We reset estimates and raise Tech Mahindra and Satyam shares to buy,forecasting a 15% EPS CAGR for FY12-15 (proforma combined entity). Strong traction in managed services deals in telecom in Europe and emerging markets,an area of strength for TechM,increases confidence in the revenue outlook.
We set TechMs price objective to R1,150 (combined financials) based on a 5-year price/earnings to growth ratio (PEG) of 0.8x 30% discount to tier-1 vendors. We believe the valuations are fair,given its smaller size and high revenue concentration to telecom vertical.
PEG of 0.8x implies target FY14 P/E of 12.8x,which is similar to its current one-year forward PE. Meanwhile,client mining and higher deal participation rates are driving Satyams revenues. Improving scale,productivity and mix support margins too. We set Satyams price objective to R135,using the swap ratio of two shares of TechM for 17 shares of Satyam. Second quarter results are likely to be muted,given wage hike and likely deal transition costs.
Deals and acquisition announced by TechM over the past fortnight are likely to give the company critical scale in large strategic accounts like Hutch and KPN. Moreover,steady growth in AT&T and likely stabilisation in top client British Telecom set stage for an improved organic growth trajectory. Deal pipeline is healthy and we could see a few more closures in next couple of quarters.
At Satyam,deal participation rates have been gradually improving over the past year,post the re-instatement of its financials and strengthening of sales efforts. Expect full benefit of these factors to drive industry level growth in FY14.
We believe TechM is well-placed on the operating margin front,given the increasing revenue contribution from managed services deals that tend to be margin accretive,scale benefits in top 2-10 accounts,and limited near term decline in top account. For Satyam,full-year benefit of an improved employee pyramid and declining legal costs are likely to aid margin performance in FY13/14. We forecast 220 bps and 320 bps ebit margin improvement for TechM and Satyam in FY13,respectively.BoFA-ML