Beat on margins; Stable outlook
Top client exposure warrants closer watch
* Mindtree’s revenue, excluding for the top account, plunged (~16% QoQ), largely weighed by Travel, Transportation, and Hospitality (-55% QoQ). Despite the nosedive in revenue (-9% QoQ), the EBIT margin remained resilient, aided by operational efficiencies and favorable currency. While the deal win run-rate was maintained (QoQ), the mix was more skewed toward renewals (~80%). The top account / overall outlook remained positive/stable.
* We upgrade our EPS estimate by 12–13% on a stronger-than-expected margin trajectory. While the top client has been driving strong growth in the recent past, we remain cognizant of increasing concentration risk. Additionally, we are watchful of the potential insolvencies of some clients within the Travel, Transportation, and Hospitality vertical. Retain BUY.
Portfolio declines sharply, excl. top client
* Mindtree reported revenue (USD)/Adj. EBIT/PAT growth of -4%/75%/130% YoY.
* The company reported yet another quarter of strong performance from the top account (Microsoft, +10% QoQ and +44% YoY). With the exception of this account, the remaining portfolio saw steep decline (16% QoQ; 16% YoY).
* While the top account now contributes ~30% to revenue, the Hi-Tech and Media vertical accounts for half of the overall revenue.
* Along expected lines, the sharp decline in revenue was largely attributed to the Travel, Transportation, and Hospitality vertical (-55% QoQ). BFSI and Retail witnessed high single digit decline.
* Across geographies, even as revenue decline in the US was relatively low, Europe/APAC also reported a sharp contraction in revenues.
* The share of revenue from fixed-price projects saw a material increase (~830bp QoQ to ~67% of revenue), largely reflecting the strategic focus on chasing long-term annuity deals.
* Tight control on cost more than offset the margin impact from a drop in the revenue run-rate. Adjusted for the differential accounting treatment of forex loss and the PM CARES fund contribution, the company reported marginal expansion (~30bp QoQ) in the EBIT margin.
* Utilization fell marginally v/s Mar’20 (100bp to 77.4%).
* Cash conversion was healthy during the quarter. DSO remained largely stable (67 days v/s 66 days in the previous quarter).
* Deal signings were maintained at the Mar’20 run-rate (~USD391m). However, deal signings in Jun’20 were largely skewed toward renewals (~80%), unlike in Mar’20, when the company reported a healthy mix of renewals (52%) and new deals (48%). On a YoY basis, deal signings still improved ~21%.
Key highlights from management commentary
* Management indicated the worst impact of COVID-19 was largely behind. It hinted that 2QFY21 should be better than 1QFY21.
* Within the top account, Mindtree indicated it is well-diversified across areas such as analytics, networks, customer/tech support, and marketing operations. Additionally, it now has decent exposure to annuity/project-based work in the account.
* Verticals such as CMT and CPG are witnessing good traction in terms of the deal pipeline. However, deal closures have been slower. The company expects continued softness in Travel, Transportation, and Hospitality.
* Management indicated it does not foresee any material margin headwinds.
* While promotions were extended to eligible candidates, the company is yet to reach a decision on salary hikes for the year.
Valuation and view – Rich multiples are justified
* Since Jul’19, post the disruption pertaining to ownership change, Mindtree has been undertaking encouraging steps toward achieving stability in both its client and employee count. Jun’20 margin performance, despite COVID-19, has reiterated its ability to adapt to a disruptive situation quickly.
* The strategy change to increase focus on annuity revenue and tail account rationalization is already reflecting in the revenue and client mix. The share of revenue from fixed-price contracts showed a meaningful increase in 1QFY21 (~830bp QoQ to ~67% of revenue).
* High exposure to Travel, Transport, and Hospitality resulted in a sharp drop in revenue in 1QFY21. However, (1) a continued robust outlook for the top account, (2) decent deal signings, and (3) strong margin execution are key positives.
* The stock is currently trading at 17x on depressed FY21E EPS. We value the stock at 17x FY22E EPS. Rich parentage and industry-leading growth/ROCE (~30%+ in steady state) should defend the premium multiple across Tier II.
* Increasing client concentration and potential insolvencies in some airlines / hospitality companies on account of the COVID-19 disruption are key risks to watch out for.
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