Unlike other information technology companies which are facing a slowdown in growth, the concerns for Tech Mahindra Ltd are largely to do with its profitability.
Robust order inflows notwithstanding, the company’s operating earnings dropped for two consecutive quarters till June this year, leading to cuts in earnings estimates. Profitability was impacted by transition costs pertaining to large projects and investments in human resources.
The September quarter earnings issued after market hours on Tuesday will address some of those concerns. Operating margin improved sequentially, helped by a recovery in revenue and better economies of scale. Consequently, operating earnings grew 13.7% from the June quarter.
The performance will please investors. The 3.2% sequential revenue growth and 1.3 percentage points expansion in operating profit margin to 12.8% is higher than Street estimates, implying traction in project execution. Revenue growth was driven by the enterprise business segment. Utilization levels perked up even as attrition remained elevated.
Deal wins were strong, with the company receiving orders worth $1.49 billion. This comes on the back of strong deal flows in the previous four quarters. In an earnings call, the management said it has a “high degree" of confidence on the project pipeline. Combine this with low exposure to financial services sector, which is seeing softness, analysts are fairly confident about revenue growth prospects. “We are confident of revenue growth acceleration in FY2021E for Tech Mahindra, even as it is too early to comment on others," analysts at Kotak Institutional Equities said in a 3 November note.
The commentary is impressive vis-à-vis the growth concerns aired by other IT majors. But as Tech Mahindra executes the recently won contracts, high transition costs may hit profits in the near term. “We see the impact (transition costs) over the next two quarters," the management said in conference call. So, even as the company expects to deliver better revenues in the second half of the current fiscal, expectations on operating earnings are muted. Improvement in last quarter notwithstanding, earnings before interest and tax (ebit) in dollar terms is down 10.6% in the first half of the current fiscal on a year-on-year basis. The management is non-committal if this will reverse in the second half of the fiscal. But it is confident profitability next fiscal (FY21) will improve to FY19 levels. This is in line with Street expectations and should hold the stock in good stead, whose valuations are at a discount to larger peers.
The stock began outperforming NSE IT index from its June quarter earnings announcement. The quantum of outperformance will be determined by the pace of improvement in profitability and net earnings in the coming quarters.