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Aiming for aggressive margin expansion- not an easy task!

Tech Mahindra (TechM) reported revenue of US$1,633mn +3.5% QoQ CC, 1.5% QoQ USD (I-Sec: 1.3%, consensus: 1.1%). Growth was broad-based between communications (+3.9% QoQ CC) and enterprise (3.2% QoQ CC) verticals. We note the impact of cross-currency revenue headwinds in communications was higher at ~290bps due to the company’s larger exposure to Europe.

Net new deal TCV was soft during the quarter at US$802mn (-1.6% YoY, -21% QoQ) vs the average TCV run-rate of US$820mn in FY22. There are early signs of impact of a weak macro (a couple of telecom operators are reprioritizing their spends). But management mentioned demand is healthy in the communications segment with focus on automation, integrating data on cloud for monetisation, and network modernisation with spend on fiber space besides investment in 5G.

EBIT margin further contracted by 220bps QoQ (411bps YoY) to 11%, which was slightly lower than consensus / our estimates (11.4% / 11.4%). Margin performance was weak despite no annual wage hike in Q1. The weakness was due to headwinds from: 1) 100bps impact of intermittent wage increments, higher subcon costs and large deal transition costs; 2) 80bps impact due to visa costs and seasonality in the mobility business; and 3) normalisation of SG&A expenses.

Management indicated that margins have bottomed out and that it expects a 100- 150bps increase every quarter hereon to reach ~14% exit margin by Q4FY23. In Q2FY23, annual wage increment cycle is expected to have an impact of 100bps on margins. Margin levers in Q2 are: absence of large deal transition costs, price improvements, lower impact of visa costs, and mobility business. Besides, the company will benefit from increased scope for utilisation and offshore mix over the next three quarters. We model 12.7% and 13.4% margins for FY23E and FY24E respectively.

TechM has exposure to engineering services and ‘experience design’ services, which are likely to slow down in case of lower discretionary spends. Aggressive acquisitions done in past one year also add to the risk in the event of a slowdown. Our EPS estimates increase by ~2% due to increase in other income and currency rate, yet they remain 6% below consensus estimates. TechM is currently trading at 16x / 14x over FY23E / FY24E EPS of Rs63 / Rs71. We value the stock at 14x FY24E earnings and arrive at a revised target price of Rs1,021 (earlier: Rs975). FCF/PAT generation has been declining for last two quarters and is now at 50.2% (vs 56% in Q4FY22 and 94% in Q1FY22). Maintain HOLD.

* Revenue slightly above estimates. TechM reported revenue of US$1,632mn, +3.5% QoQ CC, 1.5% QoQ USD (I-Sec: 1.3%, consensus: 1.1%). Growth was broad-based between communications (+3.9% QoQ CC) and enterprise (3.2% QoQ CC) verticals. We note that the impact of cross-currency revenue headwinds in communications was higher at ~290bps due to larger exposure to Europe.

Within the enterprise segment, growth was led by: 1) technology (6.4% QoQ CC); 2) manufacturing (5.7% QoQ CC); and 3) retail, transport and logistics (6.8% QoQ CC). BFSI was flat QoQ CC after strong sequential growth in the previous quarter.

In terms of markets, growth was led by the US 4.4% QoQ USD. Europe declined by 1.9% QoQ USD. RoW was down by 0.4% QoQ USD.

Growth during Q1FY23 was driven by non-top-20 accounts, which grew 5% QoQ USD, while top 5, top 6-10 and top 11-20 reported muted growth of -3.1%, 2% and -7% respectively.

* Soft deal TCV: Net new deal TCV was soft during the quarter at US$802mn (-1.6% QoQ, -21% YoY) vs the average TCV run-rate of US$820 mn in FY22. We note that TechM has discontinued providing break-up between communications and enterprise deal TCVs, making it difficult to analyse demand in the communications vertical (40% of revenue). There are early signs of impact of a weak macro (a couple of telecom operators are reprioritizing their spends). But management mentioned demand is healthy in the communications segment with focus on automation, integrating data on cloud for monetisation, and network modernisation with spend on fiber space besides investment in 5G.

In the enterprise segment, demand is led by four broad themes: cloud, connectivity engineering and experience

* Weak margin performance for three consecutive quarters. EBIT margin further declined by 220bps QoQ, 411bps YoY, to 11% slightly lower than consensus / our estimates (11.4%/11.4%). Margin performance was weak despite no annual wage hike in Q1. The weakness was due to headwinds from: 1) 100bps impact of intermittent wage increments, higher subcon costs and large deal transition costs; 2) 80bps impact due to visa costs and seasonality in the mobility business; and 3) normalisation of SG&A expenses. Utilisation (excluding trainees) declined by 100bps QoQ to 83% due to investment in freshers in H2FY22.

* Moderation in headcount addition that too more on BPO- Net headcount addition of software professionals was modest at 2,200 employees, +2.6% QoQ. BPO headcount increased by 7.1% QoQ. IT LTM attrition was lower by 200bps QoQ at 22% (highest decline in LTM attrition among peers).

* M&A strategy: In terms of M&A strategy, the company is focussing on integrating the recent acquisitions. Though CTC has higher margin profile than TechM, it had lower margins this quarter due to one-time relocation costs of certain employees working in Belarus.

* Other highlights. FCF/PAT generation has been declining for last two quarters and is now at 50.2% (vs 56% in Q4FY22 and 94% in Q1FY22). Part of the impact was due to unfavourable foreign currency movement. Management expects it to improve to historical range of 90-100% by Q4FY23. FCF (post acquisitions) was weak at US$13 mn or just 9% of net profit.

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