Margins peak,headwinds ahead

Earnings Upgrade Cycle likely to Stall: Mindtree reported Q1FY13 revenues of 105.5m,up 0.4 quarter-on-quarter.

Earnings to go up on currency benefit and better operational efficiency

Earnings Upgrade Cycle likely to Stall: Mindtree reported Q1FY13 revenues of 105.5m,up 0.4 quarter-on-quarter. Volumes and pricing were both flat sequentially. Product Engineering Services PES segment reported weaker volumes owing to couple of project ramp downs,while IT Services revenues grew 3 sequentially. The margin expansion of 210 bps q-o-q was better than our expectation of 150 bps basis points,boosting the net earnings growth to 29 over the previous quarter.

Margin expansion noteworthy: Post-the ramp down of its troubled telecom venture,the company has managed to consistently expand its margins from 11.1 in Q1FY12 to 20.8 in the Q1FY13. Both operational improvements and INR depreciation have helped the company improve its profitability. We believe the margins are near peak and are likely to face more headwinds in the coming quarters.

Margins expansion of 210 bps in the quarter was on account of a 2.3 benefit from currency net of cross currency impact,0.8 benefit from operational efficiency offset by 1 due to wage increase. Around 80 of the employees had their wage increase effective June 1,while 18 will have wage hikes effective Sept 1 and the rest 2 in October. The other income contributed to 12 of the profit before tax,owing to forex gain of 1.6m. Overall the net earnings grew 29 over the last quarter to R890m.

Other highlights

Change in reporting: The company has started reporting standalone financial from now on as the only subsidiary in China is winding up. The subsidiary generated no revenues.

Demand environment is steady,but upside to revenue growth forecasts is limited as well: Mindtree has guided for revenue growth in line with Nasscom forecast of 11-14 in FY13. This is a step down from the earlier guidance of better than Nasscom-forecast growth. According to the management while there are no deal cancellations,decision making has been slow,leading to this moderation in growth outlook. To achieve its guidance the company needs a CQGR quarterly growth of at least 4 for the next three quarters.

Visibility in FY13/14 growth remains low for Mindtree as overall demand environment remains tough. We therefore cut our valuation for Mindtree to 8x from 10x,and rollover to FY14 earnings. We revise our target price to R680 from R470,and remain Neutral.

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Risks : Primary downside risks to are macro economic weakness and INR appreciation. Also lack of broad-based growth across clients and high reliance on PES for FY13 growth are downside risks.

HSBC