Mindtree an underperformer, tgt Rs 475: Karvy

We are initiating our coverage on MindTree, with an Under performer rating as we expect the earnings growth for the next two years to be muted and the valuations are yet to correct. Besides, return ratios are showing no strength and are likely to decline from the current levels, as the incremental growth are likely to slow down. Since its business model is more skewed towards project based - the forecasting the quarterly profitability is difficult and in the current environment the stock is likely to under perform.

Our rationale for under performance is based on 1. Competition is likely to hot up, which would necessitate many tier- 2 companies to not to seek billing rate increase. 2. Derives 75% of revenues from undertaking new development services', which do not have the traditional annuity component. 3. Smaller size, higher client concentration, and necessity to pay higher wages could create abrupt changes and volatility in growth and margins on a quarterly basis. Competition would emerge to dwarf growth: MindTree has been growing its revenues in USD terms at a CAGR of 65% (between FY04 - 08E).

However, it would find it difficult to sustain the same, as the situation in US, could be turning unfavorable and the stiff competition particularly from the larger vendors could pull the growth down. Though it has a de-risked revenue model by geography, its ability to report strong growth both in USD terms is little suspect and in INR terms, the growth would be dwarfed as the rupee is likely to be in an appreciating mode. In Rs terms we expect its revenues to grow by 18.8% for FY08 and for FY09 and FY10; we at this point of time expect the growth to be at 16.9% and 24.7%. Skewed in favor of development services: We expect Rs to appreciate from an average of Rs40.5 in FY08 Rs34 by FY11, which is a risk that we cannot underplay.

Apart from the rupee factor, what we fear is, it derives little above 3/4th of revenues from undertaking new development services', which more often than not, do not have the traditional annuity component. We do not expect the revenue model to significantly change from the current project centricity, which would lead to volatility in its utilization rates. This, along with its smaller size, relatively higher client concentration, and necessity to pay higher wages to attract and retain talent could create sudden changes and volatility in growth and margins on a sequential quarter basis.

Valuations are extremely stretched:

Given MindTree's high exposure to new application development work, slow down in the global IT spending could result the company reporting serious negative growth in earnings. At present, we expect the earnings to decline by 11.4% for FY08 and for FY09 expect a further decline of 1.4%, which is more a result of rupee appreciation. However if the slow down percolates further, then the company can report can serious earnings decline, which at this point of time - the market is not factoring. The stock is currently at a valuation of -- -%FY08 and ---%FY09, which we believe are expensive. Consequently we recommend the stock as an under performer of Rs475.