Tech Mahindra’s margins impress in Q3

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Tech Mahindra Ltd’s shares have done rather well in the past year despite an unexpected hit to its profitability in the fourth quarter (Q4) of FY17. As the company embarked on a cost rationalization exercise to salvage the situation, the stock gained 29% over the last one year. The December quarter (Q3) results should help support this optimism.

The company has seen a sharp recovery in profitability. Ebit (earnings before interest and tax) margin increased 1.8 percentage points sequentially to 12.8%, significantly ahead of Street estimates. Margins are now back to pre-March 2017 levels (see chart).

According to Milind Kulkarni, chief financial officer at Tech Mahindra, three factors helped the company report a better margin. One is the improvement in the utilization level, which rose from 81% in Q2 to a record 83%. Another is the improvement in performance of the firms it acquired some time ago. The third reason is the reduction in low- yield business. What’s more, Kulkarni expects the trajectory in margin improvement to sustain. The company plans to continue discarding low-yield business and to use automation to further optimize employee utilization levels.

Another set of reasons for investor optimism comes from the management commentary. Kulkarni dubs the current demand environment to be materially better than a year ago, in line with the commentary given by the company’s larger peers, although different from their business performance in the just concluded quarter.

The mainstay communications business, which generates about 42% of Tech Mahindra’s revenue, remains sluggish, barely seeing any growth. But thanks to better performance in other business verticals, notably technology, the overall sequential revenue growth in US dollar terms stood at 2.5% in Q3. Kulkarni expects the communications vertical to recover this year, which should push up overall growth rates.

If indeed the improvement in profitability continues, then the stock can rerate, says Sanjeev Hota, analyst at Sharekhan Ltd. While the commentary should please investors, one factor investors need to be wary of is employee reduction.

As an analyst with a domestic broking firm points out, the headcount of software professionals is now down a good 10% from the March quarter. The sharp drop can impact the company in two ways. One is employee morale, the other being cost. If the business environment has to improve as projected, Tech Mahindra may have to pay a premium to scale up its employee base, says the analyst.

Tech Mahindra’s Kulkarni, on the other hand, says headcount has no direct correlation to the revenue growth trajectory because of automation and other changes. The ramp-up in headcount may lag, but scaling up should not be a problem, he avers.

While one cannot accurately analyse this risk now, Tech Mahindra investors would do well to keep a watch on this trade-off, if any.livemint