Why you should book profit in Mindtree stock

Investors can book profits in the stock of IT services company, Mindtree. Its current price implies a PE of 43 times next twelve month (ntm) EPS (Bloomberg Consensus), which is at a 125 per cent and 93 per cent premium to its 5 and 2 year average respectively. Mindtree, similar to many of the leading Indian IT services companies has manoeuvred through the pandemic related disruptions successfully and has managed to significantly improve its margins in FY21. Further it is also expected to grow faster than the industry with FY21-23 revenue and EPS CAGR at 17 and 21 per cent respectively. While this is marginally better versus Tier 1 peers who are expected to grow revenue for the same period in mid teens CAGR, it does not justify the premium valuation. At current levels these improvements are more than adequately reflected in its valuation now with PE to earnings growth ratio at more than 2. The company is also trading more expensive that the Tier 1 IT services companies that benefit from better economies of scale and have better EBITDA/EBIT margins than Mindtree. Any reversion closer to mean could result in significant correction from current levels. Hence, investors can book profit and look to re-enter at lower entry points.

Business

Founded in 1999, Mindtree has successfully traversed the Indian IT landscape over the last two decades to emerge as one of the leaders amongst the Indian mid-tier IT services companies. The company has continued to gain steam, even as significant ownership changed hands and L&T became its promoter after it garnered 60 per cent stake in the company in 2019. Under a new strategy - 4 x4 x 4 unveiled by the company recently, it plans to leverage growth over the next few years by focussing on four industry verticals across four service lines in four geographies. The four verticals are Communication/Tech, Retail, BFSI and Travel. These contributed 50, 21, 20 and 9 per cent respectively to 2021 revenue. Travel segment bore the brunt of the impact of pandemic declining from 17 per cent in FY20 and communication/tech segment saw better performance benefiting from digitisation trends. In terms of geographic exposure, North America accounted for a significant 77 per cent of revenue, continental Europe – (7 per cent), UK & Ireland (8 per cent) and APAC (8 per cent).

Recent performance

Mindtree had an excellent run in FY21 despite a decline in revenue of around 1 per cent in USD terms to around $1.08 billion (₹ 7,968 crore). This good run was driven by a significant jump in EBITDA margins during the year – up by nearly 700 bps to 20.8 per cent. The company was able to achieve this by optimization of manpower costs, reduction in travel and marketing expenses, and with benefits from currency depreciation. This resulted in company growing its net profits by a good 76 per cent for the year to ₹1,110 crore.

Positives priced in

In the last one year, the stock of Mindtree is up by around 220 per cent and by around 260 per cent from its pre-pandemic highs. As mentioned above, it is now at significant premium to historical valuations, that do not appear to be adequately supported by its future growth prospects as of now (revenue/EPS growth). While the margin improvement it delivered in FY21 warrants a re-rating, this is more than well-reflected in its stock performance. A few factors also need to be noted with regard to its margins – one, even after the improvement, its EBITDA margins at 20.8 per cent are still significantly lower than the FY21 EBITDA margin of Tier 1 companies such as Infosys and TCS at around 28 per cent. Two, much of the margin improvement is behind, with consensus expectations for FY22 and FY23 lower at around 20 per cent. The company management too has guided only to sustaining EBITDA margins at over 20 per cent, and not an increase for FY21. Hence given these factors, Mindtree trading at premium to Tier 1 IT services companies (Infy ntm PE at 30 times, TCS at 34) appears untenable. Not to mention the fact that Tier 1 IT services companies themselves are expensive.

Also, at current price levels where there is absolutely no margin of safety for errors in execution, investors also need to take cognisance of few other risks that one can normally discount off when valuation is cheap. Mindtree has high customer concentration with its top client (Microsoft), accounting for a significant 29 per cent of revenue in FY21. Finally, its free cash flow yield (FY22 FCF/Market cap) of just around 1.5 per cent, imply capital returns to shareholders are not going to be exciting.

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