Tech Mahindra Ltd’s investors can breathe a little easy, and look beyond the gloom and doom headlines following the announcement of a large strategic deal with leading US network operator AT&T Inc.
While Tech Mahindra has not disclosed the deal size, analysts suggest this could well be one of the largest contracts secured by the Indian IT services firm. The deal entails optimizing AT&T’s core operations and modernizing its internal network applications to accelerate innovation.
Investors gave a thumbs up to the transaction, taking the company’s shares up by 3.8% on Friday on the National Stock Exchange.
Even as the deal brings in incremental revenues, transition costs in the near term can be expected to weigh on profit margins. “We would not be surprised if the deal has negative Ebitda initially," said analysts at Kotak Institutional Equities in a report on 6 September. Ebitda is earnings before interest, taxes, depreciation and amortization, and is a key measure of profitability.
“Tech Mahindra has moved away from the ‘scale at any cost’ approach of the past to a profitable growth approach in the past three years. Assuming this approach continues, Tech Mahindra can make higher margins if executed well," added Kotak. The brokerage firm has revised its revenue and earnings estimates upwards for FY22 as a result of the deal announcement.
The deal is expected to help support revenue growth of Tech Mahindra’s telecom (or communications) vertical, which accounted for 42% of total revenues in the June quarter. Note, that growth rates of this segment have shown an improvement in recent quarters, albeit on a low base.
Notwithstanding the gain on Friday, Tech Mahindra shares are 7% down so far in FY20—blame it on the lacklustre financial performance in the past two quarters. The flip side is that valuations are not demanding. Currently, the stock trades at about 15 times estimated earnings for FY20, according to Bloomberg data.
While the better outlook for the telecom segment is encouraging, this doesn’t necessarily mean things will look up on an overall basis, especially given the pressure in the enterprise segment. “The overall revenue growth trajectory remains unchanged due to a sharp moderation in the enterprise segment through recent quarters," said analysts at Emkay Global Financial Services Ltd in a report on Friday.
Note that the enterprise segment’s revenues had declined by 2.2% in the June quarter.
Even so, the steadying effect of the recent deal win will calm investors’ nerves. Large deal wins of this nature can be used by a company to showcase itself to other clients and, hence, gain more business. “We raise FY21-22 constant currency revenue growth estimates by 3-4%. We forecast 12% revenue growth in FY21," said analysts at Kotak.