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Hold Tech Mahindra Ltd For Target Rs.1,010

Limited scope for further surprises

The key rationale behind our earlier BUY rating on TechM was the potential surprise on the pace of margin expansion (refer our note – Pace of margin expansion may surprise). In-line with our thesis, EBIT margin expansion of ~600 bps over H2CY20 (to 15.9%) came in significantly faster-than-street expectations. This was led by (1) headcount / mix / portfolio company rationalisation and (2) transient Covid-led industry tailwinds. Ceteris paribus, the current profitability level leaves very little further upside. In fact, given the impending cost headwinds (e.g. talent related, reversal of some expenses like travel), we see a higher likelihood of margin contraction than further expansion. Relatively (1) higher exposure to asset-heavy verticals (e.g. communications, manufacturing), (2) higher client concentration and (3) potential for delays in enterprise 5G use case adoption should translate into continued growth underperformance vs Tier-I over FY21E-23E. Given the limited scope for surprises and the not-so-undemanding valuations (as earlier, CMP implies 16x FY22E EPS), we downgrade the stock to HOLD.

* In-line and subdued revenue growth; margin beat.

Revenue growth of 2.8% (QoQ, CC) during Q3FY21 was underwhelming in the context of strong growth reported by the industry during Q3. Growth was led by communications (+3.6% QoQ, CC) and manufacturing (+4.2% QoQ, USD) verticals. Across key geographies, Europe recovered well (+8.5%). It should be noted these three segments witnessed sharp revenue decline in Jun-20 followed by a subdued Sep-20 providing scope for a strong recovery during the current quarter. Across service lines, BPO continued to outperform IT services by a wide margin in terms of growth. Reported EBIT margin of 15.9% was ~130-170bps ahead of our / consensus expectations. (1) Reduction in overall headcount (2% QoQ) and consequent rise in utilisation (+200bps QoQ), (2) offshore shift and (3) operating leverage led to this margin expansion.

* Should underperform on growth; margins have more or less plateaued.

The company announced net new deal wins of US$455mn, closer to pre-Covid run-rate. Given the funnel and pace of deal closure / conversion, management is optimistic on acceleration in the deal activity. Despite the street optimism around network services benefitting due to preparatory / rollout work of 5G, we expect TechM to continue underperforming Tier I on growth. This should be led by (1) relatively higher exposure to asset-intensive verticals (e.g. communications, manufacturing) and (2) potential for delays in enterprise 5G use case adoption led by reprioritisation of capital. While potential surprise on the pace of margin expansion was the key rationale behind our earlier BUY rating, EBIT margin of 15-16% in steady state (above guidance of 15%) is now mostly priced in. With margins more or less plateauing and given the impending cost headwinds (elaborated in our earlier note), we see higher likelihood of disappointments (vs surprises). Downgrade to HOLD.

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