Stock Review: Tech Mahindra

Tech Mahindra posted subdued results for the June 2011 quarter on the back of weak IT spends in the telecom segment and poor show posted by its biggest client – British Telecom (BT).

During the June 2011 quarter, the company's topline grew 2.5% to . 1,292 crore against the previous quarter backed by 2% volume growth. Revenues from BT, which constitutes over 40% of the company's overall business, increased marginally by 1.5% on a constant currency basis. Excluding BT, Tech Mahindra reported a 5.5% growth in its volumes.

While the BT business continues to be weak, growth during the quarter was led by the company's BPO segment which grew over 20% to . 122 crore against the previous quarter driven by ramp ups in the Bharti Zain deal. Moreover, out of 4,500 employees hired during the quarter over 80% were for the BPO arm.

However, growing contribution of the low-margin BPO business had a negative impact on the company's operating profit margin. Also, increased hiring led to a lower utilisation levels, resulting in a 180 basis points fall to 18.7% in the company's operating profit margin. The margins are expected to contract further in the next quarter on the back of wage increases --12% offshore and 2.5% onshore --effective from July 1. On the back of lower revenue growth and margin erosion, the company's bottom-line before exceptional items fell 13% to . 181 crore.

Tech Mahindra is likely to witness billing rate pressure on account of its largest client BT undergoing a process of business retendering for all its vendors. This could result in Tech Mahindra losing volumes to more competitive vendors.

A ramp-up of the company's BPO business appears to be the only positive factor for the company as of now. While Bharti Zain ramp up is onstream, Vodafone Australia deal will ramp up in the next quarter. However, with Tech Mahindra's BPO business growing much faster than its IT services arm, the margin pressure is expected to continue. At the Thursday's close of . 662, Tech Mahindra's stock trades at over 11 times its earnings in the trailing 12 months. The valuation seems to be inexpensive against other large industry players which are trading at a P/E multiple of more than 25. However, weak IT spends in the telecom segment, uncertain macro environment and top client headwinds will continue to limit an upside in the stock's valuations.