Stock corner: ‘Buy’ on Mindtree, TP Rs 890, margin improvement key

Mindtree’s business is inherently transactional which exposes it to higher revenue volatility were global macro to worsen but that does not seem to be the base assumption for CY20 yet.

We reinstate coverage on Mindtree with a ‘buy’ rating and a target price of Rs 890. The company has managed recent leadership transition post change in ownership very well having sustained all key client relationships with limited impact seen on key operating parameters like deal intake, NPS and revenue momentum.

Key underpinning of our ‘buy’ rating is significant scope for margin improvement over the next six quarters starting Q3FY20 even as we expect no meaningful inflection in revenue growth.

Mindtree’s business is inherently transactional which exposes it to higher revenue volatility were global macro to worsen but that does not seem to be the base assumption for CY20 yet. Though our margin estimates for FY21/22 are higher than consensus, we see them as conservative.

We expect dollar revenues in Q3FY20/Q4FY20 to increase by ~2% QoQ each, though we expect the EBITDA margin to increase by a sharp 150bps QoQ in Q3FY20, to be followed by another 100bps QoQ in Q4FY20. Revenue growth is expected to be stable at around 9% over FY20- 22 with EBITDA margin to increase from 13.3% in FY20 to 16.3% in FY22.

Though pyramid optimisation is a structural margin lever, we would expect improvements across other key operating metrics as well like productivity, G&A optimisation, profitability improvement in acquired entities as well as higher offshoring. Industrialisation of digital services should be a key margin lever as well. Improving attrition, absence of client specific issues, stable revenue profile and margin upside should drive continued upside in the stock in our opinion.

Deal intake is expected to be on the weaker side in Q3FY20 and potentially decline YoY as some deals get deferred to Jan’20, but visibility on these deals eventually closing is very high. Mindtree will need to build greater annuity in its revenue model, towards which creation of a large/strategic deals team with strengthened leadership is a good first step.