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Margin upside to absorb the impact of potential downgrades in revenue
Mindtree is yet to see any meaningful impact of COVID-19 outbreak on the business with order intake, revenue growth and margin expansion expected to be reasonably healthy in Q4FY20. Strength in the Hi-tech and CPG verticals is helping offset the relative weakness in travel, hospitality and insurance sub segments. Having said that, we expect deal closures to potentially get impacted in Q1FY21 given Mindtree's higher exposure to discretionary services which can potentially drive a sharper sequential decline in USD revenues in Q2FY21 (I-Sec: -5.2% QoQ). However, margins should have an upside which should help partially absorb the impact of downgrades to revenue estimates. Maintain ADD.
* Multiple areas of strength should help keep growth resilient in the near-term. Mindtree is seeing strength in various pockets like with the largest client (Microsoft) and in the consumer goods space, which should help absorb potential weakness in segments like Travel, Hospitality and Insurance. Large deal signings have been strong thus far in Q4FY20, with deals like with Realogy likely significant in size. As a result, we expect revenue growth in Q4FY20 to be reasonably healthy at 1.5% QoQ in USD terms despite book-to-bill ratio having been tepid at 0.75x in Q3FY20.
* Margins should have an upside over the medium term. We see prospect for EBITDA margins to increase every quarter for the next 2-3 quarters despite the drags from wage hikes and visa costs in H1FY21 given the benefits from higher utilisation, higher offshoring, cutbacks in discretionary costs including travel, automation and pyramid optimisation. INR depreciation should incrementally help as well. We expect EBITDA margin to increase by 80bps QoQ to 16.4% in Q4FY20 after having increased by 260bps QoQ to 15.6% in Q3FY20. There is the prospect for EBITDA margins to get into the management's aspirational band of 17-18% in H1FY21 though we are conservatively modeling 16.4%/15.6% in Q1/Q2 FY21 as we project revenues to decline by -2%/-5.2% QoQ in Q1FY21 and Q2FY21 respectively.
* Deal conversions in Q1FY21 are the key unknown; maintain ADD. We see a real prospect where deal conversions can potentially get impacted meaningfully in Q1FY21 given the following factors: 1) limited mobility of sales and account management resources, 2) sharp expected implosion in economic activity in developed economies in Q2CY20 on account of lockdowns associated with COVID19 outbreak (with impacts to be especially exacerbated in segments like Travel & Hospitality – 16.6% of revenues for Mindtree), and 3) Mindtree's higher exposure to discretionary services like Interactive and Package Implementation (22.3% and 6.5% of revenues respectively). Weak conversions can prospectively drive a sequential decline in revenues in Q1 and Q2FY21. We are projecting revenues to decline by 5.2% QoQ in Q2FY21 and 3.3% in FY21 for now though margin expansion should help FY21 EPS to still increase by ~23%. Maintain ADD rating with a target price of Rs790 even as we lower the target multiple to 14x (FY22 EPS) from 16x earlier.
* High levels of delivery preparedness. Unlike some of our other mid-size coverage companies which had to lease laptops for their employees to enable them to work from home, Mindtree gives laptops to most, if not all, of their employees on onboarding itself. For onsite delivery, almost everyone is working from home whereas a small proportion of employees offshore is still working from delivery centres in shifts (primarily for IMS). The company had set up a delivery preparedness war room in February itself and has been engaged with top-15 clients for business continuity plans for some time now. Work from home productivity has been managed well so far with clients getting regular productivity updates/access to productivity measurement tools from the company.
* Hi-tech and CPG expected to do well; Travel & Hospitality to be challenged. Growth in the near-term should be driven by the Hi-tech segment (41.5% of overall revenues) as spends continue to ramp-up at the largest client Microsoft (23.1% of revenues) and as the deal with Realogy ramps-up. Some clients within the CPG vertical have also seen an uptick in spends as they rely more on digital campaigns, analytics and direct channels to sell more. Though large clients within the Travel & Hospitality segment (16.6% of revenues) are yet to see a meaningful implosion in spends, we would expect that to be an eventuality as these clients have seen sharp declines in their capacity utilisation (Airlines) and occupancies (hospitality). Within BFSI, insurance segment is weak on large client specific issues though other banking clients are expected to be steady.
Valuation methodology and key risks
We maintain ADD rating on Mindtree with a revised target price of Rs790 (earlier Rs940) based on 14x Mar’22E EPS (earlier 16x Dec’21E EPS). The key risks to our call are: i) weakness in new deal intake relative to our expectation, ii) slower than expected expansion in margins, and, iii) INR appreciation.
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