Tech Mahindra (TECMAH) CMP: | 848 Target: | 1040 (23%) Target Period: 12 months BUY October 24, 2020 Robust margin expansion... Tech Mahindra’s (TechM) revenues increased 2.9% QoQ in constant currency terms (above our estimate of 1.1% QoQ in CC terms) mainly led by 0.8% QoQ growth in communication revenues and 4.3% QoQ growth in Particulars enterprise revenues. The company also reported a healthy expansion in EBITDA margins (up 397 bps QoQ to 18.2%) mainly led by higher utilisation, Particular Amount offshoring and rationalisation of SG&A expenses. The order book improved Market Cap (| Crore) 81,951.9 45.2% QoQ to US$421 million. Total Debt (| Crore) 2,428.2 Healthy deal pipeline, traction in digital to drive growth Cash and Invest (| Crore) 8,760.6 Update Result EV (| Crore) 75,619.5 TechM saw healthy growth in revenues in the current quarter mainly led by 52 week H/L 888 / 470 robust growth in enterprise segment (led by banking & technology vertical). Equity capital 435.9 Going forward, the company believes manufacturing has bottomed out and Face value | 5 could see healthy traction led by improving growth in engineering side (especially in auto). In addition, TechM is witnessing improving trends in retail and utility. Further, on the communication side, expect IT spends to Key Highlights improve led by 5G, digital, customer experience, AI, cloud and network Leadership in communication vertical operations. Further, TechM is seeing healthy funnel in holistic to drive long term growth. Enterprise transformation of telecom service providers and the company is in advanced segment to benefit from improved stages with many customers in transformational projects. In addition, digital revenues improving digital, healthy deal wins, 5G in enterprise and pruning of low return geographies bode well for the longer term trend in revenues. Hence, Revise our EPS estimates upwards although we expect revenues to be under pressure in FY21E, we expect an led by improving margin trajectory improved performance in FY22E & FY23E. Maintain BUY recommendation with Margins to witness gradual improvement revised target price of | 1040. Industry leading revenue growth can EBIT margins in the quarter improved 414 bps to 14.2%. Going forward, the further re-rate stock company expects margins to sustain at these levels. The company believes that despite headwinds (like higher variable pay & travel cost) it has multiple levers in terms of sustaining and improving margins, going forward. Some levers are synergies in portfolio companies (like systems, back-end, Research Equity Retail Research Analyst process), automation, reduction of sub-contracting cost (from current 13%) – higher offshoring, pruning of low return geographies and benefits of large Devang Bhatt deal won in previous quarter. Hence, we expect EBIT margins to improve [email protected] 157 bps YoY to 13.2% in FY21E and another 160 bps in FY21E-23E to 14.8%. Valuation & Outlook Securities The company is well poised to capture improving IT spend in communication and digital traction on the enterprise side. Further, in the ICICI long term, we believe TechM will be a key beneficiary of 5G opportunities. This, coupled with improving margin trajectory led by cost rationalisation prompt us to revise EPS estimates upwards. Hence, we maintain BUY with a revised target price of | 1040 (15x PE on FY23E EPS). Key Financial Summary Key Financials FY19 FY20 FY21E FY22E FY23E CAGR (FY20-23E) Net sales 34,742 36,868 37,536 40,490 44,787 6.7% EBITDA 6,337 5,726 6,419 7,450 8,375 13.5% EBITDA Margin (%) 18.2 15.5 17.1 18.4 18.7 Net Profit 4,298 4,033 4,402 5,169 5,923 13.7% EPS (|) 47.7 45.9 50.0 58.8 67.3 P/E 17.8 18.5 16.9 14.4 12.6 RoNW (%) 21.2 18.5 18.3 18.9 19.0 RoCE (%) 23.6 19.1 18.7 19.8 20.3 s Source: Company, ICICI Direct Research Result Update | Tech Mahindra ICICI Direct Research Exhibit 1: Variance Analysis Q2FY21 Q2FY21E Q2FY20 YoY (%) Q1FY21 QoQ (%) Comments Dollar revenues increased 4.8% QoQ mainly led by equal Revenue 9,371.8 9,208.4 9,069.9 3.3 9,106.0 2.9 growth in demand and receding supply side constraint Employee expenses 6,424.5 6,491.9 6,389.3 0.6 6,510.5 -1.3 Gross Margin 2,947.3 2,716.5 2,680.6 9.9 2,595.5 13.6 Gross margin (%) 31.4 29.5 29.6 189 bps 28.5 295 bps SG&A expenses 1,244.3 1,261.6 1,179.7 5.5 1,295.3 -3.9 EBITDA 1,703.0 1,454.9 1,500.9 13.5 1,300.2 31.0 The improvement in margins was due to 160 bps led by supply & demand side improvement and 160 bps due to EBITDA Margin (%) 18.2 15.8 16.5 163 bps 14.3 397 bps higher offshoring, lower subcontracting cost, lower seasonality and utilisation Depreciation & amortisation 371.7 383.2 341.5 8.8 383.2 -3.0 EBIT 1,331.3 1,071.7 1,159.4 14.8 917.0 45.2 EBIT Margin (%) 14.2 11.6 12.8 142 bps 10.1 414 bps The company had one-time income tax receipt in the Other income (less interest) 77.6 345.0 178.1 -56.4 365.8 -78.8 previous quarter. As a result, the fall in other income looks significant PBT 1,408.9 1,416.7 1,337.5 5.3 1,282.8 9.8 Tax paid 346.2 361.3 226.5 52.8 327.6 5.7 PAT 1,064.6 1,072.3 1,124.0 -5.3 972.0 9.5 Adjusted PAT 1,064.6 1,072.3 1,124.0 -5.3 972.0 9.5 PAT broadly in line with our estimate Source: Company, ICICI Direct Research Exhibit 2: Change in estimates FY21E FY22E FY23E Comments (| Crore) Old New % Change Old New % Change Introduced Improving growth in communication and enterprise Revenue 37,244 37,536 0.8 40,238 40,490 0.6 44,787 prompt us to revise revenue estimates upwards EBITDA 5,587 6,419 14.9 6,438 7,450 15.7 8,375 Considering multiple margin levers, we revise our margin EBITDA Margin (%) 15.0 17.1 210 bps 16.0 18.4 240 bps 18.7 estimates upwards PAT 3,838 4,402 14.7 4,486 5,169 15.2 5,923 EPS (|) 43.6 50.0 14.7 51.0 58.8 15.2 67.3 Source: Company, ICICI Direct Research ICICI Securities | Retail Research 2 Result Update | Tech Mahindra ICICI Direct Research Conference Call Highlights Revenue outlook: On the communication side, the company expects IT spends to improve led by 5G, digital, customer experience, AI, cloud and network operations. In addition, TechM is seeing healthy funnel in holistic transformation of telecom service providers while the company is in advanced stages with many customers in transformational projects. In addition, from the enterprise side, the company believes manufacturing has bottomed out and will see healthy traction, going forward. TechM is also seeing improving trends in retail and utility. In terms of technology, the company is seeing improving demand from artificial intelligence, machine learning, cybersecurity, customer experience and automation. In addition, this quarter growth was led by BPO but the company expects IT related growth to claw back in coming quarters. Further, in terms of geography, the company expects Europe to register improving trajectory Margin snapshot: EBIT margins in the quarter improved 414 bps to 14.2%. Going forward, the company expects margins to sustain at these levels. TechM believes that despite headwinds (like higher variable pay & travel cost) it has multiple levers in terms of sustaining and improving margins, going forward. Some levers are synergies in portfolio companies (like systems, back-end and process), automation, reduction of sub-contracting cost (from current 13%) higher offshoring, pruning of low return geographies and benefits of large deal won in the previous quarter Deal wins: The communication order book increased from US$105 million to US$208 million due to low base last quarter. Enterprise order increased ~16% due to closure in deal wins. The company is seeing improving funnel in communication across a broad range of holistic transformation of telecom service providers led by better traction in network, 5G stack, digital transformation while it is in advanced stages with many customers in communication segment Employee update: TechM saw addition of 842 employees in Q2FY21 leading to total employees of 1,24,258. The growth was largely due to BPO business offset by a decline in software professionals DSO position: DSO days declined from 107 in Q1FY21 to 97 days in Q2FY21. We believe DSO days were due to advances by customers and could see an increase in subsequent quarters Acquisitions : The company’s wholly owned subsidiary Tech Mahindra (Singapore) Pte Ltd has agreed to acquire 100% equity shares in Tenzing Ltd and Tenzing Australia Ltd (Tenzing Group) for US$29.5 million (~| 217 crore) at EV/sales of 1.1x. The target entity is engaged in the business of digital transformation & technology services with a BFSI focus. The transaction is expected to be completed by November 2020. The company has also done one more acquisition and agreed to acquire 100% stake in Momenton Pty. Ltd for AU$14.3 million (| 74.7 crore) at EV/sales of 1.32x. Momenton is a cloud and engineering services provider with a BFS focus.