Tech Mahindra Limited

Earnings rebound expected; Buy

Cutting estimates & PO; Retain Buy on strong growth

Post revs being a little short in 2Q, BT growth seeing sluggish growth in last couple of quarters due to restructuring in BT and management change and Rupee appreciation, we are cutting our estimates by 7-8% for FY08-10e. While we reduce PO to Rs1,650, we retain Buy for 24% upside, on strong 34% EPSg during FY07-09E on ML adjusted basis (factoring 5 year write-off of upfront payment to BT, though Tech Mahindra (TML) has written off fully) & 40% on reported basis.

BTGS ramp led earnings rebound from next quarter

Management said that it has transitioned 500 of the 1200 positions (25% of estimated requirement) already identified. With transitioning costs already factored in the current quarter, we expect margins to improve given significant billings from BTGS deal, resulting in double digit growth rates in earnings from 3Q.

2Q: Revs a little short; Tight margin management

TML reported 2Q revenue growth of 2.4% qoq, 2% lower than MLe. Margins remained flat at 22%, despite BTGS transitioning cost, helped by higher Utilization levels (excl fresher’s). It reported nine new client additions and added 1954 net employees during the quarter, increase of 11% to manpower base.

Maintain Buy; Strong two-yr 34% EPS growth (adj. basis)

Our PO of Rs1,650 is at 1 PEG (FY07PE to FY07-09e) and implies a target FY09e P/E of 19x on ML Adj EPS of Rs.85. We believe this is fair given sharp anticipated earnings growth of 34% (FY07-09e), robust IT spends by telecom service providers and increasing trend in offshoring.

Stock Data:

Price	Rs1,329
Price Objective	Rs1,940 to Rs1,650
Date Established	22-Oct-2007
Investment Opinion	C-1-7
Volatility Risk	HIGH
52-Week Range	Rs779.10-Rs2,050
Mrkt Val / Shares Out (mn)	US$4,213 / 125.9
Average Daily Volume	121,301
ML Symbol / Exchange	TMHAF / BSE
Bloomberg / Reuters	TECHM IN / TEML.BO
ROE (2008E)	64.9%
Net Dbt to Eqty (Mar-2007A)	-5.4%
Est. 5-Yr EPS / DPS Growth	25.0% / 25.0%
F ree Float	12.5%

Estimates (Mar)

(Rs)	2006A	2007A	2008E	2009E	2010E
Net Income(Adjusted - mn)	2,354	6,125	7,948	11,954	13,500
EPS	18.1	47.12	61.14	91.95	103.85
EPS Change (YoY)	123.10%	160.30%	29.80%	50.40%	12.90%
Dividend / Share	10	2.18	12.62	18.52	20.73
Free Cash Flow / Share	8.95	-13.16	33.1	60.63	76.27

Growth trajectory to return; Buy
2Q PAT beat MLe by 10% led by other income. Revenue was marginally below our estimates. Revenues from BT grew by 2% and 4% qoq during Q1 and Q2, given the recent restructuring. Moreover, given a couple of management changes in BT, we expect growth rates to be subdued. We are cutting earnings by 7 to 8% across FY08-10 to factor in possible sluggishness in BT, slower BT Global Services ramp than assumed by us and Rupee appreciation. Consequently we have our PO to Rs1,650 (from Rs1,940) but retain Buy for 24% upside driven by a strong earnings growth of 34% and rebound in earnings to double digit sequential growth from next quarter given significant ramp this quarter.
We believe the stock is attractively valued at 16x FY09e given strong 34% EPS CARG (07-09E) on ML Adjusted basis (factoring in a 5 year write off of upfront payment to BT, though TML has written off fully) and 15x FY09e and 40% EPS CARG (07-09E) on reported basis.

Encouraging commentary on BTGS
Management said that revenues from BTGS commenced in 2Q and billing would be “material & significant” in 3Q. It indicated that nearly 1,200 positions have already being identified and nearly 500 is in transition currently. With estimated 4,300 positions to be created, we believe management already has visibility on 25% of position, which is encouraging.

Margin expansion likely

EBITDA margins eased by 9bps during the quarter to 22%, lower than expected. While Utilisation (excl freshers) improved by 400bps to 74%, margin impact primarily was driven by transition costs in BTGS deal. With billing to commence from 3Q we expect EBITDA margins to improve by 200-300bps during the next two years.

Upside from BT restructuring remains
Revenues from BT grew by 2% and 4% during current year, as against double digit growth witnessed during the past 6-7 quarters. Given the recent restructuring in BT and management changes, we expect growth rates to be subdued. However we remain positive in long term as the restructuring is likely to drive more work offshore than before. Management too reiterated that one should now expect more holistic end to end deals rather than standard ADM outsourcing. These deals in our view could involve the vendor offering multiple service lines and could potentially be larger in size. TML too has now started offering BPO work to BT, a service offering which was introduced last year to Non BT clients.
Macro environment conducive
Management reiterated its stance on a strong demand environment with telecom service providers, also reflected in strong client additions. Even Wipro and TCS reported double digit growth rates in revenues from telecom service providers segment. It added 9 new clients during the quarter and also entered the cable and direct broadcast satellite market.
2Q results: Revs a little short; Strong margin mgt

• EBITDA margins remained at 1Q levels despite transitioning cost in BTGS, helped by higher utilization level (excl freshers)
• PAT exceeded MLe by 10% primarily driven higher margins and higher forex gains during the quarter. Other income includes forex gains of US$4mn. Management indicated that US$17mn gains were sitting in reserves currently.
• Attrition during the quarter increased to 31% from ~20%. Management indicated that around 400 candidates failed to perform in the training test conducted by TML, which resulted in higher attrition during the quarter.

Price objective basis & risk Tech Mahindra (TMHAF)
Our PO of Rs1,650 is at 1PEG (FY07e PE to FY07-09e) and implies a target P/E of 19x on ML Adjusted EPS basis of Rs85 and at a discount to peers such as Infosy (22x FY09e). We believe this is fair given sharp anticipated earnings growth of 34% (FY07-09e), robust IT spends by telecom service providers and the increasing trend in offshoring.
Risks to our rating are rapid growth-related execution risks, high vertical (telecom) and client concentration (BT- 64% revenue). Industry-wide risks include growing competition, wage and attrition pressures and risk of rupee appreciation.

-----With due apologies and full credits to Merrill Lynch-----