Investors can consider an exposure in MindTree Consulting, which is making an initial public offering in the price band of Rs 365-425 per share. The company's hybrid business model focusing on information technology and Research and Development services, a good geographic mix, and established relationships with clients inspire confidence. However, the competitive intensity in IT services, the high client concentration and the risks associated with attrition and acquisitions represent the downside.
At the announced price band, the price-earnings multiple works out to 15-18 times the annualised 2006-07 per share earnings on an expanded equity base. At the upper end of the price band, the pricing is relatively high vis-à-vis some of its listed mid-size peers. The scope for capital appreciation will be higher if the offer is finally priced at the lower end of the price band.
The positives linked to this offer are:
Hybrid Business Model: MindTree is organised into two key divisions — IT and R&D services. For the company, the focus on IT services has principally been on the manufacturing vertical, with travel and transportation and BFSI (banking, financial services and insurance) being the other key contributors. IT services contributed over 76 per cent of the total revenues in 2005-06, with R&D services coming up with the balance.
Though the revenues from R&D services are flowing in primarily from engineering, the scope for research may be the kicker that will lead to non-linear growth in the long run. The company has been creating a set of licensable IPs (intellectual property) in the area of Ultra Wide Band and Bluetooth that can have good revenue potential and can be leveraged across other areas such as storage networking, data networking or multimedia.
Good client relationships: The company has forged fairly strong relationships with Fortune 500 clients and worked with some of them for several years. In 2005-06, its key clients included AIG, United Technologies, Avis, LSI Logic, Symantec, Unilever and Volvo. As MindTree plans to deepen its relationships with existing customers through cross-selling opportunities, its long association with some of these clients should work to its advantage. Quite a few of these clients have consciously chosen mid-size firms such as MindTree for greater attention and flexibility that they can offer.
Fair geographic spread: Two key geographies, the US and Europe, account for more than 85 per cent of the revenues of MindTree. For 2005-06, the US accounted for 61 per cent and Europe 22.6 per cent of revenues, with Asia-Pacific (including India) contributing the balance. With sales offices in locations across the globe, MindTree may be well positioned to pursue growth opportunities as they emerge.
Sound financials: Crossing the $100-million mark in revenues in 2005-06, with revenues at Rs 448 crore and post-tax earnings of Rs 54 crore, MindTree stands on a fairly strong financial footing. The steady uptick in operating margins over the past three years is an encouraging trend. The operating margins of 18.3 per cent for the nine months ended December 2006 are in line with comparable mid-size peers. With return on shareholders funds in the 30-40 per cent range, the company appears to be on a good growth platform.
The risks and challenges that the company remains exposed to are:
Scalability and competition: With multinationals such as IBM and Accenture establishing a firm footprint in India and frontline players using their scale and size to good advantage in mid-to-large-size deals, of $50-200 million, mid-size players such as MindTree will find the going challenging.
Client concentration: For 2005-06, the top five and top ten clients accounted for 38 per cent and 52 per cent of revenues respectively. The contribution of its top five clients has been coming down over the years.
In relative terms, the contribution of top five clients is lower than some of its mid-size peers that are anchored to a key client. However, the company remains vulnerable to vendor consolidation in some of its mature relationships with Fortune 1000 customers and also to billing rate pressures in commoditised application maintenance relationships.
Attrition and acquisition risks: Mid-size players such as MindTree are far more vulnerable to risks surrounding high attrition and wage inflation. With frontline IT companies hiring aggressively, retention of employees is proving to be a huge challenge. Though MindTree has grown its employee strength from 441 in 2000-01 to 3,128 in 2005-06, the next phase of growth could prove to be the most challenging.
Though well placed to make acquisitions for growth, the risks of integration are quite high. It has put through two acquisitions — of ASAP Solutions and Linc Software — over the past couple of years. In the case of ASAP Solutions, it is facing a dispute that has been referred for arbitration.
Objects of the offer: The offer proceeds of Rs 205-230 crore are to be used to fund a new development centre in Chennai for Rs 120.7 crore, prepay loans of Rs 18.77 crore and general corporate purposes, the balance.
The book running lead managers are Kotak Mahindra Capital and JM Morgan Stanley. The offer opened on February 9 and closes on February 14.