Few weeks back many investors dumped IT stocks on the poor performance and bad future outlook for their business. The outlook is really gloomy for Indian companies and they are really struggling to grow their revenues and managing their operating margins. The fast changing IT demand, visa issues and rising cost of hiring are few red flag to tackle within the industry.

If you and I want to start something similar today what Infosys, TCS and Tech Mahindra do, it will be tough to survive and even breakthrough this sector if we are not specialist in any sector. But if you think about businesses who already have active clients from around the globe, they will always have an edge over us to change faster and match their services as per client’s requirement.

So when the margins are under threat and revenues are not growing, it is the toughest time for management to convince investor that what they are implementing will add any value to its business.

As an investor, with open mind I would like to do a bit of research and focus on from where the growth to expect. Tech Mahindra came under our radar when its stock price plunged down to Rs 350 and many analysts are expecting a double digit growth in its earnings.

So where will this growth come from?

Tech Mahindra business

Let me start Tech Mahindra story from 2014 financial year when Satyam business was merged with Tech Mahindra. Satyam business was twice the size of Tech Mahindra in 2014.

So before the merger, Tech Mahindra business was entirely giving its IT services to Telecom industry and they use to report the revenues from the verticals like Telecom service provider (TSP) and Telecom Equipment Manufacturer (TEM). But Satyam use to do business in all the sector and they use to report their business verticals as IT services and BPO. After merger Tech Mahindra also opted to report its revenue generation from IT and BPO segments.

2014

So let us focus on the revenues and margins for Tech Mahindra. In 2013 before merger, the business looked like this:

2013    
Tech Mahindra IT Services BPO
Revenues Rs 5,805.7 Rs 1,067.4
  100% 100%
Operating Income Rs 2,121.1 Rs 413
  36.53% 38.69%

After the merger in 2014, this is what they reported their revenues:

2014    
Tech Mahindra IT Services BPO
Revenues Rs 17,013.9 Rs 1,817.5
  100% 100%
Operating Income Rs 6,296.3 Rs 810.3
  37% 44.57%

So merging both the business there was really good synergy and their margins also improved. Before merger Europe was the biggest source for Tech Mahindra to generate its revenues but after the merger America became their biggest market to source their revenues.

2015

They managed to fetch growth of 20% in their revenues in 2015 financial year and also MES (Mahindra Engineering Services) was merged with Tech Mahindra. They also acquired few businesses like Lightbridge Communications Corporation (LCC), SoftGen and BASF IT. We will talk about acquisitions under valuations but let us focus on how their margins were in 2015.

Tech Mahindra 2015 2014 % Change
Revenues Rs 22,727.8 Rs 18,944.4 19.97%
  100% 100%  
Operational profits Rs 4,259.4 Rs 4,296.8
  18.74% 22.68%  
EBT Rs 3,618.1 Rs 3,814.7 -5.15%
  15.92% 20.14%  
Net Profit Rs 2,627.7 Rs 3,028.8 -13.24%
  11.56% 15.99%  

Overall the performance in 2015 was not that great on margins level. The growth in revenues was because of the addition of new clients and also merger with MES. The culprit for such worse margins was its final 4th quarter performance for the financial year. The IT service segment represents 92% of its gross revenues and BPO 8%. In 2014 it was 90% from IT services and 10% from the BPO segment.

2016

I know you might be thinking about why I am sharing all this previous year’s performance with you. Let me share with you 2016 figures and we will link all of this information to understand its future prospects from here on.

Tech Mahindra 2016
Revenues Rs 27,050.8
  100%
Operational profits Rs 4,875
  18.02%
EBT Rs 4,016.9
  14.85%
Net Profit Rs 3,118
  11.53%

In 2016 revenues grew by 17% and this was because of addition of new clients and the amalgamation of Tech Mahindra BPO and New vC Services private limited. The net profits grew by 19% but they were not able to improve their margins. They also faced tough times on their communication vertical and we know that it continued in 2017 too. The IT Services segment represents 93% of gross revenues and 7% BPO segment in 2016 financial year.

2017

We did covered its Q4 – 2017 results on our blog last week and if you have missed out on it then click here to read.

Tech Mahindra 2017
Revenues Rs 29,918.4
  100%
Operational profits Rs 4,961.99
  16.59%
EBT Rs 3,853
  12.88%
Net Profit Rs 2,934.21
  9.81%

There was 10% growth in their revenues but margins deteriorated badly and management expects to gain that in 2018 financial year. They also acquired company that gives IT services to health care sector.

So the operations performance in the past 4 years have been disaster. Margins from 16% (Net profits) have fallen down to 10% in 2017. The reason to share this past 4 years information was to make you understand that it is very tough to improve margins once you have lost them. Expecting them to regain 2% of their margins in 2018 is big expectation. But they managed to grow their revenues at healthy rates between 10% – 20%.

So if we anchor those revenue growth, then these are the profits to expect in 2018 on same profit margins.

Revenue Growth Profit estimate
10% Rs 3,228.50
15% Rs 3,375
20% Rs 3,522

What do you think? Where will this growth come in 2018?

There were few insight we took from investors call after 4th quarter:

  1. They do not want to do any more networking business and Q4 poor results explain the pain.
  2. They are looking towards new avenues like BFSI, Healthcare and manufacturing to replace networking sector.
  3. They see a similar growth momentum as it was in 2016 (10% – 12%) for 2018 and expect their margins to improve in coming two quarters

Valuations

Business performance is only half battle won. The other half battle decision is based on how prudent the management is in allocating shareholders fund and cash. Tech Mahindra is burning lot of cash from the past couple of years. So there is a big expectation from investors to see business transferring into cash surplus.

If we factor in 12% revenue growth with only 1% improvement in their margins then Tech Mahindra will easily report its profits for 2018 above Rs 3,600 crore. If you have read our previous post on Tech Mahindra then you might have realised that the consensus of analysts expects its profits in range of Rs 2,200 crore – Rs 4,800 crore. We don’t think there profits will plunge to the Rs 2,200 crore level and neither to outperform to Rs 4,800. But they will report within that range and for us it would be in range of Rs 3,200 – Rs 4,000 crore.

The market price today is reflecting profits of around Rs 3,400 crore. As quarter passes and we get actual figures, we will be able to predict where 2018 profits will land. Current market expectation is still close to our lower band profitability. So there is a good room for its stock price to move up as quarters passes.

Tech Mahindra does not have great reputation to improve its intrinsic value. We valued this business in 2014 for Rs 75,000 crore and that has fallen down to Rs 30,000 crore in 2017. So there has been a big disaster on valuation front too. If you have invested in this business in 2014 then you have lost money in the past four years.

That doesn’t mean they will not add value in the future. But looking at the past performance it doesn’t give 100% conviction to us that Tech Mahindra will turn the table from 2018. Our allocation meter is pointing towards most 63% exposure to this stock but that is to do when your conviction level is 100%. Our conviction level at this stage at 50% so our most allocation to this business is only 31% of our individual stock allocation.

What is your conviction level for Tech Mahindra?