants rerating
Revenue $ FY17-FY20 11.5% FY20-FY23E 5.0% FY23E-FY30E 4.1% Terminal growth rate 0.0%
EBIT Margin FY20-FY23E 15.4% FY23E-FY30E 13.5%
WACC 12% Price objective Rs 1,200 Source: Company, RSec Research
32 Key Financials Profit & Loss Statement Year ending March (Rs mn) FY19 FY20 FY21E FY22E FY23E Net Revenues (US$ mn) 1,118.0 1,239.6 1,215.4 1,327.8 1,433.5 Growth (%) 13.0 10.9 (2.0) 9.2 8.0 Net Revenues 77,311 88,436 91,155 99,582 1,07,516 Growth (%) 18.1 14.4 3.1 9.2 8.0 Employee Costs & Other expenses 55,754 62,951 66,195 71,598 77,005 SG&A and Other Operating Expenses 8,317 8,980 8,799 9,958 10,967 EBITDA 13,240 16,505 16,160 18,025 19,544 EBITDA (%) 17.1 18.7 17.7 18.1 18.2 EBITDA Growth (%) 24.6 24.7 (2.1) 11.5 8.4 D&A 759 2,318 2,370 2,589 2,795 EBIT 12,481 14,187 13,790 15,436 16,749 EBIT (%) 16.1 16.0 15.1 15.5 15.6 EBIT Growth (%) 25.9 13.7 (2.8) 11.9 8.5 Other Income 1,592 967 1,192 1,468 1,954 PBT 14,073 15,154 14,982 16,904 18,703 Tax (incl deferred) 3,339 3,730 3,596 4,057 4,489 Exceptional 0 0 0 0 0 PAT 10,734 11,424 11,386 12,847 14,214 PAT Growth (%) 28.2 6.4 (0.3) 12.8 10.6 EPS 55.5 60.8 60.6 68.4 75.7 EPS Growth (%) 30.3 9.6 (0.3) 12.8 10.6
Balance Sheet Year ending March (Rs mn) FY19 FY20 FY21E FY22E FY23E SOURCES OF FUNDS Share Capital - Equity 1,862 1865 1,865 1,865 1,865 Reserves 50,636 56431 61,294 67,617 74,376 Total Shareholders' Funds 52,498 58296 63,159 69,482 76,241 Debt 5,428 5714 5,714 5,714 5,714 Lease liabilities 28 7378 7,378 7,378 7,378 Total Debt 5,456 13092 13,092 13,092 13,092 Current Liabilities 11,687 12769 14,023 14,632 15,887 Provisions 3,100 2242 2,952 2,613 2,837 Total Current Liabilities 3,100 2242 2,952 2,613 2,837 TOTAL SOURCES OF FUNDS 72,741 86399 93,226 99,819 1,08,057 APPLICATION OF FUNDS Goodwill 19,585 21405 21,405 21,405 21,405 Net Block 2,113 2494 2,020 1,602 1,258 CWIP & Right to use assets 406 6789 6,078 5,301 4,463 Investments 13,292 13257 13,257 13,257 13,257 Deferred Tax Assets 814 2157 2,157 2,157 2,157 LT Loans & Advances, Others 12,272 11866 11,866 11,866 11,866 Total Non Current Assets 48,482 57968 56,783 55,588 54,405 Debtors & Unbilled Revenues 17,687 16947 20,911 21,425 23,263 Cash & Bank 6,572 11484 15,532 22,806 30,388 Total Current Assets 24,259 28431 36,443 44,231 53,651 TOTAL APPLICATION OF FUNDS 72,741 86399 93,226 99,819 1,08,057
33 Cash Flow Statement Year ending March (Rs mn) FY19 FY20 FY21E FY22E FY23E PBT 14,073 15,154 14,982 16,904 18,703 Non-operating & EO items -486 -721 0 0 0 Depreciation 758 2,316 2,370 2,589 2,795 Working Capital Change -1,421 423 -2,000 -244 -359 Income Tax paid -3,427 -3,960 -3,596 -4,057 -4,489 Cash Flow from Operations (a) 9,497 13,212 11,756 15,192 16,651 Capex -815 -1,243 -1,185 -1,394 -1,613 Acquisitions -1,696 0 0 0 0 Change in Investments 5,404 2,651 0 0 0 Cash Flow from Investing (b) 2,893 1,408 -1,185 -1,394 -1,613 Debt Issuance/(Repaid) 1,082 -2,333 0 0 0 Share capital Issuance/(buyback) -9,845 151 0 0 0 Dividend -4,653 -6,065 -6,523 -6,524 -7,456 Cash Flow from Financing (c) -13,416 -8,247 -6,523 -6,524 -7,456 NET CASH FLOW (a+b+c) -1,026 6,373 4,048 7,274 7,583 EO items, others -97 -10 0 0 0 Closing Cash Balance 3,519 9,882 13,930 21,204 28,786 Free Cash Flow 8,682 11,969 10,571 13,798 15,038
Key Ratios Particulars FY19 FY20 FY21E FY22E FY23E Profitability (%) EBITDA Margin 17.1 18.7 17.7 18.1 18.2 EBIT Margin 16.1 16.0 15.1 15.5 15.6 APAT Margin 13.9 12.9 12.5 12.9 13.2 RoE 18.5 21.3 20.6 21.2 21.4 RoCE 18.4 18.3 15.4 16.2 16.5 ROA 15.0 16.6 14.3 14.3 14.7 Efficiency Tax Rate (%) 23.7 24.6 24.0 24.0 24.0 Debtors (days) 38 29 36 34 36 Unbilled Receivables (days) 40 40 44 41 43 Current Liabilities (days) 51 52 54 52 54 FCF/NI (%) 80.9 104.8 92.8 107.4 105.8 Net Debt/EBITDA (x) (1.1) (0.7) (1.0) (1.3) (1.6) Net Debt/Equity (x) (0.3) (0.2) (0.2) (0.3) (0.4) Per Share Data (Rs) EPS 55.5 60.8 60.6 68.4 75.7 DPS 27.0 35.0 35.0 40.0 47.0 BV 271.4 310.4 336.3 370.0 406.0 FCF 35.2 45.3 64.2 56.7 74.0 Valuation (x) P/E 18.0 16.4 15.1 13.4 12.1 P/BV 3.7 3.2 3.0 2.7 2.5 EV/EBITDA 13.3 10.9 10.8 9.5 8.3 FCF/EV (%) 6.1 6.4 6.5 7.5 8.7 FCF/mkt cap (%) 4.5 6.4 5.7 7.4 8.1 Dividend Yield (%) 2.7 3.5 3.5 4.0 4.7
34 Company Background
Bangalore-based Mphasis is an IT service company that provides IT, business consultancy and outsourcing services to global corporations across financial services, insurance, telecom, logistics, and technology industries verticals. In revenue terms, the company was ranked at #7 among India’s IT companies in 2019. The company operates 60+ delivery and sales centers in 19+ countries with delivery centers in India, China, Australia, Japan, North America and Europe. In India, Mphasis has operations Bangalore, Chennai, Pune, Hyderabad, Mumbai, and Mangalore. Mphasis was formed in June 2000 after the merger of the US-based IT consulting company Mphasis Corporation the Indian IT services company BFL Software Limited (founded in 1992). In 2006 Electronic Data Systems (EDS) bought a controlling stake in the company and operated the company as an independent EDS unit. In 2008, Hewlett-Packard acquired EDS and Mphasis became a HP subsidiary. HP owned ~ 62% of Mphasis and contributed 50%+ of its revenues. In 2016, Blackstone group (PE firm) acquired controlling stake from HP and since then Mphasis has been a Blackstone group company.
Revenue break-up by verticals Revenue break-up by geography
India 5% RoW 6%
EMEA 11%
America 78%
Source: Company; RSec Research Source: RSec Research
Revenue break-up by client brackets Revenue break-up by geographies
Knowledge License Income Processes 0% 9% Revenue Infrastructure from Top Management client, 14% Services 13% Application Rest of the Maintenance clients, 40% Transaction 30% Processing Revenue from 6- Service 10 client, 34% 7% Service / Revenue Technical Help from 11-15 Desk Application client, 12% 7% Customer Service Development 1% 33%
Source: Company; RSec Research Source: RSec Research
35 Milestones Year Milestone/Achievement 1998 Mphasis begins as high end technology architecting firm 2004 Mphasis acquired Kshema Technologies &Onida Info Tech Exceeds $ 100Mn in revenue 2006 Acquired Princeton Consulting & Eldorado Computing EDS acquires 62% stake in Mphasis 2008 Hewlett-Packard (HP) acquires EDS and Mphasis 2009 Mphasis acquired AIG Software Solutions EDS re-branded to become HP Enterprise 2010 Mphasis reaches $1bn in revenues 2010 Mphasis global expansion - Sri Lanka, Australia & Poland Mphasis acquired Fortify IS 2011 Mphasis acquires WYDE 2013 Mphasis acquires Digital Risk LLC 2015 Launch of NextAngles- automation led compliance product. Launch of NEXTLabs solution - HyperGraf &InfraGraf 2016 Launch of DeepInsightsMachine Learning platform 2016 Blackstone acquires ~61% stake in Mphasis from HP 2017 Launch of Front-to-Back (F2B) Transformation Strategy Source: Company, Rsec Research
Management Team Name Designation Brief Profile Mr. Nitin Rakesh CEO f Prior to joining Mphasis, Mr. Rakesh was the Chief Executive Officer and President of Syntel. Nitin has deep domain expertise in Technology,Banking, Financial Services and Insurance verticals. f He holds a Bachelor's degree in Engineering (Computer Science) from Delhi Institute of Technology, Delhi University and has received his Master’s in Management from Narsee Monjee Institute of Management Studies, Mumbai and is also an alumni of Harvard Business School’s CEO workshop. MR. Dinesh Venugopal President – Mphasis f Mr. Venugopal has over 20 years+ of cross-functional leadership experience spanning strategy, technology Direct And Digital innovation, M&A, and marketing. He holds a master's degree in computer science from the University of Louisiana. MR. Elango R President – DXC & f Mr. Elango heads sales and delivery of all business lines in Hewlett Packard (HP) channel. Elango has Hi-Tech SBU completed an advanced management program from INSEAD. Mr.Sundar President Global f Mr. Subramanian has spearheaded successful global delivery, consulting, operations, and people Subramanian Delivery management functions. In his most recent role at Cognizant, where he spent over 14 years, Sundar was a member of the executive leadership team and steered the global delivery function for healthcare. Mr. Srikanth Karra Chief Human f Mr. Karra is an industry veteran and seasoned human resources (HR) officer with close to 30 years’ Resource Officer experience in business-focused, innovative, HR systems and processes. Mr. Manish Dugar CFO f MR. Dugar Joined in May-20; His past stints include CFO of Wipro Technologies, CEO of Wipro’s BPO business, among others. Source: Company, Rsec Research
36 Institutional Equity Research CMP* (Rs) 2,269 Upside/ (Downside) (%) 12 L&T Infotech Bloomberg Ticker LTI IN BUY IT | India Market Cap. (Rs bn) 398 2 Year Target Price: Rs.2,550 Free Float (%) 54 Initiating Coverage | 20 July 2020 Shares O/S (mn) 176
Consistent Growth Compounder Research Analyst: Key Triggers Sustained industry-leading revenue growth led by digital acceleration Suyog Kulkarni, ACA, CFA Contact : (022) 4303 4000 / 9890966735 Best-in-class clientele base across verticals and geographies Email : [email protected] Improving ecosystem outreach through newer partnerships and acquisitions Strong engineering parentage and joint selling opportunities with group companies Execution focused management with prudent capital allocation policy
1. L&T Infotech (LTI) – the sixth largest Indian IT services company in revenue terms – offers Share price (%) 1 mth 3 mth 12 mth Analytics & Information Management, Enterprise Integration, Applications Management, Absolute performance 20.9 57.0 44.9 Cloud Computing, Testing, and Consulting Services to global clients. Relative to Nifty 12.9 39.4 50.9 2. Its revenue clocked 15% CAGR (>1.5x of industry average) over last four years driven by consistent new client additions and wallet share gains. Looking ahead, we expect LTI Shareholding Pattern (%) Dec'19 Mar'20 to maintain its leadership position on revenue growth front driven by robust large deal Promoter 74.6 74.5 wins, new client additions and vertical-focused client mining efforts. Public 25.4 25.5 3. LTI enjoys diversified customer bases across geographies and verticals. Our deep dive on LTI’s key 20 US client’s portfolio suggests relatively stable credit quality post COVID-19 1 Year Stock Price Performance pandemic. 2400
4. Strong leadership team, stable margin and healthy dividend yields (2.3% in FY23E) 2200 supported by solid RoE make the stock a compelling investment proposition. 2000
1800
The COVID-19 Impact: LTI is expected to witness pressure on revenue as well as margin front in 1600 the near-term owing to COVID-led disruptions. It is in discussions with selective clients on specific 1400 time-bound commercial concessions for renewals and existing book. The management expects 1200 19 19 19 20 20 20 20 ------Jul Jul Sep Nov Jan Mar mid-single digit sequential decline in USD revenue growth in 1QFY21 with revenue growth recovery May in 2HFY21. It expects a slight increase in receivables for a temporary period. LTI 1 year share price chart
Note: * CMP as on 17 July 2020 Outlook & Valuation LTI seems to be well-placed to capture demand recovery once COVID-19 challenges on technology spend starts retreating. We believe LTI should continue to warrant premium valuation vis-à-vis peers on the back of its consistent industry-leading growth backed by execution focused stable management, diversified client base, robust new logo addition and client mining efforts. We initiate coverage on LTI with BUY and a 2-Year Target Price of Rs2,550 (based on a PE of 20.5x on FY23E earnings).
Year Ending March FY19 FY20 FY21E FY22E FY23E Net Sales 94,458 1,08,786 1,19,970 1,33,651 1,48,049 EBIT 17,363 17,563 19,973 22,231 25,069 PAT 15,156 15,384 16,290 18,916 21,787 Diluted EPS (Rs) 86.4 87.6 92.9 107.8 124.2 P/E (x) 26.3 25.9 24.4 21.0 18.3 RoE (%) 34.6 29.9 27.3 26.6 26.1 Dividend Yield (%) 1.2 1.2 1.3 1.9 2.1
Source: Company, RSec Research 37 Our Thesis
f Consistent Growth Outperformer: Its revenue clocked 15% CAGR (>1.5x of industry average) over last four years driven by consistent new client additions and wallet share gains. Looking ahead, we expect LTI to maintain its leadership position on revenue growth front driven by robust large deal wins, new client additions and vertical- focused client mining efforts.
f Diversified Customer Base: LTI enjoys diversified customer bases across geographies and verticals. Our deep dive on LTI’s Top-20 US client’s portfolio suggests relatively stable credit quality post COVID-19 pandemic.
Key Investment Themes f Stable Leadership: Strong leadership team, stable margin and healthy dividend yields (2.3% in FY23E) supported by solid RoE make the stock a compelling investment proposition.
f Outlook & Valuation: LTI seems to be well-placed to capture demand recovery once COVID-19 challenges on technology spend starts retreating. We believe LTI should continue to warrant premium valuation vis-à-vis peers on the back of its consistent industry-leading growth backed by execution focused stable management, diversified client base, robust new logo addition and client mining efforts. We initiate coverage on LTI with BUY and a 2-Yr Target Price of Rs2,550 (based on a PE of 20.5x of FY23 earnings).
f Slower-than-expected rebound in technology budget in light of recessionary pressure. f Key Risks Possibilities of longer term ban on US H-1B visas may slowdown project ramp-up. f High client concentration. f Appreciation of INR against USD.
EPS & Target Price
Source: Company, RSec Research
Price Sensitivity Analysis EPS (Rs) Growth (%) FWD PE 17 18 19 20 20.5 21 FY17 (-3) 55.8 40.7x 949 1,004 1,060 1,116 1,144 1,172 FY18 (-2) 66.20 18.6% 34.3x 1,125 1,192 1,258 1,324 1,357 1,390 FY19 (-1) 86.43 30.6% 26.3x 1,469 1,556 1,642 1,729 1,772 1,815 FY20 (Base Year) 86.61 0.2% 26.2x 1,472 1,559 1,646 1,732 1,776 1,819 FY21 (Year 1) 92.88 7.2% 24.4x 1,579 1,672 1,765 1,858 1,904 1,950 FY22E (Year 2) 107.85 16.1% 21.0x 1,833 1,941 2,049 2,157 2,211 2,265 FY23E (Year 3) 124.21 15.2% 18.3x 2,112 2,236 2,360 2,484 2,550 2,608 Soure: RSec Research 38 Management Meet – Key Takeaways f Pricing Pressure: LTI is in discussions with selective clients on specific time-bound commercial concessions both for renewals and existing book. Most of these clients are from Manufacturing and Energy verticals. As per the company, pricing environment remains largely stable barring few selective clients. f Impacted Verticals: Manufacturing and Energy are the most impacted due to COVID-19 pandemic and record low oil prices. f Work from Home (WFH): LTI is in discussion with few clients for implementing WFH, but it is very early to derive any medium term trend. f Credit Quality Measures: LTI expects a marginal increase in receivables for a temporary period. It has undertaken stringent credit quality measures for receivable management with well-defined exposure limits.
39 The COVID-19 Impact f Business Continuity: In early February 2020, LTI internally circulated business continuity guidelines to enable work planning following which Work from Home (WFH) initiative was started in mid-March. In accordance with the lockdown directives, the company closed all offshore facilities from March 25, 2020. LTI could manage to reach 95% deployment level through WFH-enablement within a week of the lockdown, which increased to 99% subsequently. f Productivity: LTI highlighted minimum disruptions to delivery through WFH, barring a few sensitive projects. During lockdown, the company has also witnessed improvement in employees’ productivity in few verticals. f Demand Scenario: Manufacturing and Oil & Gas verticals seem to have highly impacted by COVID-led disruptions. Looking ahead, LTI expects steady performance from CPG & Pharma, Media and Hi-tech verticals, as these businesses are better-placed. Whilst BFSI vertical is yet to see any impact, LTI expects some issues such as defaults and higher provisions etc., which might arise in 2QFY21/3QFY21. Notably, LTI has no exposure to Travel & Hospitality vertical. f Deal Pipeline: Despite some delays and deferrals in deal pipeline, the management is optimistic to close some large deal wins in 2QFY21.
40 A Snapshot of 1QFY21 Performance f L&T Infotech’s revenue (in constant currency terms) declined by 4.7% QoQ to US$390.3mn in 1QFY21 vs. consensus estimate of mid-single digit decline. f EBIT margin stood at 17.4% in 1QFY21 compared to 16.7% in 4QFY20. f Vertical-wise, revenue from Manufacturing / Energy & Utility / BFS / Insurance / Retail, CPG & Pharma witnessed QoQ decline of 16.4% / 10.5% / 4.1% / 2.7% / 1.9%. While revenue from High-Tech, Media & Entertainment remained flat (down 0.1% QoQ), Others vertical witnessed 31.1% QoQ growth. f Deal pipeline remained strong (up 19% YoY) during the quarter. Deal pipeline is holding up barring Oil & Gas and Manufacturing verticals. While deals are getting longer time to close, activity on large deal front remained healthy. f The company added 16 new logos during the quarter. It also won one large deal worth US$20mn in BFS segment in the UK. f As per the management, demand for capability-based niche IT players to enterprises likely to continue, going forward. f Currently, 99% of employees are working from home. The company is expected to open office in calibrated manner. LTI will operate its facilities at 30-50% workforce capacity in the medium-term. f Work from home has some limitations on sales and marketing front, as some degree of face-to-face conversation is needed. Thus, business related travel expenses will start once the current COVID-led disruptions recede. f The company offered some time-bound concessions/one-time discount during the quarter, which will play out in coming quarters. f The management expects 2QFY21 to remain flat with positive bias.
1QFY21 Result Table 1QFY21 4QFY20 QoQ (%) 1QFY20 YoY (%) Revenues $ 390.3 409.9 -4.8 356.5 9.5 USD/INR 75.6 73.5 -9.0 69.7 8.4
Revenues INR 29,492 30,119 -9.1 24,849 18.7 Employees cost (19,916) (20,251) -9.1 (16,625) 19.8 Gross Profit 9,576 9,868 -9.1 8,224 16.4 Other expenses (3,656) (4,086) -9.2 (3,645) 0.3 EBITDA 5,920 5,782 -9.0 4,579 29.3 D&A (781) (747) -9.0 (610) 28.0 EBIT 5,139 5,035 -9.0 3,969 29.5
Other income/(expenses) 450 479 -9.1 812 -44.6 Profit before Tax 5,589 5,514 -9.0 4,781 16.9 Tax (1,425) (1,239) -8.9 (1,225) 16.3 PAT 4,164 4,275 -9.1 3,556 17.1 EPS 23.7 24.3 -9.1 20.3 17.0
EBITDA 5,920 5,782 4,579 EBIT 5,139 5,035 3,969 Net Income 4,164 4,275 3,556 EPS 23.74 24.30 20.29
Margin Gross Profit 32.5% 32.8% 33.1% EBITDA 20.1% 19.2% 18.4% EBIT 17.4% 16.7% 16.0% Net Income 14.1% 14.2% 14.3% Source: Company, RSec Research
41 Company Comparative Analysis
LTI Mindtree Investment View f India's 6th largest IT services company. f India's 8th largest IT services company.
Business View f LTI to outperform vs peers driven by execution f Mindtree is likely to witness softer revenue acceleration focused management, diversified client portfolio driven by high exposure to T&H and top client and strong deal wins. concentration risk.
Financials (Rs Mn) FY20 FY21E FY22E FY23E FY20 FY21E FY22E FY23E Revenues 1,08,786 1,19,970 1,33,651 1,48,049 77,643 77,933 84,210 91,016 EBIT 17,563 19,973 22,231 25,069 8,144 11,220 11,831 13,135 Adj PAT 15,384 16,290 18,916 21,787 6,309 8,493 9,122 10,233 Growth (%) Revenues 15.2 10.3 11.4 10.8 10.6 0.4 8.1 8.1 EBIT 1.2 13.7 11.3 12.8 -9.6 37.8 5.4 11.0 Adj PAT 1.5 5.9 16.1 15.2 -16.3 34.6 7.4 12.2 Margin (%) EBIT 16.1 16.6 16.6 16.9 10.5 14.4 14.0 14.4 Adj PAT 14.1 13.6 14.2 14.7 8.1 10.9 10.8 11.2 Per Share (RS) EPS 87.6 92.9 107.8 124.2 41.7 51.6 55.4 62.1 DPS 28.0 29.0 42.0 48.0 13.0 13.0 17.5 20.0 Book value 307.9 372.3 438.4 515.0 191.6 230.2 268.1 310.2 Valuation (x) P/E 25.9 24.4 21.0 18.3 24.4 19.8 18.4 16.4 EV/EBIT 21.6 18.5 16.2 13.9 19.7 14.0 12.8 11.2 P/BV 7.4 6.1 5.2 4.4 5.3 4.4 3.8 3.3 Div Yield (%) 1.2 1.3 1.9 2.1 1.3 1.3 1.7 2.0 Return Ratio (%) ROCE (%) 27.4 23.7 23.6 23.5 18.1 21.4 19.8 19.5 ROE (%) 29.9 27.3 26.6 26.1 19.1 26.9 24.1 23.2 Source: Company; RSec Research
42 Key Charts
f LTI’s revenue grew by 3.8% QoQ in last 17 quarters driven by Exhibit 1: LTI reported strong revenue growth in FY16-FY20 backed by step up in new client additions. digital acceleration f Digital business grew at 2x of company growth rate at ~7.9% CQGR.
Exhibit 2: Revenue growth ($) comparison among Indian IT companie f LTI outperformed its Indian mid-cap/large-cap peers in terms of consistent revenue growth.
Source: Company, RSec Research
Exhibit 3: LTI Large deal win f LTI won large deal of US$332mn (62% YoY) in FY20. Most of these large deal wins are of annuity nature, which provides medium-term growth revenue visibility.
Source: Company, RSec Research
Exhibit 4: Robust new logo additions among mid-cap peers f LTI’s focused group such as ‘must have accounts’ specifically focuses on exploring new logos. f Since 1QFY18, LTI added 223 new logos compared to 156 and 218 by Mphasis (both direct core and DXC/HP channel) and Mindtree.
Source: Company, RSec Research 43 Investment Rationale
Our investment thesis is based on the following premises: Sustained industry-leading Revenue Growth led by Digital Acceleration Our Deep Dive on Top-20 US Clients Suggests Stable Customer Credit Quality Proactive Efforts to Strengthen Offerings via M&A & Ecosystem Partnerships Scores Well on Vertical Diversification/Client Concentration Strong Engineering Heritage & Synergy Opportunities with Subsidiaries
I. Sustained Industry-leading Revenue Growth led by Digital Acceleration In last four years, LTI’s revenue clocked ~15% CAGR driven by: (1) large deal wins momentum (21 large deal wins across the verticals and large deal TCV crossed US$1bn+ in last 3 years); (2) strong new account openings (on average LTI opened 60 new client accounts in last 3 years, while 96 new logos added in FY20); and (3) focus on client mining efforts (ramping up US$20mn/ US$50mn client bucket from 10/3 in FY16 to 16/6 in FY20). LTI’s revenues grew by 3.8% QoQ for last 17 quarters driven by higher digital offerings and regular expansion in ecosystem partnership. Since Initial Public Offering (IPO) in FY16, LTI outperformed its Indian mid-cap/large-cap peers in terms of consistent revenue growth. LTI seems to be well-placed to cash in likely demand recovery post COVID-19 headwind led by higher technology spend. We expect LTI to continue its outperformance on the back of execution focused stable management, impressive sales and marketing team and expanding digital offerings. We expect LTI to report USD revenue growth of 4.7%/11.6%/10.8% in FY21E/FY22E/FY23E.
Exhibit 5: LTI reported strong revenue growth in FY16-FY20 backed Exhibit 6: LTI outperformed its peers in revenue growth rate in by digital acceleration each year since FY17
Source: Company Data; RSec Research
A. Aggressive Multi-layered Sales Programme – Secret Sauce of Success: LTI’s secret sauce of success is its aggressive sales and marketing strategy of opening new accounts, scaling-up these accounts and continuously winning large deals. In last three years, LTI has launched multiple aggressive sales campaigns, which aided in consistent top-line growth. Within the organization, LTI has also formed different focused groups. Programme i.e. “Aspire” and “Minecraft” specifically focuses on winning large deals and growing top accounts, respectively. LTI has won digital deals from 70% of total client base driven by special accounts mining efforts Analytics & Digital in Every Account (ADEA) initiative. Looking ahead, we expect LTI to continue to invest in sales and marketing teams as well in order to expand vertical and geographical reach.
44 Exhibit 7: Key sales programme Program Objective Result Aspire Win large deals 21 large deals in last 3 years Minecraft Grow top accounts accounts in $20mn/$50mn bucket Must have accounts Open new logos 96 new logos added in FY20 vs last 3 years average ~60 ADEA Analytical digital every account Digital deals are part of ~70% of the accounts Million Dollar Club $1mn plus clients From 96 accounts in FY17 MDC grew to 135 accounts in FY20 Strategic alliances Key sales/growth channel SAP, Microsoft, Oracle, AWS, Google, IBM, Servicenow Marketing Brand development & pipeline building Strong deal pipeline Source: Company, RSec Research
B. Robust Deal Wins Offers Decent Medium-term Revenue Visibility: LTI has won more than 21 large deals since 1QFY17 with combined total contract value of >US$1bn. It has proactively used programme i.e. ADEA initiative to increase to increase its digital share in new deals. It also added digital work quotient in primary legacy accounts. Currently, digital deals are part of ~70% of total accounts, which is encouraging, in our view. Notably, LTI won large deal of US$332mn (62% YoY) in FY20. Most of these large deal wins are of annuity nature, which provide medium-term growth revenue visibility. LTI’s focused group such as ‘must have accounts’ specifically focuses on exploring new logos. Since 1QFY18, LTI added 223 new logos compared to 156 and 218 by Mphasis (both direct core and DXC/HP channel) and Mindtree, respectively. Additionally, since 1QFY18, LTI added 10 new logos with large multi-year deals, which suggest increasing awareness of LTI capabilities and strong performance of large deal sales team. We expect a very limited impact of COVID-19 on LTI’s revenue, as large deals won in 2HFY20 are likely to ramp-up in FY21.
Exhibit 8: Improving large deal win trajectory Exhibit 9: LTI reported large deal wins/added new logos across all verticals
Large deal New logos
BFS 5 1
Energy & Utilities 6 3
CPG, Retail, Pharma 4 1
Insurance 2 2
Manufacturing 1
Others 3 3
Total 21 10
Source: Company Data; RSec Research
Exhibit 10: LTI reported robust new logo additions among mid-cap Exhibit 11: ...which led to step up in $1mn client bracket peers…
Source: Company Data; RSec Research 45 C. Impressive Client Up-scaling Expertise to Drive Wallet Share: We believe LTI’s ability to scale-up in customers IT ecosystem is a key differentiator. LTI has shown impressive performance in client up-scaling and added 18/10/6 clients in US$10mn+ / US$20mn+ / US$50mn+ client buckets. As Mindtree focuses on tail accounts management, LTI comparatively looks well on customer retention. LTI lost only 15 clients in FY20, which is mere 4% of total customers (424) as of March 31, 2020
Exhibit 12: LTI reported impressive client up-scaling since FY16… Exhibit 13: …with strong customer retention
Source: RSec Research
II. Our Deep Dive on key 20 US Clients Suggests Stable Customer Credit Quality We analyzed LTI’s key 20 US clients on the basis of H-1B applications during Oct-18 to Sept-19. Our analysis suggests relatively stable credit quality of client portfolio since Dec-19. We also analyzed revenue/EPS growth trajectory of each top customer with change credit ratings if any to determine customer resiliency.
Our key findings are given in the following. 1. LTI’s pool of key 10 customer predominantly comprises of clients from diversified sectors i.e. Banking, Insurance, Energy, Telecom & Media and Manufacturing, which we believe reduces vertical concentration risk. 2. Our analysis suggests stable credit quality of key 10 customers (above investment grade), which directs to strong customer portfolio resiliency. 3. Major chunk of EPS decline in Top-10 customer comes from select manufacturing customers. 4. Consensus EPS (CY19-CY22) of banks and insurers is largely stable, whereas, telecom and pharma companies are expected to continue stable EPS growth. 5. Our analysis suggests LTI faces major competition from Virtusa Technology, Cognizant, Infosys and TCS in financial services vertical whereas major competition in manufacturing vertical comes from HCL Technologies (HCLT), Accenture and Cognizant. 6. There is only one common client between LTI and MIndtree i.e. Global CPG company in key 20 clients.
46 Exhibit 14: Applications for Oct 2018-September 2019 Top 20 Clients (on the basis Revenue CAGR EPS CAGR Current Credit rating of applications) CY19-22E CY19-22E Credit rating (Dec 2019) US bank -0.2% 3.1% A3 A3 Insurance 2.8% 3.4% A2 A2 Energy -2.6% -7.4% Aa2 Aa2 CPG 3.7% 4.3% Aaa Aaa Insurance 3.7% 6.7% Baa1 Baa1 Telecom 6.3% 12.3% Aa1 Aa1 Technology -0.2% 2.9% A1 A1 Manufacturing -1.0% -16.8% Baa1 Baa1 Media & Entertainment 0.0% -4.5% Baa2 Baa2 CPG 2.9% 7.4% Aa3 Aa3
Automotive -5.4% -6.7% A- A Manufacturing 3.0% 9.0% Baa2 Energy -0.8% -2.2% A3 A3 Pharma 11.4% 9.2% B1 B3 Insurance 3.7% 6.7% Baa1 Baa1 Technology NA NA Media & Entertainment -2.1% NA
US bank 19.3% 0.9% A3 A2
Manufacturing -4.9% -13.4% B2 B2 HEVC -1.1% 8.4% Baa2 Baa2
Source: USC IS; RSec Research
Exhibit 15: Applications for Oct 2019-March 2020 Top 20 applicants Whether LTI is in Other vendors top 10 vendors? US bank Yes Virtusa, TCS, IRIS Software, Capegemini,Oracle Financial Services, E&Y, Synechron Inc, Accenture & Hexaware Energy Yes Tech Mahindra, Deloitee, L&T Tehnology, Accenture, Wipro, EPAM Insurance Yes Accenture, Cognizant, Infosys Technology Yes Infosys, TCS, Tech Mahindra, Accenture, HCL, Persistent, Cognizant CPG Yes Cognizant, IBM, TCS, Deloitee, Capegemini, Wipro Manufacturing Yes Accenture, LTTS, Delta Computer Consulting, Altran, Cognizant HCLT Insurance NA Cloud Big Data LLC, M3 BI Manufacturing Yes IBM, Cyient, HCLT Manufacturing Yes IBM, Cyient, HCLT Technology NA Global logic Inc Media NA Cognizant, Birlasoft, Pamten
Insurance NA Infosys Bank/Insurance No Cognizant, TCS, NTT, IBM, HCLT Media No Capgemini, Cognizant, TCS, Horkus Solutions Manufactiring Yes HCLT, E&Y, LTTS Technology Yes Genpact, TechM Energy NA Aristone Tech Energy Yes Digital scripts Inc
Insurance NA NA CPG Yes Accenture, Capgemini, Mindtree, TCS Source: USC IS; RSec Research; Note: Green colour denotes new additions in the list
47 III. Proactive Efforts to Strengthen Offerings via M&A & Ecosystem Partnerships LTI continues to strengthen its partnership and alliances ecosystem by upgrading existing relationships and entering into new ecosystem partnerships. It has partnership with all three large public cloud vendors i.e. AWS, Google & Microsoft Azure. The company achieved SAP competency on AWS in 3QFY20. Notably, LTI is one of the 16 global strategic service partners, which have attained this competency certification on AWS. Recently, LTI also announced global services partnership with Temenos (leading banking software .provider), which we expect to aid in gaining wallet share from the financial services customers in US and Europe.
Exhibit 16: LTI has stepped up ecosystem partnerships and alliances
Source: LTI
Amplified Capabilities in Cloud, Artificial Intelligence (AI), Machine Learning & Data Analytics: LTI has also amplified capabilities in Cloud, AI, Machine Learning and Data Analytics by way of acquisitions. Syncordis and Neilesen+Partner provide edge to LTI in expanding outreach to Temenos customers in Europe and the US. Powerupcloud, Lymbyc, Ruletronics and AugmentIQ fit well in LTI’s Mosaic platform. As per our channel check, Syncordis has witnessed step-up in hiring, with which total workforce grew by >40% in last one year.
Exhibit 17: Key acquisitions by LTI Revenue CAGR EPS CAGR Acquisition Current Credit rating Date Acquisition Revenue price Description Employees Oct-19 Powerupcloud $3.5mn $15mn Cloud , DevOps automation, machine learning and big data 180 Technologies Jul-19 Lymbyc $1mn $6mn Artificial intelligence (AI), machine learning and advanced analytics 31 Feb-19 Nielsen+Partner ~$12mn $31.5mn Temenos WealthSuite specialist and a leading Temenos partner in Europe 98 and APAC Jan-19 Ruletronics $3.4mn $7.5mn Pega Suit implementer 68 Nov-17 Syncordis Eur13mn Eur15mn Independent pure play Temenos specialist 200+ Oct-16 AugmentIQ INR 2.4 cr INR 7 cr Big data Analytics 10 to 50 Source: RSec Research
48 Our analysis of FY16-FY20 free cash flow (FCF) distribution suggests that LTI has invested around 25% of FCF back into business/capability by way of capex and acquisitions
Exhibit 18: LTI invested ~25% cash flow back in business Exhibit 19: Stable capex as percentage of sales ratio
Source: RSec Research
MOSAIC – LTI’s Digital Transformation Platform: LTI has developed productized IT services platform – Mosaic, which offers data engineering, advanced analytics, process automation, IoT (Internet of Things) connectivity and improved solution experience for its users. Mosaic is positioned to address the convergence of digital + physical boundaries; technologies + skills; and business context + knowledge. LTI continues to strengthen its Mosaic platform with every acquisition and partnership.
Exhibit 20: MOSAIC – LTI’s Digital Transformation Platform
Source: LTI
49 IV. Scores Well on Vertical Diversification/Client Concentration Indian mid-cap companies are more prone to client concentration risk than their large-cap peers. Against this backdrop, LTI seems to be well-placed, as it has reduced client concentration levels of Top-5/Top-10 customers by 570/740bps since FY16. Our analysis of H1B visa applications suggests strong upsurge in new logo additions and wallet share gain in non Top-20 accounts. Further, LTIs revenue growth in manufacturing vertical is attributable to diversified client portfolio compared other US$1bn+ annual run rate IT companies like Mphasis (financial and insurance vertical) and Mindtree (technology vertical). Notably, LTI’s primarily operating verticals have also changed dramatically since FY16. Revenue from Application Development & Maintenance and Testing has declined by 1,500bps along with a strong acceleration in revenue from Enterprise Solutions (software implementation work- through alliances and partnerships) and Analytics, AI & Cognitive (digital work).
Exhibit 21: LTI proactively reduced client concentration of Top 5 clients… Exhibit 22: ...and top 10 customers
Source: RSec Research Source: RSec Research
Exhibit 23: Revenue break-up by services lines during FY16… Exhibit 24: Revenue break-up by services lines during FY20
Source: RSec Research Source: RSec Research
50 V. Strong Engineering Heritage & Synergy Opportunities with Subsidiaries LTI enjoys rich engineering heritage of parent i.e. Larsen & Toubro (L&T), which has been helping the company in integrating both Operational Hardware Technology (OT) and Information Technology (IT). Manufacturing sector lags in IT transformation vs. other sectors owing to lack of communication between both OT & IT teams. Looking ahead, we expect distinction between IT & OT to gradually diminish. We believe engineering DNA of L&T puts LTI in advantages position vs. pure play IT players. LTI is also likely to benefit from synergies in offerings with fellow subsidiaries - L&T Technology Services (LTSS) and Mindtree (acquired IT company).
LTI generates ~16% of its total revenue from manufacturing vertical, which we expect to go up in near to medium term.
Exhibit 25: Digital maturity by industry: manufacturing industry lags
Source: Deloitte
51 LTI & Mindtree: Complimentary Segments In June 2019, L&T (LTI’s parent company) acquired controlling stake in Mindtree having an annual revenue run rate of US$1bn. Now, L&T operates three IT and Engineering services company namely LTI, LTTS and Mindtree. Notably, there is limited client overlap between Mindtree and LTI. While Mindtree’s acquisition adds significant scale to L&T Group’s Hi-tech, CPG, Retail and Travel verticals, it also enhances digital capabilities and presence in IMS & Cloud (Azure, Salesforce & SAP) domain. We believe ‘merger possibility’ between LTI and Mindtree in the long run will be beneficial for both, as the combined entity will have benefits of scale, broader offerings and greater client diversification. We envisage ample possibilities in terms of collaboration on new deals and workforce management in the short to medium term.
Exhibit 26: Limited overlap between Mindtree and LTI
Source: L&T
I. Margin Likely to Remain in Comfort Zone Since FY16, LTI’s operating margin expanded by 140bps on the back higher utilization, productivity benefits and cost optimization measures (specifically at sales). LTI has been managing to maintain net profit margin in the range of 14%-15% (and even beat that) driven by consistent hedging policy. Whilst LTI has not provided any margin guidance for FY21 due to COVID-led uncertainties, we believe LTI has multiple levers(cost optimization measures, employee pyramid optimization and higher off shoring) to boost its EBIT margin. We expect induction of ‘Work from Home’ in the operating model will prove to be tailwind for margin expansion in the medium term.
Exhibit 27: EBIT margin likely to remain within comfort zone in FY22E-23E
Source: Company; RSec Research
52 II. Robust FCF convrsation Strong revenue growth, focus on margin execution and working capital management has aided LTI to witness robust cash flow conversion. LTI’s average FCF conversation stands at 88% for last 5 years, and we believe the company is likely to sustain the trend over FY20-23E as well driven by strong EBIT margin, stable credit quality of top customers and low capex requirement (2-3% of sales).
Exhibit 28: Expect strong FCF conversion trend likely to sustain
Source: Company; RSec Research
53 Outlook & Valuation
LTI seems to be well-placed to capture demand recovery once COVID-19 challenges on technology spend starts retreating. We believe LTI should continue to warrant premium valuation on the back of its consistent industry-leading growth backed by execution focused stable management, diversified client base, robust new logo addition and client mining efforts. We initiate coverage on LTI with BUY and a 2-Year Target Price of Rs2,550 (based on a PE of 20.5x on FY23E earnings).
Exhibi 29: LTI deserves premium multiple considering its stable Exhibit 30: Currently LTI trades at 7% discount toTCS business quality
24.0 22.0 20.0 18.0 16.0 14.0 12.0 10.0 8.0 6.0 17 17 18 19 17 18 19 18 19 17 17 17 18 19 18 19 18 19 20 20 20 ------Jul Jul Jul Jan Jan Jan Sep Sep Sep Nov Nov Nov Jan Mar Mar Mar May May May Mar May
BEST_PE_12M_BF AVG STDEV+1 STDEV-1
Source: Bloomberg Source: Bloomberg
Exhibit 31: Reverse DCF calculations to our TP Rs2,550 suggests high to mid single digit revenue growth and a margin decline of 100bp over a period of 10 years
Revenue $ FY17-FY20 16.3% FY21E 4.7% FY21E-FY23E 11.2% FY23E-FY30E 6.7% Terminal growth rate 3.3%
PAT margin FY21E-23E 14.2% FY23E-FY30E 13.0%
WACC 11.5% Price objective Rs 2550 Source: Company, RSec Research
54 Key Financials
Profit & Loss Statement Year ending March (Rs mn) FY19 FY20 FY21E FY22E FY23E Net Revenues (US$ mn) 1,349.1 1,524.6 1,596.7 1,782.0 1,974.0 Growth (%) 19.1 13.0 4.7 11.6 10.8 Net Revenues 94,458 1,08,786 1,19,970 1,33,651 1,48,049
Growth (%) 29.3 15.2 10.3 11.4 10.8 Employee Costs & Other expenses 61,643 73,589 81,624 90,705 99,736 SG&A and Other Operating Expenses 13,980 14,904 15,330 17,375 19,542 EBITDA 18,835 20,293 23,016 25,572 28,770 EBITDA (%) 19.9 18.7 19.2 19.1 19.4 EBITDA Growth (%) 58.6 7.7 13.4 11.1 12.5 D&A 1,472 2,730 3,043 3,341 3,701 EBIT 17,363 17,563 19,973 22,231 25,069 EBIT (%) 18.4 16.1 16.6 16.6 16.9 EBIT Growth (%) 68.3 1.2 13.7 11.3 12.8 Other Income 2,915 2,465 1,784 2,659 3,411 PBT 20,278 20,028 21,757 24,890 28,480 Tax (incl deferred) 5,122 4,824 5,467 5,974 6,693 Exceptional 0 -180 0 0 0 PAT 15,156 15,384 16,290 18,916 21,787 PAT Growth (%) 30.5 1.5 5.9 16.1 15.2 EPS 86.4 87.6 92.9 107.8 124.2 EPS Growth (%) 23.6 1.4 6.0 16.1 15.2
Balance Sheet Year ending March (Rs mn) FY19 FY20 FY21E FY22E FY23E SOURCES OF FUNDS Share Capital - Equity 174 174 174 174 174 Reserves & other 48,772 53,877 65,119 76,724 90,155 Total Shareholders' Funds 48,946 54,051 65,293 76,898 90,329 Debt - 320 320 320 320 Lease liabilities - 8,799 8,799 8,799 8,799 Total Debt - 9,119 9,119 9,119 9,119 Current Liabilities 13,981 19,095 19,520 20,040 20,587 Provisions & other liabilities 3,335 5,802 6,534 6,580 6,569 TOTAL SOURCES OF FUNDS 66,262 88,067 1,00,466 1,12,636 1,26,604 APPLICATION OF FUNDS Goodwill 4,947 6,368 6,368 6,368 6,368 Net Block 4,467 5,728 4,485 3,816 3,076 Right to use assets - 7,692 7,692 7,692 7,692 Investments 17,402 22,186 22,186 22,186 22,186 Deferred Tax Assets 1,956 2,857 2,857 2,857 2,857 LT Loans & Advances, Others 9,495 10,442 10,442 10,442 10,442 Total Non Current Assets 38,267 55,273 54,030 53,361 52,621 Debtors & Unbilled Revenues 23,845 27,541 31,225 34,054 36,911 Cash & Bank 4,150 5,252 15,211 25,221 37,072 Total Current Assets 27,995 32,793 46,436 59,275 73,982 TOTAL APPLICATION OF FUNDS 66,262 88,066 1,00,466 1,12,636 1,26,604
55 Cash Flow Statement Year ending March (Rs mn) FY19 FY20 FY21E FY22E FY23E PBT 15,155 15,205 16,290 18,916 21,787 Non-operating & EO items 5,135 4,930 5,467 5,974 6,693 Depreciation 1,472 2,730 3,043 3,341 3,701 Working Capital Change -3,061 -2,313 -2,528 -2,262 -2,321 Income Tax paid -4,751 -4,118 -5,467 -5,974 -6,693 Cash Flow from Operations (a) 13,950 16,434 16,806 19,995 23,167 Capex -1,530 -2,426 -1,800 -2,673 -2,961 Acquisitions -2,157 -591 0 0 0 Change in Investments -3,751 -3,503 0 0 0 Cash Flow from Investing (b) -7,438 -6,520 -1,800 -2,673 -2,961 Debt Issuance/(Repaid) -605 -3,221 3 0 0 Share capital Issuance/(buyback) 3 0 0 0 0 Dividend -5,341 -5,679 -5,048 -7,311 -8,356 Cash Flow from Financing (c) -5,943 -8,900 -5,045 -7,311 -8,356 NET CASH FLOW (a+b+c) 569 1,014 9,961 10,011 11,850 Fx/other -53 86 0 0 0 Closing Cash Balance 4,149 5,250 15,211 25,221 37,072 Free Cash Flow 12,420 14,008 15,006 17,322 20,206
Key Ratios Particulars FY19 FY20 FY21E FY22E FY23E Profitability (%) EBITDA Margin 19.9 18.7 19.2 19.1 19.4 APAT Margin 16.0 14.1 13.6 14.2 14.7 RoE 34.6 29.9 27.3 26.6 26.1 RoCE 25.2 19.9 17.2 17.7 18.2 ROA 5.7 4.8 7.6 10.6 14.4 Efficiency Tax Rate (%) 25.3 24.1 25.1 24.0 23.5 Debtors and Unbilled Receivables (days) 92 92 95 93 91 Other Liabilities (days) 10 14 14 14 14 FCF/NI (%) 81.9 91.1 92.1 91.6 92.7 Net Debt/EBITDA (x) (1.1) (0.9) (1.2) (1.5) (1.7) Net Debt/Equity (x) (0.4) (0.3) (0.4) (0.5) (0.6) Per Share Data (Rs) EPS 86.4 87.6 92.9 107.8 124.2 DPS 28.0 28.0 29.0 42.0 48.0 BV 279.1 307.9 372.3 438.4 515.0 FCF 70.8 79.8 85.6 98.8 115.2 Valuation (x) P/E 26.3 25.9 24.4 21.0 18.3 P/BV 8.1 7.4 6.1 5.2 4.4 EV/EBITDA 20.0 18.7 16.1 14.1 12.1 FCF/EV (%) 3.3 3.7 4.1 4.8 5.8 FCF/mkt cap (%) 3.1 3.5 3.8 4.4 5.1 Dividend Yield (%) 1.2 1.2 1.3 1.9 2.1
56 Company Background
Larsen & Toubro Infotech (LTI) – a wholly owned subsidiary of Larsen & Toubro (L&T) – was founded in 1996. In terms of export revenues, it is the sixth-largest IT services company in India. The company offers services in the realm of Analytics, Information Management, Enterprise Integration, Applications Management, Cloud Computing, Testing, and Consulting. LTI has more than 400 clients including 66 Fortune-500 companies. It operates at 59 sales offices across 30 locations in the US, EMEA and Asia Pacific and employs >30,000 people across 29 delivery centers.
Milestones Year Achievements 1997 Commenced operations as LTI subsidiary 2002 Achieved SEI CMM-L5 certification 2004 First large multi-year contract with MNC energy company 2007 1st acquisition of US based GDA Tech 2008 Established business in South Africa 2011 Acquired transfer agency business unit of Citigroup Fund Services Canada 2013 Focus on Manufacturing and Services sector 2014 Acquired ISRC from Otis 2016 LTI came with IPO which was subscribed at upper price band of (Rs705-710), Issue size Rs1,400 crores 2017 Syncordis acquisitios 2018 Tops in the'Challenger' list in Everst Group's PEAK Matrix service provider of year 2018 2019 Acquired Rauletronics, Nielsen+ Partner, Lymbyc Source: Company, Rsec Research
Management Team Name Designation Details Mr. Sanjay Jalona CEO & MD f Mr. Jalona is the CEO and Managing Director of Larsen & Toubro Infotech (LTI). He joined the company in 2015 and has since led a rapid and comprehensive transformation of LTI into a leading technology consulting and digital solutions company, partnering with some of the most prestigious global enterprises. f Prior to joining LTI, he was the EVP & Global Head of High-Tech, Manufacturing and Engineering Services business at Infosys. During his 15 years at Infosys, he held several leadership positions across Banking, Financial Services, and Retail & CPG in USA, Europe and India. Prior to Infosys, he held leadership roles at Gemplus and Wipro. Mr. Nachiket Deshpande COO f Mr. Deshpande has over 23 years of rich experience in delivery management, customer relationships management, account and P&L management across verticals, technologies and geographies. f Before joining LTI, he was with Cognizant Technology Solutions where he spent nearly two decades in various executive management roles across North America, Europe, and India. Mr. Sudhir Chaturvedi President )Sales) f Mr. Chaturvedi has over 25 years of industry experience across Sales, Business Development, Consulting and Delivery Operations. Prior to LTI, he was the Chief Operating Officer at NIIT Technologies where he was responsible for worldwide sales and delivery for technology and business services. Source: Company, Rsec Research
57 Revenue break-up by verticals Revenue break-up by service
Source: Company; RSec Research Source: RSec Research
Revenue break-up by client brackets Revenue break-up by geographies
Source: Company; RSec Research Source: RSec Research
58 Institutional Equity Research CMP* (Rs) 1,020 Upside/ (Downside) (%) (12) SELL Mindtree Bloomberg Ticker MTCL IN IT | India Market Cap. (Rs bn) 168 2 Year Target Price: Rs.900 Free Float (%) 27 Initiating Coverage | 20 July 2020 Shares O/S (mn) 165
Hefty valuation amidst uncertain revenue, cost trajectory
Research Analyst: Key Setbacks: Suyog Kulkarni, ACA, CFA Exposure to travel and hospitality (T&H) vertical to drag revenue acceleration Contact : (022) 4303 4000 / 9890966735 Deep dive of client portfolio suggests deteriorating credit quality primarily in T&H/ Email : [email protected] financial services verticals Unhealthy dependency on top client which increases client concentration risk High operating cost base vis-à-vis peers
1. Mindtree – now part of Larsen & Toubro Group – provides business and technology Share price (%) 1 mth 3 mth 12 mth solutions through global software development and IT services. Absolute performance 12.5 35.5 52.9 2. Under the new management, while it reported strong margin rebound to the tune of Relative to Nifty 4.4 17.8 58.9 800bps since 1QFY20, broader margin continues to remain ~200bps lower than peers (Mphasis, L&T InfoTech). Shareholding Pattern (%) Mar'20 June'20 3. Revenue share from top clients has grown from 11% in FY16 to 22%in FY20. We believe Mindtree’s reliance on top client for growth is unhealthy, as it increases the client Promoter 74.1 73.4 concentration risk. Public 25.9 26.6 4. Mindtree has high exposure to T&H vertical, which is the hardest hit during the current pandemic. We believe this vertical is likely to drag LTI's revenue over FY21-23E. 1 Year Stock Price Performance
1100 5. Decline in credit profile of key clients primarily in T&H/financial services vertical, which we believe poses medium-term credit risk. 1000 900
The COVID-19 Impact: We expect COVID-led disruptions to severe impact Mindtree’s revenues 800
from T&H vertical (16% of total). At the same time, the company is witnessing higher demand 700
in other segments i.e. Communication, Media and Technology (CMT) and Consumer Packaged 600 19 19 19 20 20 20 20 ------Goods (CPG). We believe soft outlook on T&H vertical to weigh on revenue and profitability - Jul Jul Sep Nov Jan Mar May acceleration in the medium-term. Mindtree 1 year share price chart
Outlook & Valuation Note: * CMP as on 17 July 2020 We believe risk-reward is unfavourable due to Mindtree’s high exposure to T&H vertical, disproportionate dependence on top clients and limited clarity on medium-term margin trajectory. At CMP, the stock trades at expensive valuation of 16.4x on FY23E EPS (18.4x on FY22E EPS) which is 24% premium to Mphasis one year forward PE. We assign target multiple of 14.5x (10% discount to 5 year average) as high T&H revenue exposure & limited margin clarity to weigh on growth outlook. We initiate coverage on Mindtree with SELL and a 2-Year Target Price of Rs900.
Year Ending March FY19 FY20 FY21E FY22E FY23E Net Sales 70,215 77,643 77,933 84,210 91,016 EBIT 9,004 8,144 11,220 11,831 13,135 PAT 7,541 6,309 8,493 9,122 10,233 Diluted EPS (Rs) 46.3 41.7 51.6 55.4 62.1 P/E (x) 22.0 24.4 19.8 18.4 16.4 EV / EBITDA (x) 14.9 14.7 11.5 10.5 9.2 RoE (%) 27.5 19.1 26.9 24.1 23.2 Dividend Yield (%) 2.9 1.3 1.3 1.7 2.0
Source: Company, RSec Research 59 Our Thesis
f High exposure to T&H vertical: Mindtree has high exposure to T&H vertical, which is the hardest hit during the current pandemic. We believe this vertical is likely to be drag on revenue front over FY21-23E. f Lower margin vs peers: Under the new management, while it reported strong margin rebound to the tune of 400bps since 1QFY20, but broader margin continues to remain ~300bps lower than peers (Mphasis, L&T InfoTech). f Top client concentration: Revenue share from top clients has grown from 11% in FY16 to 22%in FY20. We believe Key Investment Themes Mindtree’s reliance on top client for growth is unhealthy, as it increases the client concentration risk. f Outlook & Valuation: We believe risk-reward is unfavorable due to Mindtree’s high exposure to T&H vertical, disproportionate dependence on top clients and limited clarity on medium-term margin trajectory. At CMP, the stock trades at expensive valuation of 16.4x on FY23E EPS (18.4x on FY22E EPS). We assign target multiple of 14.5x (10% discount of 5 year average) as high T&H revenue exposure & limited margin clarity to weigh on growth outlook. We initiate coverage on Mindtree with SELL and a 2-Year Target Price of Rs900
f Earlier-than-expected rebound in travel and hospitality vertical. f Stronger than expected growth in key technology customer. Key Risks f Aggressive cost savings plans leading to accelerated margin recovery. f Higher-than-expected depreciation in INR against USD.
EPS & Target Price
Source: Company, RSec Research
Price Sensitivity Analysis EPS (Rs) Growth (%) FWD PE 12 13 14 14.5 15 16 FY17 (-3) 24.9 41.0x 298 323 348 361 373 398 FY18 (-2) 34.3 37.8% 29.8x 411 446 480 497 514 548 FY19 (-1) 46.3 35.1% 22.0x 556 602 648 671 695 741 FY20 (Base Year) 41.7 -9.9% 24.4x 501 542 584 605 626 668 FY21 (Year 1) 51.6 23.5% 19.8x 619 670 722 747 773 825 FY22E (Year 2) 55.4 7.4% 18.4x 664 720 775 803 831 886 FY23E (Year 3) 62.1 12.2% 16.4x 745 807 870 900 932 994 Soure: RSec Research 60 Management Meet – Key Takeaways f Update on Strategic Initiative: The management has stepped up hiring in leadership roles and carved out a special team to focus on strategic deals. This has helped in winning large deal from Realogy, an existing real estate client. On the tail account management, Mindtree has closed 40+ accounts considering profitability, technology and talent retention. Its deal pipeline consists of decent mix of project based new deal wins and longer term annuity deal. f Relationship with Group Companies: Each subsidiary of L&T carries specific capabilities. L&T’s board has allowed Mindtree to operate independently. In 2QFY20, Mindtree aligned itself with L&T and introduced long-term hedging policy vs. short-term hedging policies. On the other hand, Mindtree has its own employee productivity measurement methodology, which is getting applied in other group companies. Notably, there is limited overlap between L&T Infotech (LTI) and it’s mostly in BFSI and CPG verticals. In BFSI vertical also, LTI is more in to banking, while Mindtree’s expertise is more into property and casualty insurance. Going forward, in case of any imminent opportunity, both Mindtree and LTI would work as joint partners. f Focused Areas: Mindtree is going to focus on four key service areas: (1) Improved customer success/experience (aids company to embark on digital transformation journey); (2) Cloud and Intelligence (working on Azure platform, SAP and Salesforce); (3) Data and Analytics; (4) Enterprise IT (end-to-end offering of legacy products, DevOps, continuous release of offerings) f Top Client Outlook: Mindtree expects growth at top client to continue to grow in next few quarters. As the company is aware of its exposure to top clients, its sales team is accordingly instructed to deep mine other top clients as well. Additionally, Mindtree is engaged into strong alliances with Salesforce, SAP and others, which will aid in client diversification. f Work from Home: Mindtree has work from home policy for several years. It didn’t face any supply side issue in 4QFY20 and does not expect this in coming quarters as well. f Rise in Subcontractor Cost: Over the period of 2-3 years, the subcontractor cost has gone up for Mindtree as well as of other companies due to the very nature of work, availability of talent and visa restrictions. In past 2 quarters, Mindtree managed to reduce subcontractor cost driven by ongoing re-skilling initiatives. In current scenario, Mindtree will be able to reduce subcontractors due to availability of clients.
61 The COVID-19 Impact f Update on Business Continuity: Mindtree has achieved 99.5% work for home level in a quick span of time. f Demand Scenario: Travel, Hospitality, Manufacturing, and Retail verticals are likely to witness higher immediate impact due to drop in demand and disruption in supply chain. Clients in BFSI vertical are also likely to prioritize their discretionary spend to conserve cash. Mindtree expects to see traction in Hi-Tech and CPG vertical due to high demand in collaborative tools, adoption of Cloud, Data, SAP, IT modernization and workplace automation. f Execution: Mindtree has launched several co-innovation initiatives with the clients. It witnessed no productivity loss in due to COVID-led disruptions. f Update on Customers: There are clients from travel industry in Mindtree’s Top-10 clients list. Thus, the company expects some softness in 1QFY21 revenue. It is in discussions with the clients to carve out specific offerings along with right commercial models to help them sail through the current situation. Mindtree expects continued demand in digital and transformational services in light of continued investment in data, cloud-enabled solutions, customer-centric and end user experience.
62 A Snapshot of 1QFY21 Performance f Revenue declined by 9% QoQ to US$253.2mn in 1QFY21, largely led by 53% QoQ decline in Travel & Hospitality (T&H) vertical despite ~10% QoQ growth in Communication, Media and Technology (CMT) vertical. f Reported EBITDA came in at 18.2% in 1QFY21 compared to 17.1% in 4QFY20 driven by improved operational efficiency (30bps), and favourable currency movement (80bps). Adjusted EBITDA margin came in at 18.2% in 1QFY21 compared to 17.1% in 4QFY20. Net profit grew by 3.3% QoQ (up 129.8% YoY) to Rs2.13bn in 1QFY21. f The company’s deal wins came in at US$393mn in 1QFY21 compared to US$391mn in Q4FY20. New wins stood at US$76mn. f As per the management, the COVId-19 pandemic has proved the belief that technology is core to business. While it expects uncertainty to continue in T&H vertical in the near- term, it sees good demand in CMT vertical. f Top client contributed more than 30% to revenue in 1QFY21 compared to 24% in 4QFY20. The management expects the top clients are likely to remain stable in the near-term. f The company added 740 new employees on gross basis during the quarter, while attrition rate reduced to 16.6% in 1QFY21 compared to 17.4% in 4QFY20. f The management has identified four focus areas of the company i.e. (a) customer success; (b) data and intelligence; (c) Cloud as end-to-end transformation strategy; and (4) Enterprise IT in order to enable its clients to transform their technology ecosystem. f The management expects revenue to grow sequentially in 2QFY21 owing to improved operating efficiency despite near-term uncertainty in T&H vertical.
1QFY21 Result Table Millions except EPS 1QFY21 4QFY20 QoQ (%) 1QFY20 YoY (%) Revenues $ 253.2 278.4 -9.1 264.2 -4.2 USD/INR 75.4 73.7 -9.0 69.4 8.6
Revenues INR 19,088 20,505 -9.1 18,342 4.1 Employees cost 12,776 12,933 -9.1 12,532 1.9 Gross Profit 6,312 7,572 -9.2 5,810 8.6 Other expenses 2,834 4,060 -9.4 3,969 -28.6 EBITDA 3,478 3,512 -9.1 1,841 88.9 D&A 597 679 -9.2 669 -10.8 EBIT 2,881 2,833 -9.0 1,172 145.8
Other income/(expenses) 17 (220) -10.1 90 -81.1 Profit before Tax 2,898 2,613 -8.9 1,262 129.6 Tax 768 551 -8.7 335 129.3 PAT 2,130 2,062 -9.0 927 129.8 EPS 12.9 12.5 -9.0 5.6 129.5
Margin Gross Profit 33.1% 36.9% 31.7% EBITDA 18.2% 17.1% 10.0% EBIT 15.1% 13.8% 6.4% Net Income 15.2% 12.7% Source: Company; Rsec Tesearch
63 Company Comparative Analysis
Mindtree LTI Investment View
f India's 8th largest IT services company. f India's 6th largest IT services company. f f Business View Mindtree is likely to witness softer revenue LTI to outperform vs. peers driven by execution focused acceleration driven by high exposure to T&H and management, diversified client portfolio and strong deal top client concentration risk. wins.
Financials (Rs Mn) FY20 FY21E FY22E FY23E FY20 FY21E FY22E FY23E Revenues 77,643 77,933 84,210 91,016 1,08,786 1,19,970 1,33,651 1,48,049 EBIT 8,144 11,220 11,831 13,135 17,563 19,973 22,231 25,069 Adj PAT 6,309 8,493 9,122 10,233 15,384 16,290 18,916 21,787 Growth (%) Revenues 10.6 0.4 8.1 8.1 15.2 10.3 11.4 10.8 EBIT -9.6 37.8 5.4 11.0 1.2 13.7 11.3 12.8 Adj PAT -16.3 34.6 7.4 12.2 1.5 5.9 16.1 15.2 Margin (%) EBIT 10.5 14.4 14.0 14.4 16.1 16.6 16.6 16.9 Adj PAT 8.1 10.9 10.8 11.2 14.1 13.6 14.2 14.7 Per Share (RS) EPS 41.7 51.6 55.4 62.1 87.6 92.9 107.8 124.2 DPS 13.0 13.0 17.5 20.0 28.0 29.0 42.0 48.0 Book value 191.6 230.2 268.1 310.2 307.9 372.3 438.4 515.0 Valuation (x) P/E 24.4 19.8 18.4 16.4 25.9 24.4 21.0 18.3 EV/EBIT 19.7 14.0 12.8 11.2 21.6 18.5 16.2 13.9 P/BV 5.3 4.4 3.8 3.3 7.4 6.1 5.2 4.4 Div Yield (%) 1.3 1.3 1.7 2.0 1.2 1.3 1.9 2.1 Return Ratio (%) ROCE (%) 18.1 21.4 19.8 19.5 27.4 23.7 23.6 23.5 ROE (%) 19.1 26.9 24.1 23.2 29.9 27.3 26.6 26.1 Source: Company; RSec Research
64 Key Charts f Our analysis of recent commentary of key T&H players suggests extensive cost pressure, which we believe is likely to impact revenues/collections. f Whilst Mindtree is likely to benefit from workforce virtualization and strong growth in Technology, Communication & Media (43% of revenues) vertical, imminent downturn in T&H vertical is likely to trawl revenue acceleration over FY20-23E. f During 1QFY21, Mindtree reported 50% qoq decline in revenues from T&H vertical and sharply contracted to 8.7% of revenues. We will closely watch credit quality of receivables from T&H vertical.
Exhibit 1: T&H vertical contributes ~16% to total revenues
Source: Rsec Research f Mindtree reported strong deal wins during last 4 years but Exhibit 2: Mindtree's deal win momentum remains strong declining renewal rate remains concern. f New deal wins during 1QFY21 remained stable with improving renewal rate. We will closely watch consistency on deal renewals.
Source: Company; Rsec Research
f Revenue from top client (Microsoft) clocked 19% CAGR over Exhibit 3: Top client dominated incremental growth… FY16-FY20, which was almost 2x of company's average of >11%.
Source: Company; Rsec Research
f High operating cost base is a risk to Mindtree’s medium-term Exhibit 4: High cost base of Mindtree vs peers is the medium term risk competitiveness, in our view. f Whilst its efforts on margin revival Q1FY21 is commendable, we expect further clarity on medium-term margin trajectory given comparatively lower EBIT margin vs. peers.
Source: Company; Rsec Research
65 Rationale for SELL Recommendation
Our “SELL” recommendation is based on the following premises: Disproportionate Exposure to Travel & Hospitality Vertical Higher Dependency on Top Clients Increases Concentration Risk Deep Dive on Client Portfolio Suggests Weak Credit Quality High Operating Cost Base Lowers Competitiveness amid No Clarity over Margin Trajectory Limited Focus on Capability-based Inorganic Opportunities
I. Disproportionate Exposure to Travel & Hospitality Vertical Mindtree recorded strong revenue CAGR of 11.2% over FY16-20 (vs. India IT industry growth of 7.5%) of on the back of robust growth in digital business (Data Science and Cloud services) and step up in test engineering business. Digital business contributed 38% to Mindtree’s total revenue in FY20. T&H vertical is the hard hit due to the current COVID-19 pandemic. Mindtree receives ~16.2% of total revenues from this vertical, which is one of the highest compared to peers. Furthermore, it also has T&H customers in Top-10 & Top-20 clients list. We believe T&H vertical is likely to witness the highest pricing pressure, volume compression and payment deferrals. Our analysis of recent commentary of key T&H players suggests extensive cost pressure, which we believe is likely to impact revenues/collections. Whilst Mindtree is likely to benefit from workforce virtualization and strong growth in Technology, Communication & Media (43% of revenues) vertical, imminent downturn in T&H vertical is likely to trawl revenue acceleration over FY20-23E and put pressure on margin and receivables as well. We forecast FY21/22/23 USD revenue growth of (4.0)%/8.2%/8.1% respectively.
Exhibit 5: T&H vertical contributes ~16% to revenues
Source: Rsec Research; Note: Red colour suggests severe impact of COVID
Read-across Suggests Key Players in T&H Space to Witness Cost Pressure: According to International Air Transport Association (IATA), global air traffic demand is likely to fall by 82%, 56% and 33% YoY in 2QCY20, 3CY20 and in 3QCY20, which will lead to revenue loss to the tune of ~US$300bn for the airline industry in CY20. As per IATA, the airline industry generally takes longer time to recover than general economic recovery. Notably, the US airlines almost took three years to revive in the wake of 9/11. As the current COVID-19 situation is even more serious than that, we believe the airline industry will take longer time to revive, as people are expected to undertake necessary travel only. As the growth in both travel and hospitality vertical is interdependent, the outlook on the hospitality vertical is likely to remain subdued in the medium-term. Tata Consultancy Services also indicated in its 1QFY21 release that Airlines and T&H vertical in general is yet to bottom out. It expects recovery in T&H vertical in FY22.
66 Exhibit 6: US air traffic took three years to revive post 9/11 attack
Source: US department of Transportation
Exhibit 7: Key T&H companies have stepped up cost savings and cash conservation measures Company Comments Southwest Airlines f It froze hiring and non-contract salary increases as well as voluntary time off and separation programs. Airline has also reduced executive officers’ salaries and BOD fees by 20%. It canceled/deferred hundreds of capital spending projects and modified vendor and supplier payment terms f It said “We are realizing the efficiencies of various technology and equipment investments that we have made previously. And those investments proved to be invaluable in March and they allowed to rapidly adjust our network and accruing in our maintenance plans as we reacted to the COVID-19 demand changes.” Delta Airlines f It expects June quarter total expenses to decline by ~55% YoY. Labor saving to the tune of US$700mn is likely in the June quarter driven by reduced work schedules and more than 40% of workforce taking voluntary leaves. Consolidated airport facilities, including the temporary closure of concourses and SkyClubs. Delta has reduced contractor and discretionary spend. f Multi-year recovery requires Delta to be a smaller carrier and make structural cost changes. Marriott International f “We estimate the cost cutting measures currently in place will reduce 2020 G&A costs by at least US$140mn. We are still in the process of implementing some of these plans and expect there will be additional savings beyond that amount.” f On May 26, Marriott International provided an update that prior levels of business will not return until 2021. The company anticipates a significant number of above-property position eliminations later this year. Avis f “We took dramatic action, including significant reductions in personnel, shrinking the size of our fleet and halting all nonessential spending, initially targeting US$400mn in annualized cost savings, which we've materially improved upon over in April-May. We have taken actions to reduce our costs as well as to maintain a 75% variable and 25% fixed cost mix.” f “We have seen revenue decline of 80% in April and expect the demand to begin to recover in June, with further improvement throughout the year, as travel restrictions are lifted and leisure demand begins to recover. Our current reservations show improvement in June and over the balance of the summer.” Source: Company
Declining Renewal Rate despite Robust Deal Environment – Key Concern: We acknowledge that Mindtree has consistently reported a healthy book to bill ratio during last 5 years on the back of strong wins in cloud, interactive services lines. However, declining renewal rate even while deal win data remains robust is the key concern. Additionally, we will closely watch progress on deal ramp-up front as well as execution of existing book in T&H space.
67 Exhibit 8: Growing deal wins but decline in renewal is a concern
Source: RSec Research
Despite strong deal wins in 4QFY20, which is likely to limit downside risk to revenue, we expect strong pricing pressure and lower activity in T&H space to weigh on revenue growth acceleration from CMT vertical. II. Higher Dependency on Top Clients Increases Concentration Risk Revenue from top client (Microsoft) clocked 19% CAGR over FY16-FY20, which was almost 2x of company average of >11%. Mindtree has been working with Microsoft since last decade and currently company has more than 4,000 professionals working on Microsoft’s projects. Revenue exposure within top client is diversified and has decent mix of annuity/short-term projects and service lines i.e. Analytics, Marketing Operations, Networking and Customer Support. In its latest earnings release, Microsoft highlighted limited impact of COVID-19 on its net revenues. Additionally, on the back of higher Cloud usage during the pandemic period, Mindtree expects Microsoft is likely to continue its growth momentum. As the company is aware of increasing revenue exposure to Microsoft, it plans to offset this by deep mining the books of other key clients. During 1QFY21, further growth downside was protected stop uptick from large clients end. Whilst we see decent revenue contribution from the top client in the near-term, excessive dependency on top client increases risk from client-specific events in the medium-long-term.
Exhibit 9: Top client dominated incremental growth… Exhibit 10: ...which led to consistent rise in top client contribution
Source: Rsec Research Source: RSec Research
68 III. Deep Dive on Client Portfolio Suggests Worsening Credit Quality We analyzed hiring/visa trends of Mindtree and its end customers in the US. We also analyzed revenue/EPS growth trajectory of each key 10 client (on the basis visa applications and credit rating changes, if any) to determine portfolio resiliency.
Our key findings are as below: 1. Mindtree’s key 10 clients (by visa applications) comprise of players from Technology, CPG, Financial Services, and T&H domain. 2. Despite decline in credit quality of 4 out of key 10 clients are still investment grade or above, which indicate risk of further credit rating downgrades in T&H vertical. 3. Majority EPS decline comes from T&H vertical. 4. Step-up in visa applications for Insurance, Financial Services (3 accounts) and Professional Services during Oct’19-Mar’20 period. 5. Primary competition for Mindtree in key accounts comes from Cognizant, TCS and Infosys.
Exhibit 11: Key customers by visa applications during Oct-18-Sept-19 Top 20 key clients- Revenue CAGR EPS CAGR Credit rating as Credit rating at applications CY19-22E (%) CY19-22E (%) of today Dec 2019 Unknown (28% of total) NA NA NA NA Travel & Hospitality -3.4 -10.6 Baa1 A3 Financial Services 1.2 14.7 Baa1 Baa1 Travel & Hospitality -1.1 -6.5 Baa3 Baa2 Financial Services 1.7 2.8 A3 A3 Technology NA NA NA NA CPG 3.2 4.2 A2 A2 Financial Services 5.8 7.6 Baa2 Baa1 Travel & Hospitality -6.4 -14.7 Baa2 Baa3 Insurance -1.8 4.2 Baa1 Baa1 Automotive -1.9 -3 A1 Aa3 CPG 2.9 7.4 Aa3 Aa3 Real estate -1.1 1.3 NA NA Travel & Hospitality -3.2 4.9 B+ BB Professional Services NA NA Other NA 4.9 Manufacturing 0.5 -3.4 Technology/ Other NA NA A+ A+ Retail/Other NA NA University NA NA Source: RSec Research; USCIS
69 Exhibit 12: Key customers by visa applications during Oct-19-March-20 Oct-19-March-20 Top 20 key clients- Whether Mindtree come Key Vendors applications under top ten vendors? Unknown NA NA Travel & Hospitality Yes DXC Technology, Mastech Digital, Cognizant, Capgemini Retail Yes TCS, ATOS, Cognizant, Deloitte, Kforce, EY Financial Services Yes Compuer Science Corporation, NIIT Technology, Deloitte, Accenture Travel & Hospitality Yes Accenture, TCS, Deloitte Financial Services Yes UST Global, TCS, Mastech, EPAM Financial Services Yes Atos, Cognizant, Infosys, TCS, IntraEdge, IBM, Deloitte Manufacturing Yes Cognizant, Infosys, HCLT, Deloitee, Fujitsu, Hexaware, Hinduja Tech Insurance Travel & Hospitality/ Other Yes Cognizant, TCS, Averon Solutions Real estate services NA Cognizant Financial Services Travel & Hospitality Yes Cognizant, TCS, Hexaware Manufacturing. Financial Services Technology Business school Fujitsu America, NTT data CPG Financial Services Professional services Source: Rsec Research, USCIS; Note: Green colour sugests new addition in the list.
IV. High Operating Cost Base Lowers Competitiveness amid Limited Clarity over Margin Trajectory Our benchmarking analysis suggests that Mindtree’s FY16-FY20 EBIT margin levels were ~300- 400bps lower than its peers i.e. Mphasis and LTI primarily due to cost based acquisitions of Bluefin and Magnet360 and subsequent increase in subcontractor cost. Its employee cost and subcontractor cost base have also gone up from 66.3% in FY16 to 72.6% in FY20 (excluding one- time ex gratia payment). Q1FY21, EBITDA came at 18.2% vs 17.1% Q4 (+30bp operational efficiency and +80bps favorable currency) movement). During the period, the company has revised the useful life of computers from 2-3 years to 2-4 years. Had the company continued with the old useful life of computers, the incremental charge to the depreciation and amortization expense, EBIT margin would have been 40bps lower. We also expect limited development on tail account rationalization here on, which we believe limits further margin upside. For FY21/FY22/FY23, we forecast EBIT margin of 14.4%/14%/14.3% respectively. High operating cost base is a risk to Mindtree’s medium-term competitiveness, in our view. Whilst its efforts on margin revival is commendable, we expect further clarity on medium-term margin trajectory given comparatively lower EBIT margin vs. peers.
70 Exhibit 13: Mindtree’s FY16-FY20 EBIT margin levels were ~300- Exhibit 14: High cost base of Mindtree vs peers is the medium 400bps lower vs. peers term risk
Source: Rsec Research Source: RSec Research
V. Limited Focus on Capability-based Inorganic Opportunities During 2015-16, Mindtree acquired four companies in the field of cloud based sales and marketing services (Magnet 360), CPG focused IT services firm (Relational Solutions), SAP consulting (Bluefin) and property and casualty insurance (Discoverture solutions LLC). Out of the four acquisitions, Bluefin and Magnet 360 took longer time to stabilize as cross selling benefits did not materialize on expected lines. Post that, Mindtree did not pursue any new acquisitions. On the other hand, in last three years, Mindtree’s peers were on an acquisition spree. LTI acquired six companies in the field of Cloud, Data Analytics, DevOps and Temenos banking suit. Mphasis has also acquired DevOps automation services provider Stelligent, whereas Hexaware acquired Mobiqity, a customer experience firm for around US$182mn.
We believe constant renewal and up-gradation of services is essential to maintain client relevancy in the medium-term for IT services firm. In that context, limited focus of Mindtree on inorganic capability may impact depth and breadth of its product offerings, which can directly impact client relevance in the medium-term. We strongly believe that Mindtree needs to accelerate focus on capability based acquisitions in new generation growth areas such as Data Analytics, Cloud for improved experience.
Exhibit 15: Mindtree acquisitions during FY15-FY17 Date Target Brief Consideration Employees Jan-16 Magnet 360 Salesforce partner/ Cloud based sales and $50mn 150 marketing Jul-15 Relational Solutions IT solutions CPG $10mn ~30+ Jul-15 Bluefin Solutions SAP consulting $66mn 150+ Jan-15 Discoverture Solutions LLC Property and Casualty Insurance: IT Services $15mn 200 Source: RSec Research
71 Outlook & Valuation
We believe current risk-reward is unfavourable due to Mindtree’s high exposure to T&H vertical, disproportionate dependence on top clients and limited clarity on medium-term margin trajectory. At CMP, the stock trades at expensive valuation of 16.48x on FY23E EPS (18.4x on FY22E EPS) which is at par 24% premium to Mphasis. We assign target multiple of 14.5x (10% discount to five year average) as high T&H revenue exposure & limited margin clarity to weigh on growth outlook. We initiate coverage on Mindtree with SELL and a 2-Year Target Price of Rs900.
Exhibit 16: Unfavourable risk reward as at current valuation Mindtree is trading above its STDEV+1
Source: RSec Research
72 Key Financials
Profit & Loss Statement Y/E Mar (Rs mn) FY19 FY20 FY21E FY22E FY23E Net Revenues (US$ mn) 1,001.4 1,088.8 1,037.8 1,122.8 1,213.5 Growth (%) 18.3 8.7 (4.7) 8.2 8.1 Net Revenues 70,215 77,643 77,933 84,210 91,016 Growth (%) 28.5 10.6 0.4 8.1 8.1 Employee Costs 44,212 50,647 52,338 55,788 59,622 SG&A and Other Operating Expenses 15,358 16,098 11,943 14,003 15,473 EBITDA 10,645 10,898 13,652 14,419 15,922 EBITDA (%) 15.2 14.0 17.5 17.1 17.5 EBITDA Growth (%) 43.8 2.4 25.3 5.6 10.4 Depreciation 1,641 2,754 2,432 2,588 2,787 EBIT 9,004 8,144 11,220 11,831 13,135 EBIT (%) 12.8 10.5 14.4 14.0 14.4 EBIT Growth (%) 58.2 (9.6) 37.8 5.4 11.0 Other Income 893 673 687 856 1,033 Interest 29 529 524 524 524 PBT 9,868 8,288 11,383 12,162 13,644 Tax (incl deferred) 2,327 1,979 2,890 3,041 3,411 PAT 7,541 6,309 8,493 9,122 10,233 PAT Growth (%) 32.3 (16.3) 34.6 7.4 12.2 EPS 46.3 41.7 51.6 55.4 62.1 EPS Growth (%) 35.1 (9.9) 23.5 7.4 12.2
Balance Sheet Y/E Mar (Rs mn) FY19 FY20 FY21E FY22E FY23E SOURCES OF FUNDS Share Capital - Equity 1,642 1,646 1,646 1,646 1,646 Reserves 31,419 29,922 36,275 42,517 49,458 Total Shareholders' Funds 33,061 31,568 37,921 44,163 51,104 Total Debt including lease oblogation 5 4,964 4,964 4,964 4,964 Long Term Provisions & Others - 1,798 1,798 1,798 1,798 Creditors 2,131 2,587 2,491 2,705 2,911 Other Current Liabilities & Provns 1,573 3,522 3,446 4,016 4,333 Total Current Liabilities 5,020 8,925 8,621 9,300 9,954 TOTAL SOURCES OF FUNDS 41,790 51,566 57,444 65,149 73,266 APPLICATION OF FUNDS Goodwill 5,912 5,491 5,491 5,491 5,491 Net Block 3,757 3,400 4,014 4,774 5,443 CWIP 297 136 136 136 136 Investments 1,200 804 804 804 804 Deferred Tax Assets 388 1,835 1,835 1,835 1,835 LT Loans & Advances, Others 2,564 7,351 8,801 8,930 9,317 Total Non Current Assets 14,118 19,017 21,082 21,969 23,027 Debtors 13,356 14,389 15,160 16,150 17,455 Cash & Bank 2,562 5,870 8,893 14,296 19,590 Liquid Investments 6,836 6,944 6,944 6,944 6,944 Other Current Assets 4,918 5,346 5,366 5,790 6,250 Total Current Assets 27,672 32,549 36,362 43,179 50,239 TOTAL APPLICATION OF FUNDS 41,790 51,566 57,444 65,149 73,266 73 Cash Flow Statement Y/E Mar (Rs mn) FY19 FY20 FY21E FY22E FY23E PAT 7,541 6,309 8,493 9,122 10,233 Non-operating & EO items 1,738 1,367 0 0 0 Depreciation 1,692 1,795 2,432 2,588 2,787 Working Capital Change -2,360 420 -1,266 49 -589 Cash taxes -2,255 -1,640 -2,023 -2,128 -2,388 Cash Flow from Operations (a) 6,356 8,251 7,636 9,630 10,043 Capex -1,759 -1,220 -1,247 -1,347 -1,456 Acquisition 0 0 0 0 0 Investments -225 991 0 0 0 Cash Flow from Investing (b) -1,984 -229 -1,247 -1,347 -1,456 Debt Issuance/(Repaid) -4 -5 0 0 0 Share capital Issuance 3 4 0 0 0 Dividend -5,912 -5,940 -2,139 -2,880 -3,291 Other 814 1,227 0 0 0 Cash Flow from Financing (c) -5,099 -4,714 -2,139 -2,880 -3,291 NET CASH FLOW (a+b+c) -727 3,308 4,250 5,403 5,295 Closing Cash Balance 2,332 2,332 2,332 2,332 2,332 Free Cash Flow 4,597 7,031 6,389 8,283 8,586
Key Ratios Y/E Mar (Rs mn) FY19 FY20 FY21E FY22E FY23E EBITDA Margin 15.2 14.0 17.5 17.1 17.5 APAT Margin 10.7 8.1 10.9 10.8 11.2 RoE 27.5 19.1 26.9 24.1 23.2 RoCE 24.9 18.1 21.4 19.8 19.5 Efficiency Tax Rate (%) 23.6 23.9 25.4 25.0 25.0 Fixed Asset Turnover (x) 7.0 5.5 5.3 5.4 5.6 Debtors (days) 69 68 71 70 70 Payables (days) 12 13 12 12 12 Net Debt/EBITDA (x) (0.9) (0.7) (0.8) (1.1) (1.4) Net Debt/Equity (x) (0.3) (0.2) (0.3) (0.4) (0.4) Per Share Data (Rs) EPS 46.3 41.7 51.6 55.4 62.1 DPS 30.0 13.0 13.0 17.5 20.0 BV 201.0 191.6 230.2 268.1 310.2 Valuation (x) P/E 22.0 24.4 19.8 18.4 16.4 P/BV 5.1 5.3 4.4 3.8 3.3 EV/EBITDA 14.9 14.7 11.5 10.5 9.2 FCF/mkt cap (%) 2.7 4.2 3.8 4.9 5.1 Dividend Yield (%) 2.9 1.3 1.3 1.7 2.0
74 Company Background
Owned by Larsen and Toubro(L&T), Bangalore-based midcap IT company Mindtree provides analytics and information management, application development and maintenance, business process management, business technology consulting, cloud, independent testing, infrastructure management services, mobility, product engineering and SAP services. . The company was formed in 1999 and listed to bourses in 2007.L&T took over Mindtree in June 2019. As of FY20, Mindtree employs around 22,000 employees across 41 offices in 18 countries.
Milestone Year Achievement 1999 Mindtree was formed on August 18, 1999 by 10 founders; Two VCs committed $9.5 mn USD. The founders were industry professionals who came from Cambridge Technology Partners, Lucent Technologies, and Wipro. 2000 Unilever, one of the largest CPG firms, became a Mindtree client. 2001 Began an IT outsourcing partnership with Volvo Information Technology. 2002 Continued to earn business from some of the most well respected brands, including Aventis, Cendant, Sonoco, Hindustan Times, TVS, Kraft Foods, EPSON, Toshiba and Mitsubishi. 2003 Became a People Capability Maturity Model (P-CMM) Level 5 company within 5 years of our founding 2004 Acquired the software division of ASAP Solutions Private Limited, and the entire equity share capital of Linc Software Services. These acquisitions enabled Mindtree to augment our SAP and iSeries capabilities. 2007 Mindtree came out with 5,593,300 equity shares inIPO in India. Public issue was oversubscribed by ~100 times. 2008 Acquired Aztecsoft Ltd. and became one of the strongest independent testing service providers in India. 2009 Signed our largest multi-year multi-mn services contract with the largest telecom company headquarted in the Netherlands. Signed a partnership with P&G. 2010 Signed a contract with The Carlyle Group, one of the world's largest private equity firms, to provide IT infrastructure management and support services for their global data centres. 2015 Launched Mindtree Kalinga, the global learning and delivery center in Bhubaneswar, India, to build the engineers of tomorrow. This is still one of Mindtree's largest investments to date. 2016 Acquired Magnet 360, a Salesforce Platinum consulting partner, to strengthen its offerings in digitizing the value chain and building sense-and- respond systems. 2019 L&T acquired controlliong stake 2019 Crossed $1 bn USD in annual revenue. Source: Company, Rsec Research
75 Management Team Name Designation Breif Profile Mr. Debashis Chatterjee CEO &MD f Mr. Chatterjee (DC) is the CEO and Managing Director of Mindtree. He has over 30 years of experience in the field of IT, spanning customer relationship management, building and managing large business units, strategic alliances, M&A, change management and delivery management across multiple industries, business domains, technologies & geographies. f In his earlier role, as President, Global Delivery and Digital Systems and Technology at Cognizant, he was responsible for delivery of technology services across all industry segments. Mr. Dayapatra Nevatia COO f Mr. Dayapatra has rich experience in incubating new business verticals, leading business units/ client accounts, managing P&L/ complex programs, business development, and nurturing fruitful long lasting client relationships f Prior to joining Mindtree, Dayapatra was the MD and Director of Delivery for advanced technology centers in India for Accenture, and was responsible for the entire gamut, spanning system integration, digital, application outsourcing, infrastructure, and security services across industry groups. Vinit Teredesai CFO f Mr. Teredesai is responsible for providing financial leadership to Mindtree in its global growth journey. f He has over 25 years of experience in finance, accounting, auditing, taxation, fund raising, risk management, mergers and acquisitions, and corporate restructuring. Earlier, he served as the CFO. Source: Company
Revenue break-up by geographies Revenue break-up by service-lines
Source: Company, RSec Research Source: Company, RSec Research
76 Change in Ratings f We have shifted to BUY & SELL ratings only and no longer continue with HOLD rating. f We have also shifted to 2-year Target Price from 1-year Target Price earlier.
Reliance Securities Limited (RSL), the broking arm of Reliance Capital is one of the India’s leading retail broking houses. Reliance Capital is amongst India’s leading and most valuable financial services companies in the private sector. Reliance Capital has interests in asset management and mutual funds, life and general insurance, commercial finance, equities and commodities broking, wealth management services, distribution of financial products, private equity, asset reconstruction, proprietary investments and other activities in financial services. The list of associates of RSL is available on the website www.reliancecapital.co.in. RSL is registered as a Research Analyst under SEBI (Research Analyst) Regulations, 2014 General Disclaimers: This Research Report (hereinafter called ‘Report’) is prepared and distributed by RSL for information purposes only. The recommendations, if any, made herein are expression of views and/or opinions and should not be deemed or construed to be neither advice for the purpose of purchase or sale of any security, derivatives or any other security through RSL nor any solicitation or offering of any investment /trading opportunity on behalf of the issuer(s) of the respective security(ies) referred to herein. These information / opinions / views are not meant to serve as a professional investment guide for the readers. No action is solicited based upon the information provided herein. Recipients of this Report should rely on information/data arising out of their own investigations. Readers are advised to seek independent professional advice and arrive at an informed trading/investment decision before executing any trades or making any investments. This Report has been prepared on the basis of publicly available information, internally developed data and other sources believed by RSL to be reliable. RSL or its directors, employees, affiliates or representatives do not assume any responsibility for, or warrant the accuracy, completeness, adequacy and reliability of such information / opinions / views. While due care has been taken to ensure that the disclosures and opinions given are fair and reasonable, none of the directors, employees, affiliates or representatives of RSL shall be liable for any direct, indirect, special, incidental, consequential, punitive or exemplary damages, including lost profits arising in any way whatsoever from the information / opinions / views contained in this Report. Risks: Trading and investment in securities are subject to market risks. There are no assurances or guarantees that the objectives of any of trading / investment in securities will be achieved. The trades/ investments referred to herein may not be suitable to all categories of traders/investors. The names of securities mentioned herein do not in any manner indicate their prospects or returns. The value of securities referred to herein may be adversely affected by the performance or otherwise of the respective issuer companies, changes in the market conditions, micro and macro factors and forces affecting capital markets like interest rate risk, credit risk, liquidity risk and reinvestment risk. Derivative products may also be affected by various risks including but not limited to counter party risk, market risk, valuation risk, liquidity risk and other risks. Besides the price of the underlying asset, volatility, tenor and interest rates may affect the pricing of derivatives. Disclaimers in respect of jurisdiction: The possession, circulation and/or distribution of this Report may be restricted or regulated in certain jurisdictions by appropriate laws. No action has been or will be taken by RSL in any jurisdiction (other than India), where any action for such purpose(s) is required. Accordingly, this Report shall not be possessed, circulated and/or distributed in any such country or jurisdiction unless such action is in compliance with all applicable laws and regulations of such country or jurisdiction. RSL requires such recipient to inform himself about and to observe any restrictions at his own expense, without any liability to RSL. Any dispute arising out of this Report shall be subject to the exclusive jurisdiction of the Courts in India. Disclosure of Interest: The research analysts who have prepared this Report hereby certify that the views /opinions expressed in this Report are their personal independent views/opinions in respect of the securities and their respective issuers. None of RSL, research analysts, or their relatives had any known direct / indirect material conflict of interest including any long/short position(s) in any specific security on which views/opinions have been made in this Report, during its preparation. RSL’s Associates may have other potential/material conflict of interest with respect to any recommendation and related information and opinions at the time of publication of research report. RSL, its Associates, the research analysts, or their relatives might have financial interest in the issuer company(ies) of the said securities. RSL or its Associates may have received a compensation from the said issuer company(ies) in last 12 months for the brokerage or non brokerage services.RSL, its Associates, the research analysts or their relatives have not received any compensation or other benefits directly or indirectly from the said issuer company(ies) or any third party in last 12 months in any respect whatsoever for preparation of this report.
The research analysts has served as an officer, director or employee of the said issuer company(ies)?: No RSL, its Associates, the research analysts or their relatives holds ownership of 1% or more, in respect of the said issuer company(ies).?: No
Copyright: The copyright in this Report belongs exclusively to RSL. This Report shall only be read by those persons to whom it has been delivered. No reprinting, reproduction, copying, distribution of this Report in any manner whatsoever, in whole or in part, is permitted without the prior express written consent of RSL. RSL’s activities were neither suspended nor have defaulted with any stock exchange with whom RSL is registered. Further, there does not exist any material adverse order/judgments/strictures assessed by any regulatory, government or public authority or agency or any law enforcing agency in last three years. Further, there does not exist any material enquiry of whatsoever nature instituted or pending against RSL as on the date of this Report. Important These disclaimers, risks and other disclosures must be read in conjunction with the information / opinions / views of which they form part of. RSL CIN: U65990MH2005PLC154052. SEBI registration no. (Stock Broker: INZ000172433, Depository Participants: CDSL IN-DP-257-2016 IN-DP-NSDL-363-2013, Research Analyst: INH000002384); AMFI ARN No.29889. 77