The stock of mid-cap IT player Mindtree, which rallied about 13 per cent after our buy recommendation in September, has fallen since and now trades at ₹660. In January, after the management issued an earnings warning indicating delay in project commissioning in the retail and BFSI segments, the stock took a beating.

However, at 6.1 per cent sequential growth in revenue in dollar terms in the March 2016 quarter, the company’s results were not as bad as expected. For 2015-16, the company delivered 18.6 per cent growth in constant currency terms, higher than Nasscom’s estimate for the industry of 12.3 per cent. Long-term investors can hold the stock as a strong order book and increasing share from digital revenues are positives.

But given that the company’s margins could slip in the near term due to the margin-dilutive acquisitions and clouded outlook for key verticals, fresh buying in the stock at current levels can be avoided.

At ₹660, the stock discounts its likely earnings for 2016-17 by 17 times.

As larger peers- Infosys and TCS itself now trade at 17.8-18 times on one year forward earnings, Mindtree’s valuation look little expensive.

Pressure on profits Until the new acquisitions (Magnet360, Bluefin, Relational Solutions) consolidate with the company and synergies in operation happen, there will be pressure on the company’s profitability as the acquired businesses have lower margins than Mindtree. In the March 2016 quarter, operating margin was 17.1 per cent, down 60 basis points sequentially and lower by 240 basis points over the same time last year. The change in business mix with more onsite revenue could also be a reason for drop in margins. Onsite revenue accounted for 57.7 per cent of revenues in the March 2016 quarter, up from 54.5 per cent in the December quarter and 47.1 per cent in the March 2015 quarter.

Given that there will be also expenses to integrate the acquired entities with the parent and the company has also indicated wage hikes in 2016-17, improving margins this year may be challenging. Employee utilisation stood at 70.6 per cent in the March 2016 quarter, up from 69.9 per cent in the December 2015 quarter, but lower than last year’s 71.1 per cent. One saving in 2016-17 could be on visa costs. The company has indicated that in 2016-17 it may likely spend around $2 million on visas, lower from $3.5 million spent in 2015-16 on increase in local hirings.

The weakness in performance of the key verticals in the last quarter is also worrying. The retail and manufacturing vertical, which contributes a fifth of the company’s revenue, reported a 5 per cent drop in revenue sequentially in the March quarter. The BFSI division’s revenue was down 2 per cent.

Mindtree’s management has indicated that retail, manufacturing and BFSI verticals may continue to see headwinds for a couple of more quarters.

In the March quarter, Mindtree’s US geography grew a healthy 10 per cent (on constant currency basis), but whether this growth will sustain, given the weakness in the global financial services sector, needs to be seen.

Revenue visibility Mindtree has been reporting strong order wins. In the March 2016 quarter, it reported signing of $281 million worth of orders, a jump of 38 per cent from the December 2015 quarter and 71 per cent from the wins in the March 2015 quarter. Deal wins from new clients in the quarter was to the tune of $72 million, up from $51 million in the December 2015 quarter. So, long term revenue visibility is good. Digital now contributes 38.6 per cent to revenue, up from 32 per cent last year and 36.1 per cent in the December 2015 quarter. Given that, globally, companies continue to invest more on digital platforms as they are cutting legacy investments, Mindtree’s growing digital presence is an advantage. Contributions from the digital business grew 13 per cent sequentially in the recent March quarter for the company.

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