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Clarity on business investment impact in April 

-      Tech Mahindra (TECHM) reported 3QFY24 revenue of USD1.57b, up 1.1% QoQ in CC terms. Adjusting for a one-time product-related revenue gain of 140bp, 3Q growth came 80bp ahead of our expectation. CME remains a weak area, declining marginally despite a low base. Enterprise growth was mixed, with Manufacturing and Retail doing well, while BFSI and Technology declined.

-      TECHM had another quarter of low profitability, with 7.0% adj. EBIT margin (excluding restructuring and other one-time costs), down 30bp QoQ/500bp YoY and slightly below our estimates. Reported EBIT margin stood at 5.4%, up 70bp QoQ. 3Q TCV came in at USD381m (-40% QoQ/-52% YoY), pulling down its trailing 12m TCV/book to bill to its lowest in the last 3/5 years.

-      We remain positive about the restructuring initiatives at TECHM under the new leadership. The recent steps, including right-sizing SBUs, investing in key accounts, establishing vertical delivery teams, and prioritizing employee investments, as moves in the right direction. However, we expect to see the positive impact of these actions only gradually, which can result in near-term misalignment with investor expectations, particularly in terms of profitability. With the management committing to incremental clarity post 4Q earnings, April remains the key to any view change.

-      TECHM management continues to see growth headwinds in the key Communications vertical (36.5% of 3Q revenues), which is on course for double-digit decline in growth in FY24. While we are factoring in a modest growth in FY25 in this business, management commentary indicates downside risks. 

-      Moreover, the weak deal wins and low profitability will also add to the pressure on growth pickup in FY25, as it leaves limited flexibility to the management to be aggressive on growth opportunities. Our estimates indicate a modest 4.4% USD revenue CAGR over FY23-26E for TECHM.

-      The combination of low profitability (adjusted) and elevated operational metrics (high utilization, low attrition, and low sub-contractor expense) imply limited immediate benefits from margin improvement initiatives, something which the management also indicated in its commentary. While we see 3Q as the bottom for EBIT margin, TECHM should take more than two years to reach 14%+ EBIT margins. We see FY25E/FY26E EBIT margins at 9.8%/12.0%, resulting in only 6.0% PAT CAGR over FY23-26E.

-      We remain on the sidelines as we feel the current valuation fairly factors in the uncertainties around growth and margin. Our FY25/FY26 EPS estimates remain broadly unchanged post 3Q results. We remain Neutral on the stock with a TP of INR1,360, as we roll forward to 20x FY26E EPS.

Weak deal TCV, operational performance remains muted

-      Revenue stood at USD 1.57b, up 1.1% QoQ in CC terms (including 140bp one-off revenues), above our estimate of -1.1% QoQ CC.

-      IT service growth was strong 2.3% QoQ, while BPO was down 0.7% QoQ.

-      CME (flat QoQ) stable after two consecutive quarters of decline; Manufacturing (+2.9%), Retail (+6.4%), and Other (+8.4%) led the growth, while BFSI (-2.0%) and Technology (-2.9%) registered weak performance.

-      Adjusted EBIT margin stood at 7.0%, 30 bp QoQ below our estimates. Reported EBIT margin stood at 5.4% (up 70bp QoQ).

-      Net Employee declined 4.4k QoQ vs. +2.3k in 2Q; BPO at -4.78k QoQ and software professionals at +500 QoQ

-      Utilization (ex. trainees) at +200 bp QoQ at 88%; LTM attrition improved 140bp QoQ to 10%.

-      NN Deal TCV was weak at USD381m, down 40.5% QoQ/down 52.1% YoY.

-      Reported PAT stood at INR5.1b (up 3.2% QoQ/down 60.6% YoY).

Key highlights from the management commentary

-      On the communication segment, the management indicated that it will continue to be volatile for a couple of more quarters before it sustains and delivers steady growth. It would be too early to call out any green shoots for the sector.

-      Europe growth was majorly driven by the one-off revenue recorded in 3Q. Otherwise, manufacturing is doing well in the region, while it has also made significant investments to fuel incremental growth within BFSI.

-      The manufacturing segment has been performing well with proactive investments around industry manufacturing and design engineering.

-      Normalized EBIT margin in 3Q stood at 7%, adjusted for investments made in reorganization. The reorganization initiative also includes pruning the contracts that do not fit into the long-term strategic vision of the company.

Valuation and view

-      Although 3Q performance was weak, it was better than our estimates. TECHM’s high exposure to the Communications vertical offers a potential opportunity, as a broader 5G rollout is likely to result in a new spending cycle in this space.

-      Near-term growth remains weak and we await greater comfort on margins. We value the stock at 20x FY26E EPS. We maintain our Neutral rating on the stock.

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