Mindtree: Margin pressure and high valuation may limit upside

Record deal win, recovery across verticals may push FY22 dollar revenue growth to 20%

Robust revenue growth and margin outlook in addition to stellar June quarter results helped Mindtree’s stock gain over 8 per cent in trade on Wednesday. After registering a 7.7 per cent sequential sales growth in the first quarter of financial year 2021-22 (Q1FY22), the management guided for double-digit sales growth and margins of 20 per cent for FY22. Strong growth expectations rubbed off on the broader mid-cap IT sector with L&T Infotech, Mphasis, L&T Technology, and Coforge gaining 3-8 per cent.

The basis for the company’s positive commentary was the record order book of $540 million, compared with the average quarterly run rate of $375 million over the last few quarters. Recovery in travel, transport, and hospitality vertical, and continued traction in digitalrelated contracts are other triggers. Most brokerages expect 20 per cent plus growth in FY22.

Say analysts at Motilal Oswal Financial Services, led by Mukul Garg: “Combined with strong deal wins in the last two quarters (average book-to-bill ratio of 1.5 times), Mindtree is expected to deliver dollar revenue growth of 23 per cent year-on-year in FY22, one of the highest in our coverage universe.”

Strong employee addition in the quarter is also boosting the company’s outlook. Its headcount grew by 14.5 per cent on a sequential basis after it added 3,442 employees, its highest ever addition in a quarter. Say Kawaljeet Saluja and Sathishkumar S of Kotak Institutional Equities, “We believe the strong additions will be used for three reasons—reduce subcontractor dependence, build a bench that is running pretty thin (utilisation of 83 per cent is unsustainable) and meet future demand.”

The 160 basis points (bps) reduction in operating profit margins (OPM) on a sequential basis to 20.3 per cent was largely due to a surge in subcontracting and hiring costs, which were up 170 bps.

The management has guided for an OPM of 20 per cent in FY22, but analysts believe this will be difficult to achieve, as discretionary costs, including travel, will make a comeback. An analyst at a domestic brokerage believes that maintaining margins across the mid-cap IT companies will be a tough challenge, unlike for larger IT peers, who have more levers and scale to manage these pressures.

Given unsustainable margins and the sharp price runup of the stock (30 per cent over three months), brokerages believe near-term upsides are priced in. Valuation at 29 times its FY23 earnings estimates is rich, with most brokerages valuing the company in the 2025 times band. Investors should await deal flow momentum and the firm’s ability to stick to stated margin guidance in the coming quarters before considering the stock.