Description

Tech Mahindra is the fifth largest provider of offshore IT services in India with revenues of ~$4bn. Company was initially incorporated as a JV between Mahindra & Mahindra and British Telecom in 1986. Over the years, the company developed a niche in telecom vertical by providing end-to-end services to telecom OEMs and service providers. Through a series of acquisitions, it has enhanced the services within telecom vertical but also diversified its business into the enterprise segment (i.e. Comviva Technologies - a mobile VAS provider, Hutchison Global Services - a customer services BPO, Satyam – enterprise solutions).  Telecom still constitutes a little over half of its revenues with US making a little less than half of the revenues.

Overall Indian IT sector did poorly in 2016, underperforming the broader Nifty Index.  A few different factors led to the underperformance - lack of spending from banks and retailers in US and Europe, which make up 35-55% of IT revenues, provided a headwind to top-line growth, leading to a number of earnings misses in FY2016.  The Trump election win created further uncertainty in the sector, particularly related to potential increased restrictions on high-skilled immigration, which would further dampen growth for Indian IT companies. 

While these broad issues affected all Indian IT service companies, Tech Mahindra had specific problems which led to growth slowdown and margin compression.  Much of company’s growth issues in FY16 were limited to the telecom vertical with major accounts reducing spend which led to a large top line slowdown.  The decline in large account spending has been primarily driven by some pull-back in spending by some of the large accounts (i.e. AT&T) due to capital outlays for large acquisitions, spectrum payments and investments in overseas expansion.  In addition, some large managed services deals did not close on time and expected increase in spending in some other accounts did not materialize.  

Over the past five years, the company has also made a number of strategic partnerships and acquisitions to not only enhance its capabilities in telecom but also diversify its business. Tech Mahindra completed a large $240MM acquisition of Lightbridge Communication (LCC) in 2014, but revenues and margins were lower than initial expectations and integration targets were missed, which put further pressure on margins.  The slowdown in telecom capex has led to slower-than-expected growth in these accounts and is also impacting the telecom network management business, LCC’s main focus area, depressing revenues in that segment. 

Top line revenues have slowed down to mid-single digits from high teens while EBITDA margins are now at ~16%, down from ~22% in 2013.  As highlighted earlier, main driver of revenue decline was the telecom sector, where growth went from ~25% in 2014 to ~6% today. While the decline in revenues has been high, we believe the trend is not structural.  Most of the slowdown from the telecom segment is coming to an end as M&A cycle rolls over and companies start focusing again on spending.  We expect the Enterprise segment to continue to grow top-line at mid-double digit levels as it continues to expand its business and benefit from its strong positioning in auto, aerospace and defense.  Margin will further expand due to improvement in utilization, reduction in subcontracting expenses (significant margin lever), tightening of sales execution with greater emphasis on high realization services and finally, investments in automation. 

Tech Mahindra has stepped up its focus on execution and profitability that will drive margin improvement over the next 12-24 months. Company consolidated the bench of the enterprise and telecom segment into a common pool which improved utilization rates to ~80% from 74% in March 2015. Company has also tightened sales execution, introduced targets for high realization services and brought in better discipline on pricing. Efforts are also underway to improve profitability of acquired entities (especially LCC) over time through consolidation of G&A and offshore shift.

Tech Mahindra is currently trading at 12x FY 2018 earnings and ROE of over 20% with a net cash balance sheet.  With top line expected to go back to the high teens over the next 3-5 years and margins rising closer to industry average, we believe market is currently too pessimistic about the near-term challenges in the telecoms vertical and not taking into account Tech Mahindra’s fundamental strength in the market. 

Catalyst

- Increased spending from large telecom accounts as M&A cycle rolls-over

- Margin improvement due to company's focus in reducing costs