No short-term gains from engineering unit’s merger for Tech Mahindra

The stock of Tech Mahindra has been flat since the company’s announcement last week to merge the engineering business of the parent group with itself. The decision to merge Mahindra Engineering Services (MES) will strengthen Tech Mahindra’s engineering vertical at a time when the revenue from its key telecom client BT is sliding. However, given the smaller size of operations, MES’s acquisition is largely a long-term decision and will not have a major impact in the near term.

The merger will strengthen the manufacturing practice of Tech Mahindra, which contributes one-fifth to the topline. MES offers engineering services to global automobile, aerospace companies.

Some brokerage reports count Caterpillar, GM, Hindustan Aeronautics, Honda, McLaren, Mercedes Benz, and Seabird Aviation among the clients of MES.

It depicts a highly concentrated client metrics with top five clients contributing over 70% to its revenue.

There is no client overlap now between MES and Tech Mahindra, which improves the possibility of cross- selling of services to each other’s client base.
MES has been growing at over 20% for the past three years. It has more than 1,300 employees and clocked a revenue of Rs 250.6 crore in FY13. Moreover, the operating margin profile of MES is better than that of Tech Mahindra. Analysts peg MES’s profitability at 24-27% compared with 21% for Tech Mahindra.

As part of the merger, Tech Mahindra will issue five shares for every 12 shares of MES. Currently, M&M owns 80% in MES, while the rest is with the employee trust. Angel Broking’s Ankita Somani noted in a report that at the current price of over Rs 1,700 for Tech Mahindra’s stock, MES is valued at Rs 723 crore. This makes its enterprise value (EV) 2.3 times its sales and the price-earnings ratio works out to be around 15.

“The valuation appears a tad higher compared with Infotech Enterprises, which trades at a P/E of 12 and EV/sales of 1.2,” she noted.

Given the FY13 revenue, MES is about 1% the size of Tech Mahindra. This will limit its positive impact on the consolidated performance of Tech Mahindra in the near term. Analysts at Angel Broking and Prabhudas Lilladher expect an upside of 6-9% from the current stock price of Tech Mahindra over the next 12 months. This reflects that the current valuation is more or less rich and takes into account the future growth prospects of the company.