Mindtree's Q4 casts doubts on immediate gains for L&T from the buyout

Lower deal wins, high attrition and management transition due to L&T's takeover to weigh on Mindtree's growth

With Larsen and Toubro (L&T) lapping up ne­arly 20 per cent of Mind­tree’s promoter stake, the engineering and infrastructure major has taken its first step towards acquiring the information technology firm.

But Mindtree’s stock didn’t react much (up 0.38 per cent) on Tuesday to the development as the move was on expected lines, and the L&T stock was marginally in the red, down about half a per cent. However, going by Mind­tree’s Q4 show, the key question is how accretive will the buyout be for L&T in the near- to medium-term. Some operational parameters mirror the medium-term business pressures for Mind­tree that were flagged off by analysts after L&T announced its acquisition plan.

“Factors like lower deal wins and high attrition rate could be early signs of impact of L&T’s Mindtree takeover. After the acquisition, which looks certain, the focus will be shifted to management transition. This could hurt Mindtree’s performance in the near-to-medium term,” said Aniket Pande, analyst at Prabhudas Lilladher. On its part, Mindtree’s management in the Q4 analyst call clarified that deal wins and attrition rate weren’t impacted by L&T’s hostile bid.

Numbers, though, spe­ak differently. For instance, Mindtree’s to­tal deal wins of $242 million fell 19 per cent year-on-year in Q4, the lowest in six quarters. Even for the full-year of FY19, deal wins rose by just 6 per cent against a 9 per cent growth in FY18. This could weigh on Mind­tree’s revenue potential in the coming quarters. According to analysts at Macquarie Capital, Mindtree will need to work hard even to achieve its low-teens revenue growth guidance, in constant currency, for FY20. 

The guidance itself is lower than the Street’s expectations, though better than Infosys’ guidance of 7.5-9.5 per cent. For now, the Street is factoring in a sharp downgrade in revenue growth — to 12.7 per cent in FY20 against 28.5 per cent seen in FY19.

Even these estimates are at risk, given the client-specific issues in select verticals, particularly from clients in the banking and financial services sector operating in the European region. Part of it is already reflecting in the book-to-bill ratio, a critical measure to gauge a company’s ability to fulfil orders, that fell to 0.9 times in Q4. A ratio above one indicates that more orders were received than fulfilled (executed), suggesting strong demand, while a ratio below one implies weak demand.

Moreover, dissecting the deal wins, those from high margin-digital segment also fell 7 per cent sequentially in Q4; in absolute value, digital deal wins were the lowest in four quarters and it was the second consecutive quarter of decline. Given that these deals are known to be margin accretive and have short turnaround duration (6-8 months), it could have implications for Mindtree’s profitability if deal wins in the digital segment remain weak.

An attrition rate of 14.2 per cent in Q4 – highest in six quarters – could also keep employee costs elevated for Mindtree, apart from weighing on revenues. Keeping a check on attrition is important to sustain client relationship, particularly those in the consumer discretionary sector, which involves constant client engagement.

In this context, whether the management’s expectations of 100-120 basis point improvement in earnings before interest and tax (EBIT) margin is met in FY20 needs to seen. Increased campus hiring and ability to implement price hikes in the digital segment may cushion margins.

Analysts at HDFC Securities expect moderate margin expansion of over 80 basis points due to challenges of employee utilisation, elevated sub-contracting expense (up 51 per cent in FY19) and competitive wage hike ahead. For investors, at current valuation of over 19 times FY20 estimated earnings, Mindtree’s asking rate is at par with the industry. 

A capital allocation policy, anno­unced last week by the company, would provide some cushion to the stock in the near term, though it entails substantial cash outgo (around 57 per cent of net cash of Rs 940 crore as of March 2019). 

The company declared a final dividend of Rs 27 per share (including a special dividend of Rs 20, subject to shareholders’ approval), totalling Rs 533 crore of cash outflow.