MindTree Consulting (CMP: Rs592)
Mkt Cap: Rs23.2bn; US$572m Bloomberg code (MTCL IN)
MindTree Consulting (MindTree), a mid-sized IT and R&D services company, has strong management bandwidth. It services marquee clients like Volvo, AIG, LSI Logic, United Technologies, Symantec, Avis and Unilever. However, a high share of development services in revenues creates a project-based business profile, which lowers sales productivity, hurts utilization and leads to poor client mining. Thus, contrary to street expectations of an expansion, we see margins declining by 170bp over FY07-09 due to rupee appreciation and salary inflation. The management has cut its FY08 earnings guidance after Q1FY08 results, but we see further risk to consensus estimates for FY09. While the stock price has fallen 23% in just one month, further downside is likely at valuations of 19.8x FY09E earnings (19.2x for Infosys). Initiating coverage with Underperformer and a price target of Rs510.
Superior quality management: A strong management has successfully steered MindTree even through troubled times, which is a testimony to its ability. MindTree registered a robust 65% revenue CAGR over FY04-07 on the back of its positioning as the second best choice for clients offshoring IT and R&D services and looking for management attention. While R&D services are a good differentiator, we believe MindTree offers generic IT services with little differentiation.
Project-based nature of business and poor client mining haze visibility: Mindtree derived 65% of its FY07 revenues from development services, which tend to be volatile as they are project-based. Despite having a 71% share of offshore revenue compared to 35% for Hexaware (a comparable peer), MindTree fares poorly in terms of client mining with an average of just 15 billed people per client compared to 23 for Hexaware. Poor client mining lowers sales productivity, reduces visibility and affects utilization.
Valuation premium to tier-1 peers unjustified: Mindtree trades at premium valuations even to tier-1 companies, which we attribute to its superior management. However, we expect margins to decline by 170bp over FY07-09 due to the impact of rupee appreciation and salary inflation. We do not see too many operating levers playing out as most of the metrics are inherent to the business. At 19.8x FY09E earnings and 12.1x EV/EBITDA, we initiate coverage with Underperformer and a price target of Rs510.
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