Tech Mahindra Q1 FY24 – A complete washout

Highlights

• Revenues nosedive led by communications, enterprise too was soft


• Margin collapses on multiple headwinds


• Order flows weak


• Headcount declines and attrition is falling


• Management commentary cautious although hopeful of H2 recovery


• Valuation too costly for the growth outlook


• Avoid before the stock corrects meaningfully

Tech Mahindra (CMP: Rs 1143, Market Cap: Rs 111,433 crore) has started this financial year (FY24) on a disastrous note with revenues nosediving, margins collapsing, and order inflows slowing. Not a particularly great start for Mohit Joshi, the new MD & CEO, who has recently joined the company to take over the reins from C P Gurnani. While the management talks about gradual improvement, expecting second half of the year to be much better, the outlook for its key communications vertical is still quite clouded. The earnings trajectory for the coming two years is going to remain uninspiring making the valuation heady. The stock has to correct meaningfully for even taking a risky bet.

Q1 FY24 – disappointment on all fronts

Source: Company

Revenue nosedives

Revenue for the quarter at $1601 million declined 4 percent in reported currency and 4.2 percent in Constant Currency (CC). The sharp decline in the communications vertical resulted in this large revenue miss. The company attributed it to the completion of a  few transformative projects, delay and deferment of discretionary projects, bankruptcy in one client, and seasonal weakness in subsidiary Comviva.

Source: Company

Even within enterprise, manufacturing was the only bright spot. In terms of key markets, Americas was flat whereas a steep decline was seen in Europe and the rest of the world on project closure and spending cuts by telcos.

Margins collapse

The quarter saw one of the worst margin performances in recent memory with a sequential decline in margin by over 450 basis points. Close to 200 basis points of this decline was on account of the revenue decline. The bankruptcy of a client and the resultant provision also had a similar impact on the margin whereas the remaining 50 basis points was on account of the weakness in Comviva.

Source: Company

Despite revenue headwinds, the company went ahead and effected its annual wage revision for the majority of employees which had a 130-basis-point margin impact. The revision for the remaining employees effective Q2 would have a lower impact.

While utilisation remains high at 87 percent and has not much headroom, the management alluded to several levers for margin improvement, including lower subcontracting cost that, as a percentage of revenue at 14 percent, has room to fall below 10 percent. Correcting the pyramid by deploying more freshers, higher offshoring, which can go up by another 4-5 percent, and divestment of non-core businesses are the other levers at the company’s disposal. We feel margin improvement will be a gradual exercise and is contingent on the uptick in the demand environment as well. We have built in gradual improvement in our estimates.

Order inflow slows down

Order intake was weak — down year on year (YoY) and quarter on quarter (QoQ). While alluding to a better second half, the commentary on demand deserves focus. The management called out reprioritisation of spending by telcos away from 5G, hold on discretionary spending, and meaningful cutting down of discretionary transformation projects as enterprises across verticals focus on return on investment in the short term and are on a cash conservation mode due to the steep hike in capital costs.

Source: Company

Deal wins in the past four quarters have been lower by close to 25 percent YoY which give an indication of a relatively soft revenue trajectory ahead.

Headcount continues to fall

Despite an elevated utilisation, overall headcount declined for the third consecutive quarter, while the headcount for software professionals declined for the fourth consecutive quarter. This is one  one more pointer to a near-term subdued outlook.

Source: Company

The only good news is the decline in attrition from 15 percent to 13 percent. This should take some pressure off wage increments amid the several challenges the company is battling.

While we agree that the worst may be over, we expect the recovery to be gradual and nothing meaningful to excite investors in the near term. Given the decline in earnings in FY24, we expect a modest 7 percent CAGR in earnings between FY23-FY25e. Seen in this context, the valuation on PEG basis (price earnings to growth) is too costly at 2.6. The stock has to correct meaningfully before putting a bet for the long term.

Source: Company, Moneycontrol Research

Key risks: Severe contraction in technology budgets for a long period