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  • Stock Recommendation | Mindtree - ADD - Target price : 1,080

    Publish date: OCTOBER 19, 2018

    Reality check. Mindtree disappointed with muted constant-currency revenue growth of 2.4% in a seasonally strong quarter. Growth was strong from top-10 clients but weak from the rest. Health of the business is in good shape as reflected in growing rate of deal wins and improvement in client metrics. We retain our revenue growth estimates but moderate profitability assumption due to higher-than-expected reinvestment rate. Cut EPS by 0-3% and target price by 12% to ₹1,080. Mindtree is well-poised to grow at an elevated rate with measured pace of margin expansion. ADD.

    Mindtree reported 2% sequential revenue growth to US$246 mn (2.4% in constant currency). Revenues from the top client grew 6.2%, while the rest of the top-10 clients grew 4.1% sequentially. Client metrics were healthy with two additions to US$10 mn bucket. Yet revenues missed our estimate due to lack of growth from clients outside the top-10 bracket and lack of replenishment of projects in retail, CPG & manufacturing vertical (-4.2% qoq) due to delay in decision-making. EBITDA margin increased 130 bps qoq to 15.4% with the entire increase attributable to rupee depreciation. The impact of promotions and campus hires (60 bps) was offset by absence of one-off cost in the previous quarter. Net profit of ₹2.06 bn (+65% yoy) was 16.2% ahead of our estimate and largely due to ₹403 mn of forex gain.

    Even as revenues fell short in the quarter, we retain our FY2019-21E revenue growth estimates. A few factors lend comfort—(1) TCV of deal wins is tracking up 22% in 1HFY19. Value of contracts to be executed over the next 12 months has also grown at the same rate, (2) revenue growth is getting broad-based. Clients beyond the top name and in the 2-10 category have started growing, (3) improvement in the client bucket with a few added to US$10 mn category, and (4) the deal pipeline is strong. The management indicated that growth rates in seasonally weak December quarter will be similar to September quarter.

    We cut FY2019-21E EPS estimate by 0-3% largely due to cut in margin assumption by 20-40 bps from FY2019-21E. Moderation in margin assumption captures the aggressive talent onboarding and investments in enterprise re-imagination segment. Core profitability assumption remains unchanged. We cut our target price to ₹1,080 (from ₹1,225) due to mix of EPS moderation and marginal alignment in multiples. Mindtree can grow at an elevated rate courtesy strength in digital competencies, strong wins from advisory channel and alignment of portfolio to growth areas. We remain constructive and retain ADD rating.
    Mindtree’s gross profit margin declined on a sequential basis despite rupee depreciation. The margin improvement has been largely due to currency depreciation with little operational efficiency to show for. We believe this is partly on Mindtreeount of reinvestments in business. We highlight two specific areas of investments.
    Mindtreeelerated onboarding of talent. Mindtree continues to hire aggressively and believes that plenty of high quality talent are keen to join the organization. The company is willing to onboard high profile quality talent and keep a bench as long as such recruitments can drive additional projects from clients and Mindtreeelerate growth further. In effect the company is recruiting aggressively in anticipation of strong demand. The downside of this approach is that it leads to increase in cost structure and can impact margins if the demand was to slow down.
    Enterprise re-imagination. Mindtree is developing a new global business from the ground up under the leadership of Dr Satya Ramaswamy. Dr Ramaswamy developed the global digital services business in TCS from the ground up over a seven-year period starting 2010. Creation of this new line of business calls for sustained investments, which Mindtree is willing to make. The company is also investing in the platforms business. These initiatives may not have material near-term revenue potential but can create a new engine of growth over the medium term.
    Despite these investments, Mindtree’s EBITDA margin will increase over the next two years led by strong growth profile, improvement in fixed-price project execution and operational efficiencies. We forecast EBITDA margin of 15.4%, 16.6% and 16.5% for FY2019E, FY2020E and FY2021E, respectively. However, margin improvement will have its share of quarterly volatility.
    Deal closures increase further. The company’s TCV of deal wins was US$271 mn in the September 2018 quarter, a yoy growth of 31%. Deals wins in 1HFY19 grew 22%. We do note that Mindtree captures all wins (renewals and new) in the TCV; hence the focus should be on total wins to gauge direction of growth. Mindtree further indicated increasing digital deal sizes, a positive and shows progress towards the theme of industrialization of digital. Of the US$271 mn TCV, deals expiring in
    Margin walk-through. EBITDA margin increased 130 bps sequentially to 15.4% due to (1) 60 bps headwind from promotions and new campus hires, offset by, (2) 60 bps tailwind from absence of one-time grant to Stanford University and (3) 130 bps tailwind from rupee depreciation net of cross-currency movements.
    Revenue and margin outlook. Mindtree expects 3QFY19 revenues to be impacted by a volatile macro-environment and seasonality. The management indicated that 3QFY19 revenue growth rate will be similar to 2QFY19 growth rates based on visibility in the deal pipeline. The company expects 3QFY19 margins to be slightly better than 2QFY19 margins. FY2019 margins will be better than FY2018 margins excluding the impact of currency.
    Commentary on retail, CPG & manufacturing vertical. Retail, CPG & manufacturing vertical revenues declined by 4.2% qoq. Management attributed the decline to delay in deal closure in the US leading to a gap in the deal pipeline following completion of projects in Europe. Management indicated that the vertical will revert to growth in the next quarter.
    Commentary on margins. Mindtree reported that it did not face headwinds to margins from price negotiation with customers in light of the recent rupee depreciation. Margin drivers include (1) revenue growth, (2) leverage of pyramid and (3) efficiencies from automation apart from rationalization of SG&A costs.
    Commentary on BFSI vertical. Mindtree has a higher proportion of ‘run the business’ projects among its BFSI clients. The company has not seen a strong pickup for digital in BFSI unlike other verticals leading to weak growth visibility in the near term.
    Travel vertical. Mindtree continues to see good momentum in the vertical. Mindtree enjoys good domain knowledge and credibility in both airline and hospitality subsegments. Projects in the vertical involve cutting edge work on personalization and related trends in digital, which are in a sweet spot for the company.
    Top Mindtreeounts. Revenue from top client and revenues from top 2-10 clients increased by 6.2% and 4.1% on a sequential basis, respectively. Mindtree expects good growth from its top 2-10 customers. Management does not expect Mindtreeount-related challenges from its top 2-10 clients barring one client. Mindtree does not expect pricing pressure from its top client.
    Client metrics. Mindtree added two clients to US$10 mn bucket. Number of clients in US$25 mn, US$50 mn, US$100 mn buckets remained unchanged.
    Digital. Mindtree reported that the average size of digital deals won by the company is rising. Mindtree is able to win higher proportion of projects involving high levels of consulting, domain knowledge and technology. Margins in digital business remained flat in the quarter.
    Hiring. Mindtree has hired roughly 600 campus graduates in 1HFY19. The company expects to hire 800 more campus graduates in 2HFY19 evenly across the next two quarters. Lateral additions will be based on availability of talent and business needs. ▶ Macro concerns. Based on discussions with clients, management reported that the prevailing macro situation negatively affected client sentiments leading to delay in signing of new contracts. Delay in decision-making by clients equally impacted both ‘run’ and ‘digital’ parts of the business.
    Dividend. Mindtree board has declared an interim dividend of ₹3/share for the quarter.

    Definitions of ratings

    BUY - We expect this stock to deliver more than 15% returns over the next 12 months.
    ADD - We expect this stock to deliver 5-15% returns over the next 12 months.
    REDUCE - We expect this stock to deliver -5-+5% returns over the next 12 months.
    SELL - We expect this stock to deliver

    Our target prices are also on a 12-month horizon basis.

    Other definitions

    Coverage view. The coverage view represents each analyst's overall fundamental outlook on the Sector. The coverage view will consist of one of the following designations: Attractive, Neutral, Cautious.

    Other ratings/identifiers

    NR = Not Rated. The investment rating and target price, if any, have been suspended temporarily. Such suspension is in compliance with applicable regulation(s) and/or Kotak Securities policies in circumstances when Kotak Securities or its affiliates is acting in an advisory capacity in a merger or strategic transaction involving this company and in certain other circumstances.
    CS = Coverage Suspended. Kotak Securities has suspended coverage of this company.
    NC = Not Covered. Kotak Securities does not cover this company.
    RS = Rating Suspended. Kotak Securities Research has suspended the investment rating and price target, if any, for this stock, because there is not a sufficient fundamental basis for determining an investment rating or target. The previous investment rating and price target, if any, are no longer in effect for this stock and should not be relied upon.
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    NM = Not Meaningful. The information is not meaningful and is therefore excluded.

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