Why Tech Mahindra has a bright outlook

Following approval of the Andhra Pradesh High Court, Tech Mahindra announced it had consummated the merger of Mahindra Satyam.

The move, analysts believe, is positive for the combined entity (which will be known as Tech Mahindra) from the financial and business aspects, as well as from the stock perspective.

Tech Mahindra will now have a diversified presence across various verticals (manufacturing, telecom, BFSI, technology, media, healthcare, etc) thereby de-risking it from the telecom sector which is undergoing some pressure over the past two-three years.

Telecom accounts for most of Tech Mahindra revenues, and post-merger, it will form 47-48 per cent of the consolidated revenues. Additionally, a bigger balance sheet will aid the combined entity to bid for large deals (above $50 million) and thus push topline growth, going forward.

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The merged entity will emerge as the fifth largest listed Indian information technology (IT) company with revenue of Rs 15,000 crore (Rs 150 billion), employee base of 84,000 and 540 clients. 

From the stock perspective, analysts believe there is possibility of a re-rating even as the Tech Mahindra stock has outperformed the Sensex as well as the BSE IT index over the past year.

The Tech Mahindra stock trades at nine times FY14 estimated earnings and analysts expect this multiple to inch up to 11 times over a year as merger synergies fructify.

“We believe a 25 per cent price/earnings multiple discount relative to HCL Tech (PE of 12-13) is unjustified, given the combined entity could fill the gap between HCL Tech ($4.7 billion FY13 revenues) and a number of Indian vendors with revenues of $1 billion,” says Abhishek Shindadkar, IT analyst at ICICI Direct. He has a ‘Buy’ rating and target price of Rs 1,200 on the stock.

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Shashi Bhusan, IT analyst at Prabhudas Lilladher Securities is positive on the company. The merger would help the Tech Mahindra-Satyam combine to reap the benefit of the scale and cross-selling opportunities, says Bhusan.

“We believe  focus would now shift to execution and realisation of synergy. The merger could also push forward the argument for re-rating”. According to Bloomberg data, of the 15 analysts polled in June, 12 have a ‘Buy’ rating on the Tech Mahindra stock and three have a ‘Hold’. The consensus target price for the stock is Rs 1,194, which indicates an upside potential of 18 per cent from the current levels of Rs 1,010.

On the business front, while Europe was a large part of Tech Mahindra’s revenues earlier (46 per cent), post-merger the revenues will be divided between America (43 per cent), Europe (33 per cent) and emerging markets (24 per cent).

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Also, post-merger the company’s revenue dependence from troubled British Telecom (BT) will halve to 12 per cent. 

Going ahead, improving traction in the non-BT business and the successful turnaround of Satyam provide good visibility for the combined entity. The management, too, is confident and hopes that the company will grow at a good pace.

While margins could be under pressure in the near term (due to expensive deals and limited upside from utilisations, cost savings as well as the challenging environment), a weaker rupee will provide some cushion.

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High return ratios and cash conversion ratios are other key positives. “Return on equity ratio is healthy at 20 per cent and Tech Mahindra has seen improvement in cash conversion (cash flow from operations/Ebitda) over the past two years from 40 per cent to 80 per cent.

We note that the cash conversion ratio, though slightly more volatile, is now trending in line with HCL Tech. Satyam’s cash conversion remains better at 75 per cent plus,” says Rumit Dugar, IT analyst at Religare Capital Markets. 

Sharper-than-expected deterioration in clients’ IT budgets or sharp decline in Euro zone economic growth, though, remain key risks, and need to be monitored.

Tech Mahindra has fixed July 5  2013, as the record date for Mahindra Satyam shareholders to receive Tech Mahindra shares according to the approved scheme (two shares of face value Rs 10 of Tech Mahindra against 17 shares of face value Rs 2 of Mahindra Satyam).