Tech Mahindra: Street questions inorganic growth strategy

Inorganic growth has been the buzzword for India’s information technology (IT) sector, with large companies announcing an acquisition or two over the past 12 months. The Street is now turning cautious, as it needn’t always be margin-accretive. An example is Tech Mahindra’s weaker than estimated performance in FY15, thanks to a sharp fall in profitability at Lightbridge Communications Corp (LCC). Tech Mahindra acquired Lightbridge for $240 million in 2014.

After reporting superior revenue growth rates through FY13-14, Tech Mahindra’s organic growth has come off sharply in FY15. Its revenue growth in constant currency declined 1.2 per cent sequentially and margins contracted 530 basis points (bps), worse than peers. The margin shocker came from LCC. Operating margin of LCC fell to 2.5 per cent in the quarter gone by, against the reported 8-10 per cent at the time of acquisition, on high integration costs and seasonal weakness.

Jefferies says, “Growth through the inorganic route, where both scalability and profitability of acquired companies, has come under question, given LCC’s performance in the quarter.” Margins of LCC are expected to revert to seven-eight per cent a few quarters down the line but till it does, Tech Mahindra’s performance would be impacted.

Analysts believe margins are unlikely to revert to 20 per cent levels before FY18. Revenue growth is also expected to remain tepid in the first two quarter of this financial year, with telecom growing in single digits in FY16. Inherent volatility in telecom will also impact FY16 revenue growth. Kotak Institutional Equities says while the core theme of market share gains in telecom and robust manufacturing practice remains unchanged, what changes is the Street perception on Tech Mahindra's ability to execute. The March quarter’s sharp fall in utilisation levels has driven this perception. Lower utilisation and higher sales and general administration costs would also put pressure on margins. If currency the impact reverses in FY16 and utilisation picks up, Nomura expects a 300 bps margin improvement over the next two to  three quarters.

Not all analysts, though, are optimistic.

On the back of overall disappointing performance in the fourth quarter of FY15 and a not so encouraging near-term outlook, IIFL has cut earnings estimates by 15 per cent and 20 per cent for FY16 and FY17, respectively. The cut has been driven by much lower operating margin assumptions. Several analysts have cut the stock’s target price to Rs 640, valuing the stock at 15 times the FY17 earnings.

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