Apply for MindTree IPO; quality all the way: Edelweiss Sec

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MindTree Consulting, an international IT and R&D Services Company that delivers business and technology solutions through global software development, is open for subscription with an initial public offering, IPO of 5,593,300 equity shares of Rs 10 each at a price band of Rs 365 to Rs 425 per equity share through the 100% book building process.

The issue will constitute 15% of the post-Issue capital of the company and the net issue will constitute 13.25% of the post-Issue capital of the company.

The Edelweiss Securities report on Mindtree IPO:

Investment Rationale

Promoter quality and stability of management team

MindTree has a high quality broad-based senior management team, which has few parallels in the Indian IT services industry. Ashok Soota, the Chairman and MD, prior to co-founding MindTree, was the Vice-Chairman of Wipro. Subroto Bagchi, co-founder and chief operating officer, was earlier with Lucent Technologies in product realization and with Wipro, where he was involved in setting up the company's six-sigma initiatives. Other co-founders, with an average of 20 years of experience, have previously worked with leading firms such as Cambridge Technology Partners and Wipro. MindTree has frequently been cited and rated highly for its management competence. Notably, the management team comprising 72 personnel, which reports directly to the co-founders, has had only one departure in the past five years.

Flexibility in changing course to embrace growth

MindTree started operations in late 1999 as an internet consulting company. However, the dotcom bust exposed it to trouble very early on. It then shifted focus to technology-led services in the telecom domain, but subsequent weakness in that domain also adversely affected the company. It has successfully navigated these early troubled waters by restructuring its business model. We believe that this is a testament to the management quality, quality of execution, as also the company's ability to adapt to the business environment.

Robust and diversified business model

We believe that MindTree is among very few mid-tier Indian IT services companies to have a two pronged complementary business model. The IT services segment embraces some of the more recent and/or more profitable service lines such as business intelligence and data warehousing, package implementation, and testing & validation services. On the R&D front, the
company is engaged in end-to-end product development (right from concept through prototype design through development and testing), embedded software design, systems software, among others, serving varied industrial segments. The company also has a dedicated team (about 80 personnel) to develop licensable IPs. We believe that this R&D effort is lean and focused given the overall employee base of about 4,000.

Sound risk mitigation policies

MindTree has reduced dependence on key clients over time. Contribution from the top 5 clients has declined meaningfully to about 32% of revenues (YTDFY07) from about 51% in FY04. This is comparable with the leaders. Since inception, MindTree has instituted a strong employee orientation with the result that its attrition (12% in FY06 and 15.6% in YTDFY07) is lower than its peers.

Strong financials

We believe that MindTree's progress to a USD 100 mn plus company in a little over six years since inception is indicative of its strong business momentum. Notably, such robust revenue growth has been accompanied by improving profitability (net profit margins of 15% and return on average equity of 51% in FY06). We believe that MindTree should, at a minimum grow at the industry rate going forward (conservative near-term growth rate of 30% over 2007-09E). Operating margins should sustain given: (a) leverage of SG&A with increasing size; (b) latitude to broaden the employee pyramid to include a greater proportion of entry-level and lesser-experienced professionals; and (c) ability to get price hikes of 3-5% from existing clients.

Risks and Concerns

R&D services could be volatile

Nasscom estimates the global market for outsourced R&D services (including product engineering) at USD 27 bn currently, which is projected to nearly double over the next four-five years. However, we note that the market for outsourced R&D, while significant, could be volatile given that the nature of this spend is relatively more cyclical than secular. Such a scenario could impact MindTree, though its broad-based industry exposure acts as a natural hedge.

MindTree's R&D offerings need size and scale

The average size of an engagement is relatively modest, within USD 100,000. While small-tomodest order sizes are typical in outsourced R&D, we believe that MindTree can offset this through more relationships with global technology majors (such as telecom equipment majors, communication service providers, and other technology-oriented industrial concerns). IT services segment needs more annuity-based revenue streams We believe that the next leg up for MindTree's IT services business is to develop predictable annuity-based revenue streams. The company will have to participate more in application outsourcing than it has done so far.

MindTree needs more significant clients to sell into

We believe that while MindTree has diversified its portfolio of offerings, the diversity of its larger clientele has not kept pace. It currently boasts of six-seven significant clients (as measured by how large the client is and not by the size of the engagement) such as LSI Logic, Symantec, Volvo, AIG, and Unilever. But very few of them are recent client wins.

Valuations

MindTree is well poised for growth in the buoyant demand environment. We expect the company to sustain its above industry growth rate over the next two-three years, though our estimates temper that expectation. Given the strong growth that the company is expected to register, quality management, superiority of its business model, and positive macro prospects, we expect MindTree to trade at a premium to mid-tier IT services companies.

We estimate the company to earn net profit of INR 866 mn in FY07E, translating into an EPS of INR 23.4 and for FY08E we estimate an EPS of INR 30.4. At the upper end of the price band (INR 425), the company's stock is valued at a P/E of 18.3x and 14.0x for FY07E and FY08E, respectively (refer to table 5). This seems very reasonably priced compared with the current valuations of several second-tier Indian IT firms. We thus recommend a 'Subscribe' with a long-term perspective.