Mind tree : The tree will keep branching out

MindTree Consulting IPO: A growing story u cannot afford to skip or miss out

Recommendation: Investing is a no-brainer

Basic Details:

Issue Open Date: 9^th Feb 2007

Issue Close Date: 14^th Feb 2007

Price Band : Rs. 365-425

Bid Lot : 15 Shares

Objective of the Issue:

Ø To fund a new development centre in Chennai and Bhubaneshwar

Ø To pursue strategic initiatives and tap inorganic growth opportunities

Ø To increase market penetration and sales apparatus

Ø To fund brand building exercises and general corporate purposes

Company Background:

The company was incorporated in 1999 by a group of 10 professionals led by Mr.Ashok

Soota (Ex Honcho of Western India Vegetable Products) through an entity incorporated in Mauritius. The company delivers business and technology solutions through global software development to major Fortune 100 and enterprise software organizations. The entity is organized into two divisions namely:

Ø Information Technology Services (IT services)

Ø Research and Development Services (R&D services)

The company, a CMM level 5 outfit, provides end to end project execution through a hybrid delivery model for its onshore and offshore operations.

The company currently has three development centres, one each in Bangalore, Chennai and New Jersey and 18 sales offices across the globe. In 2004, the company acquired the software businesses of ASAP Solutions and Linc Software Solutions to include SAP implementation and maintenance, customized application development and data management to its basket of service offerings.

The company is headed by a professional management with a proven track record comprising of erstwhile CEO’s of established companies like Wipro, Lucent and Cambridge Technologies.

Chennai Development Centre:

A significant part of the net proceeds of the issue will be used to fund a development centre in Chennai, for which the Memorandum of Understanding (MOU) has already been executed. The issue proceeds will be expended to set up the development centre at Ascendas SEZ, Mahindra City, Chennai once the approvals are obtained from the SEZ development commissioner. In case the approval is not received, the company may alternatively use the funds for acquisitions across US and Europe or pursue strategic initiatives to strengthen the existing business verticals.

Overview of Information Technology Services

• IT services comprise IT strategic consulting, application development, data warehousing and business intelligence, application maintenance, package implementation and application product engineering services.
• The IT services business unit offers services with a strong focus on manufacturing, travel, transportation, banking and financial services

Overview of Research and Development Services

The R&D services are organized into two divisions namely

• Engineering division which provides product realization services to technology and product firms including product architecture and product design, product reengineering and product assurance.
• Research division which conceives and develops intellectual property in the short range wireless communication segment.

R&D services- Engineering is organized into three business units that serve six industries including consumer appliances, storage, computing systems, communication infrastructure and communication terminals.

New Service Offerings:

Ø The company has steadily enhanced the portfolio of services offered by it to meet the diverse requirements of its clients. It has recently added new service offerings in the form of infrastructure management, technical support and CIO toolkit under IT services and new capabilities in the form of Ultra Wire Band Technology under R&D services.

Ø The success of these new service offerings is dependant upon continued demand from existing and new customers and the ability of the company to deliver these services at competitive rates.

Ø As IT industry is marked by rapid technological changes, the company will have to be proactive and preempt the client requirements by putting in place a mechanism for developing new service offerings on a continuous basis.

Ø Technological redundancy is very high in the IT industry and high cost investments are required in R&D, know-how to improve the global delivery models of IT majors. Mindtree, given its strong domain expertise is well poised to leverage on growth opportunities in R& D services.

Ø Going forward, the increased breadth of service offerings of Mindtree will be a major catalyst for the company to get inclined in large, complex, high margin projects for niche players where technological redundancy is high.

Business Model

Ø The business of the company depends on the continuous growth in use of IT in business by existing and prospective clients, their customers and suppliers forming part of the value chain.

Ø The IT services and R&D services are characterized by rapid technological changes, evolving industry standards, changing client preferences and new service offerings.

Ø The company has technological alliances and forum memberships with ARM, Bluetooth, Intel, Wi Max, Wi Media, SAP and LANSA to name a few.

Ø The company executes its contracts on fixed price or time and material basis which is the general norm for any IT company.

Ø For the fiscal 2006, the company has derived 77% of its revenues from IT services and 23% from R&D services. Going forward, the company is exploring opportunities to increase the service offerings in R&D segment so as to strike the right proportion in its service mix at the same time mitigating the risk of fall in IT spending by companies across the board.

Customer Profile

Ø The company has developed several strategic client relationships with American International group (a Fortune 10 company), United Technologies (A fortune 100) Unilever, Volvo, Symantec, Avis Budget Group and LSI Logic with its strong domain skills and customer centric approach.

Ø The company derives significant portion of its revenues from a limited number of clients as disclosed in the table below :

Particulars	2004	2005	2006	9M ended Dec 2006
Revenue from top five customers	51%	40%	38%	32%

Top ten customers accounted for 50% of FY 06 revenues

The data clearly indicates that the company is making committed efforts to reduce

customer concentration risk and ramp up its client base at large. The company’s largest customer is a global travel conglomerate (having contributed 14% to the FY 06 topline) and is in the process of a restructuring exercise to spin off its divisions into separate companies. Going forward, the company expects additional revenues to flow from the demerger, arising from increased technology spends and outsourcing activity among the resultant companies.

Segment Wise revenue distribution

Stable revenues from the two major verticals. Product mix expected to settle at 65:35

by FY 08 with aggressive growth plans being outlined by the company in R&D

segment.

Product Segment	2004	2005	2006	9M ended Dec 2006
IT services *	73%	75%	77%	76%
R&D services	27%	25%	23%	24%

* Majority of revenues were from custom application development

Geographical segment	2004	2005	2006	9M ended Dec 2006
USA	61%	63%	63%	63%
Europe	17%	23%	23%	23%
Asia Pacific	22%	14%	14%	14%

The revenue distribution across geographies clearly indicate that US and Europe have been the significant revenue drivers which in any case is justified by the fact that margins for clients located in these areas is much higher than those based in Asia Pacific. Going forward the revenues across geographies will continue to be skewed in favour of the Western countries to maintain stable operating margins.

Employee Profile

• Any IT company’s ability to execute projects and obtain new clients is dependant on the talent available on rolls of the company. In this regard, Mindtree has largely been able to attract and retain skilled software professionals, project managers and other mid level professionals in spite of the heavy competitive pressures and a limited talent pool.
• Attrition rates are pegged at 12% for FY 06 which is in line with other IT conglomerates like Infosys, Wipro and TCS.
• People strength has increased from 442 in FY 2001 to 3200 in FY 2006. The employees on roll have grown at a CAGR (Compounded Annual Growth Rate) of 74% from 1000 to 3200 in the last couple of years.
• 4.7 years of average experience of employees.
• The company has a stable on- shore: offshore mix and employee utilization rates.
• Ranked second in the survey conducted by Business Today on “Best Companies to work for in India” (an improvement from 10^th position in 2005).

A note on the financials

• The revenues of the company have seen a robust growth over the last couple of years. The revenues grew at a CAGR of 47% from Rs.66 crore to Rs.449 crore in the last five years. Similarly the net profit has grown at a CAGR of 360% over the last two years (from Rs.2.6 crore for FY 04 to Rs.54 crore for FY 06) after being in the red since incorporation in 1999.

Rs. in crore

Particulars	2002	2003	2004	2005	2006	9m ended Dec 2006
Income from Operations
Overseas	65	72	106	209	397	408
% Increase YoY		12	46	98	90
Domestic	8	10	25	38	52	26
% Increase YoY		31	151	51	38
Total Income from Operations	72	82	130	247	449	434
% Increase YoY		14	58	89	82
Expenditure
Software Development	48	50	81	160	273	258
% Increase YoY		4	62	97	71
Interest	1	1	2	2	5	2
% Increase YoY		-21	64	34	152
PBDIT	-11	3	11	30	82	85
% Increase YoY		-126	277	183	175
Operating Margins		3	8	12	18	20
PAT	-20	-7	3	17	54	66
% Increase YoY		-63	-135	559	221
PAT Margins			2	7	12	15
Debt : Secured Loans	6	17	24	50	74	41
Shareholder Funds	80	74	75	93	129	194
Debt Equity Ratio *	0.08	0.23	0.32	0.54	0.58	0.21
EPS			0.69	8.34	19.96
Return on Net Worth (%)			1.98	19.16	41.76

Book Value per share: Rs.62, Price to Book Value: 6.86

*The company has reduced its interest outflow during the 9 months ended Dec 2006 by retiring a significant portion of its on balance sheet debt.

• The company derives higher margins on its business in US and Europe in spite of operating in a competitive environment. The company faces severe competition from MNC Indian IT players.
• Increasing focus on offshore business and diversification across geographies

Onshore :Offshore Revenue Mix	2005	2006	9 m ended Dec 2006
Domestic Revenues	15.20%	11.50%	6%
Overseas Revenues	84.80%	88.50%	94%

• The company has shown consistent increase in Operating Margins and PAT Margins over the last five years indicating betterment of billing rates and cost control.

• The company enjoys tax exemptions until FY 2009 and will continue to enjoy tax benefits for the income generated from the development centres located in SEZ’s.
• The value of rupee has risen against the US $ by approximately 2.4 % and 1.6% in FY 05 and FY 06 respectively. A majority of the company’s revenues are denominated in US $ and to a lesser extent in Euro, Pound Sterling and other foreign currencies whereas 62 % of the costs are denominated in Indian Rupees. Going forward the margins may come under significant pressure in spite of growth in service offerings, cost control and hedging techniques, if the rupee’s appreciation against the $ continues unabated for a third yr in succession.

Inter Firm Comparison - All figures based on year ending FY 06

Name of the Company	Sales	PAT	OPM	EPS	Face Value	PE	Market Cap /Sales	NAV	Price/Book Value
	(Rs.crore)	(Rs.crore)						(Rs.)
LARGE CAP IT
Infosys	9028	2421	33.1	43.4	5	52	13.9	94	23.9
Wipro	10227	2021	24.3	14.0	2	45	8.9	35	17.8
HCL Technologies	3033	638	26.7	19.7	2	34	7.1	71	9.3
I- Flex Solutions	1154	241	25.9	29.6	5	67	13.9	139	14.3
MID CAP IT
Mindtree Consulting	449	54	18.0	20.0	10	21	3.5	62	6.9
I Gate Global Solutions	564	15	8.4	4.9	4	74	2.0	109	3.3
Hexaware	356	78	24.7	5.9	2	28	6.2	20	8.3
Mastek	387	49	17.6	17.4	5	21	2.7	58	6.4
Mphasis BFL	381	76	22.4	4.7	10	61	12.3	28	10.4
Polaris	684	13	9.3	1.4	5	54	3.3	54	4.3
Patni computers	876	194	34.2	14.1	2	32	7.1	97	4.6
Tulip IT services	508	49	13.1	16.7	10	37	3.5	51	11.9

Source: Capital Market

Highest PE ratio of IT industry: 77.2

Lowest PE ratio of IT industry: 20.2

Industry Average PE : 39

• As observed from the above table, Mindtree on the basis of the price of Rs.425 at the upper band discounts trailing FY 06 earnings by 21 times which is among the lowest of PE ratios for the IT industry .
• The financials of the company (which is still an evolving story) cannot be strictly compared with large cap players whose scale of operations and resources are much larger. The table above has been prepared with the intent of highlighting the valuation gap between the different players and the reasonable pricing at which the issue is being offered to the public.

Strengths:

Ø Comprehensive range of IT services across different industry segments

Ø Strong R& D capabilities

Ø High quality of top management with proven track record

Ø Higher billing rates and better employee utilization rates when compared to most of its peers.

Ø Strategic alliances and Long term client relationships with global conglomerates

Ø CMM level 5 quality certification

Ø One of the most preferred places to work in Indian IT industry

Ø Diversification of business risk by increased service offerings

Ø Stable and evolving financial profile with consistent growth in margins.

Weaknesses:

Ø The company is subject to the general vagaries of the IT industry arising from reduction in IT spending or outsourcing by clients/economic slowdown in western countries.

Ø Magnitude of customer concentration risk is on the higher side with 10 customers accounting for 45 % of topline albeit variegation efforts.

Ø Highly competitive business environment with a number of established players

having a better brand recall and large resources.

Ø Absence of a pan India presence

Ø Investment in R& D services is made in anticipation of technology redundancy and potential growth opportunities in certain areas. Being a high risk venture, the investment may not yield the desired benefits to the topline if the opportunities do not materialize.

General concerns for the Indian IT industry:

§ Large MNC corporations are setting up captive centres in low cost destinations to address their technology needs.

§ Reduction or postponing of IT spending/ pressure on IT budgets of Western corporations in the event of an economic slowdown/ political opposition can reduce the demand for offshore services.

§ The competitive advantage of India as a low cost destination for outsourcing is under serious threat from countries like China and Philippines (having similar cost structure), with increasing wage costs in the country. disproportionate to the increase in pricing power of Indian companies.

§ Rising rupee continues to hurt the Indian IT sector with the resultant slackening of operating margins.

§ Immigration restrictions placed by US/European governments could limit the ability of Indian companies to expand their operations or pursue strategic initiatives. The US Govt. has already reduced the annual limit of H-1B visas from 195000 to 65000 accompanied by an increase in visa processing costs effecting additional pressure on the IT sector.

§ The Government of India is once again revisiting the aspect of BPO taxation and any drastic amendment in taxation laws can be prejudicial to the interests of the India growth story and may lead to adverse repercussions for the IT sector.

Valuations

The issue is being offered at a price band of Rs. 365-425 and the pricing discounts

trailing FY 06 earnings by 18 x at the lower end of the price band and 21 x at the upper end of the price band. The company has maintained triple digit earnings growth rate for the last couple of years and PE growth rate (PE/Earnings growth rate) works out to merely 0.1 which indicates enough scope for capital appreciation upon listing.

Recommendation:

Investing in this IPO is an absolute no-brainer. The investing call stems from the following positives namely:

1. “Information Technology “as an industry sector is expected to continue its

outperformance vis a vis the benchmark indices in the medium to long term

albeit concerns of a slowdown in growth

2. Midcap IT is the cash cow that is currently being milked by market players and

Mindtree Consulting with stellar growth rates in the last couple of years

accompanied by sensible valuations would definitely command a premium

valuation upon listing.