Tech Mahindra: Margins should worry investors after Brexit

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Mumbai: There’s not much to get excited about Tech Mahindra Ltd’s June quarter results. Revenues declined by 0.5% in constant currency terms after adjusting for the contribution from an acquisition. Besides, the results underscored the company’s struggles with profit margins. Ebitda (earnings before interest, tax, depreciation and amortization) margins fell by 180 basis points sequentially, far higher than the Street’s estimates.

Still, the company’s shares have risen by over 2% since the results were declared. Clearly, expectations were running way too low. The June quarter is a seasonally weak quarter for Comviva—the mobility solutions business that Tech Mahindra acquired around three years ago. The remaining telecom business has barely recovered too. As a result, this industry vertical was expected to drag overall growth.

Revenues from the telecom vertical fell 2.5% quarter-on-quarter. Adjusted for Comviva, revenues from the segment grew by about 2%, the company told analysts. Questions abound whether this growth is sustainable, especially given the company’s exposure to large telcos in the UK.

Growth in the manufacturing business was sluggish at 1.6% after adjusting for the impact of the Pininfarina S.p.A acquisition. Some other industry verticals, though, performed well. The BFSI (banking, financial services and insurance) and retail, transport and logistics verticals grew by as much as 7.5% and 5.8% sequentially. But clearly, the high growth in these two verticals isn’t sufficient to offset the troubles of the telecom segment, which still accounts for about half of the company’s revenues.

Besides, investors should be worried about margins. The company told analysts that the sharp depreciation in the British pound after the Brexit poll is likely to impact margins. Operating profit margins were expected to improve this fiscal; now they are expected to be flat.

Analysts at JPMorgan wrote in a note to clients, “‘One step forward, two steps back’—this phrase pretty much sums up Tech Mahindra’s endeavour to lift its revenue and margin profile after seeing this deteriorate through the first half of 2016.” They added that this raises the question whether the company has a lop-sided focus on revenue growth, without adequately attempting to improve efficiency through levers such as automation.

Not that revenues growth has been too impressive either. Adjusted for acquisitions, analysts at Nomura Research expect a growth of only around 5.5% in the 2017 fiscal, largely because of the company’s high exposure to the troubled telecom sector.

The only justification for the rise in the company’s shares is that valuations were inexpensive at around 12-12.5 times estimated fiscal 2017 earnings. Tech Mahindra is now among the cheapest IT services stocks in terms of its price-earnings multiple. Far smaller companies such as Hexaware Technologies Ltd trade at higher valuations. But unless growth picks up in the coming quarters, without a further deterioration in margins, valuations may well remain cheap.