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Margin pressure to drag FY23 growth improvement

Valuations pricing in performance

* Tech Mahindra (TechM)’s 3QFY22 USD revenue growth at 4.7% QoQ CC (organic growth at 4.0% QoQ CC) was 100bps above our estimates. It was driven by yet another quarter of strong performance from BPO (9.7% QoQ / 35.3% YoY), while IT Services was impacted by furloughs (up 2.0% QoQ, exacquisitions). Vertical growth was led by Comm. (+6.9% QoQ CC), while Enterprise (3.2% QoQ CC) was modest. New deal wins at USD704m (down 6% QoQ) have stayed in a narrow range in recent quarters. Although, the management continues to see sustained traction in the deal momentum.

* Excluding one-off gains, the 3Q EBIT margin dipped 120bps QoQ to 14.0% v/s our expectation of 15.1% on higher subcontracting expenses (+12% QoQ), employee-related interventions, and lower utilization (-300bps QoQ to 86%). TechM added a modest 3.9k in 3Q after an all-time high net addition of 15k employees in 2Q.

* We expect the company to deliver good topline performance going forward, driven by continued spending from telcos / equipment makers in preparation for the 5G deployment, along with demand-led strength in the Enterprise vertical. The company should also see meaningful contribution to its FY23E revenues from recent acquisitions (MOFSLE of c400bps). With healthy deal bookings, a robust pipeline, and strong net additions, we expect TechM to deliver an FY22–24E USD revenue CAGR of 16.0% YoY.

* Continued pressure from the supply side, along with sales investments, would result in a dip in the EBIT margin in FY23E (est. -50bps YoY). This would result in a miss on the company guidance of improving margin trajectory going forward. Moreover, while quarterly attrition at the company has now stabilized, the LTM figure of 24% (+300bp QoQ), over and above industry-high sub-con expenses and elevated utilization, would make it difficult to rapidly moderate costs despite elevated fresher onboarding – which is one of the main levers for moderating cost pressures. We further expect the company to see higher amortization on account of the recent spate of acquisitions (nine in FY22, valued at INR65.2b). This would result in TechM delivering a relatively unexciting PAT CAGR of 16% over FY22–24E.

* We continue to stay on the sidelines on TechM as we see stronger business performance as balanced by elevated operational risks in a supplyconstrained environment. We reduce our EPS estimates by 3–4% for FY22E/FY23E post the 3Q miss. Our TP implies 19x FY24E EPS. We remain Neutral on the stock.

3Q topline beat driven by BPO, slight margin miss

* 3QFY22 revenue increased 17.2% YoY (v/s estimated increase of 15.9% YoY), EBITDA grew 8.7% YoY (v/s estimate of 11.3% YoY), and PAT was up 4.5% YoY (v/s estimated increase of 13.2%).

* 9MFY22 USD revenue / INR EBIT / INR PAT grew 16%/29%/21% YoY.

* TechM’s 3QFY22 revenue grew 4.1% QoQ to USD1,534m, above our estimate of USD1,516m (+3% QoQ). This implies CC revenue growth of 4.7% QoQ.

* Communications and Enterprise revenue grew 6.9% QoQ CC and 3.2% QoQ CC, respectively.

* Growth in Enterprise was driven by Retail (+13.5% QoQ) and Manufacturing (+2.8% QoQ), while BFSI (-1.6% QoQ) and Technology (-2.8% QoQ) were softer due to furloughs.

* The EBIT margin at 14.8% was down 40bps QoQ and came in 30bps below our estimates.

* Net employee additions were modest at ~3.9k employees. Utilization fell to 86% (v/s 89% in 2Q).

* However, at the same time, attrition inched up 300bps QoQ to 24%.

* PAT at INR13.7b (+2% QoQ) came in 8% below our estimates on lower margins and other income.

* Total net new TCV stood at USD704m, of which USD478m was in Enterprise and USD226m in Communications. Deal wins have been higher than the average run-rate of USD400–500m.

* FCF for the quarter stood at USD123m, implying FCF/PAT of 67%.

* DSO at 101 days was up from 92 days in 2Q.

Key highlights from management commentary

* TechM reported net new deal wins of USD704m (TCV) in 3QFY22, marking the fourth straight quarter of USD700m+ in deal wins. The company’s momentum in deal wins has accelerated v/s the historical average of USD450–500m. The management sees sustained and broad-based acceleration in the deal pipeline. It expects the deal win momentum to continue.

* Within Communications, the strong growth of 6.9% QoQ CC was led by traction from 5G engagements and legacy-to-digital modernization. A ramp-up in large deals contributed to the strong growth in Communications. The 5G contribution in the deal pipeline, deal bookings, and revenues is improving; the management expects this trend to continue. The overall growth momentum in Communications is expected to continue.

* Traction is seen in broad-based growth across sectors. Strong deal wins and a robust pipeline would aid the continuing growth momentum.

* Margins for the quarter were down 40bps QoQ due to increased wages, lower utilization, higher sub-contractor expenses, and deployment costs for freshers. This decline was partially offset by one-time gains on SG&A (70–80bps) and operating leverage.

* Revenue growth, offshoring, sub-con costs (in FY23E), and higher pricing are key margin levers. Headwinds include higher attrition, wage inflation, travel costs, and investments in pyramid rationalization.

Valuation and view

* TechM’s high exposure to the Communications vertical remains a potential opportunity as a broader 5G rollout could lead to a new spending cycle in this space. The company is seeing traction in 5G investments.

* We expect margins to remain stable in FY22 and decline 40bps in FY23.

* We expect TechM to deliver growth in the high teens in FY22. We value the stock at 19x FY24E EPS. Maintain Neutral.

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