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Earnings surprise at Tech Mahindra

Earnings surprise at Tech Mahindra
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First Published: Wed, Oct 27 2010. 12 50 AM IST

Updated: Wed, Oct 27 2010. 12 50 AM IST
Tech Mahindra Ltd has reported a positive earnings surprise for the September quarter, with operating profit adjusted for one-offs rising by 32.1% quarter-on-quarter. But investors are likely to have questions about the sustainability of this growth and hence the rise in the company’s share price, when trading resumes on Wednesday, may well be limited.
The company reported a 35.3% sequential growth in revenue to Rs 1,534 crore, but this includes revenue of Rs 299 crore billed to an Indian client for hardware and software purchases and third-party services. This is essentially pass-through revenue from a customer, on which the company has earned a margin of less than 5%. Adjusted for this one-off revenue source, revenue grew by around 9% sequentially. While this looks impressive and in line with the growth reported by top-tier IT firms, it must be noted that much of this is on account of favourable currency movements. Volume growth stood at 4.5%.
Also See Growth Concerns (Graphic)
But again, even this growth is a positive, considering that revenue have been flat in the past few quarters. Demand from the company’s top client, BT Group Plc, continues to be sluggish. Volumes from non-BT clients grew at a handsome rate of 9.5%, indicating that demand for telecom IT services has revived. But as pointed out earlier, investors are likely to have questions about the sustainability of the company’s growth, and may prefer to wait and watch. Besides, BT still accounts for 43% of revenue (adjusted for pass-through revenue), and non-BT clients would have to grow at a brisk pace to drive overall growth.
Tech Mahindra also reported a handsome 300 basis points (bps) improvement in margins, excluding the impact of the pass-through deal. Again, this was largely on account of favourable currency movements, which affected margins positively by 200 bps. Savings on selling, general and administration expenses accounted for much of the remainder of the increase in margins. The company also benefited from a sharp increase in employee utilization rate from 69% in the June quarter to 75% last quarter, though this was largely offset by salary hikes given to 75% of the company’s employee base last quarter. The net result of all this is that operating profit rose by as much as 26% last quarter.
The pass-through revenue mentioned earlier is from a “build and manage services” contract handed by an Indian firm. Revenue of Rs 299 crore booked last quarter pertains to the “build” phase, which involved hardware and software purchases. The terms of the deal with the client are such that Tech Mahindra will fund these purchases and the customer will repay it over a three-and-a-half-year period. Analysts say such a model is typical of turnkey projects, though being an asset-heavy proposition for Tech Mahindra, it would involve relatively low returns on capital employed.
As the chart shows, Tech Mahindra shares have underperformed this year because of the weakness in the telecom IT services space. While things are beginning to look up in the sector, the company’s shares may not fully benefit because valuations aren’t particularly cheap. Besides, as an end-September report by Citigroup points out, “Tech Mahindra’s organic business still carries higher domain (telecom) and client concentration (BT) risk. Given the risks and challenges at BT, Tech Mahindra will continue to struggle in the near term.”
Graphic by Ahmed Raza Khan/Mint
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First Published: Wed, Oct 27 2010. 12 50 AM IST