Subscribe to MindTree IPO: Angel Broking

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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 Angel Broking report on MindTree Consulting IPO:

Company Background

MindTree Consulting is a mid-sized IT services company that operates in 2 major businesses - IT Services and Research and Development (R&D) Services. The company derived 76.5% of its total revenues from IT Services in FY2006, while the balance 23.5% was accounted for by R&D Services. The corresponding figures for 9MFY2007 were 75.8% and 24.2%. The company offers services such as consulting, application development and maintenance (ADM), package implementation, data warehousing and business intelligence to its clients.

Investment Rationale

Quality management team with a strong track record

In the software industry, management quality is a key factor to judge the ability of any software company to maintain a strong pace of growth in future. MindTree Consulting is led by an experienced and visionary management team, spearheaded by its chairman and managing director, CMD, Ashok Soota. Most of the key management personnel have worked formerly with Wipro, one of India's most respected conglomerates and third-largest software service company. Soota, in fact, was the Vice Chairman at Wipro before co-founding MindTree. He was instrumental in building the base for a strong global IT Services business, increasing company revenues from USD 2mn to USD 500mn when he left to start MindTree.

The Global IT Services business of Wipro clocked revenues of USD 1.8bn in FY2006 and is expected to hit USD 2.5bn in FY2007. The seeds for this strong performance were undoubtedly sown partly by Soota. The other members of the top management team have also worked with Wipro in key capacities before founding the company and this lends confidence in the ability of the management team to chart a strong growth path in future for MindTree as well.

Strong capabilities in the high potential R&D space, IP-led business model

MindTree derived 24.2% of its revenues from the R&D space in 9MFY2007 and is the fifth-largest R&D Services provider in India. The company offers a vast range of services, including product architecture, product design, re-engineering, validation and technical support. It is present mainly in the communications space, particularly in the short-range segment (Bluetooth). The company licences and customizes the IP for its clients.

It should be noted that global telecom equipment manufacturers (TEMs) generally spend anywhere between 10% and 15% of their revenues on R&D. As per Ovum Research, TEM revenues are expected to hit USD 347bn by 2009 from USD 308bn in 2005. Thus, even assuming the lower end of the range (10%), the total R&D spend stands at a potential USD 34.7bn. Thus, there is a significant market to tap for MindTree.

As regards the IPs that the company owns, these include Bluetooth, where it licenses all silicon and software components except radio that are required to build a Bluetooth wireless technology product. MindTree earns revenues from licensing the IP as well as from the integration of the silicon and software IP in its customers' products. An example of royalty-based revenues earned by MindTree is the income earned from the sale of each GSM-based cell phone of the Japanese networking, technology and telecom major, NEC Corporation.

The company is currently working on developing the Ultra Wide Band (UWB) technology, which is similar to Bluetooth but having a higher speed. All these initiatives will ensure that in future, MindTree will have some proportion of its revenues coming from 'non-linear growth' (an increase in revenues without a proportionate increase in employees), rather than just revenue growth based on an increase in the employee headcount (linear growth), which is the model that most software companies currently work on.

Strong client relationships and client mining initiatives

MindTree has managed to effectively mine its clients over the past few years, through the expansion of its service offerings and cross-selling of its major services. Such a strategy must be effectively executed in order to get a greater share of the client's wallet. The number of clients giving the company annualised revenues in excess of USD 1mn has steadily increased over the past few years, from just 7 in FY2004 to 30 at the end of 9MFY2007.

A total of 4 clients gave MindTree annualised revenues in excess of US$ 5mn, of which 2 gave it annualised revenues in excess of USD 10mn. These figures clearly indicate that the company has been able to successfully expand its service offerings in order to be an able strategic partner to its clients. The total number of clients increased from 28 in FY2002 to 153 at the end of 9MFY2007. Marquee names such as AIG, Volvo, Symantec, United Technologies, Avis and Unilever adorn MindTree's client roster.

Below-industry attrition rates

MindTree, despite being a mid-sized software company, has managed to maintain its attrition rates at manageable levels. In FY2005, these stood at 13.6%, while in FY2006, they actually fell to 12.0%. Although these have increased to nearly 16% in FY2007 to date, it should be noted that this is still below the industry average of around 17% to 18%. This is undoubtedly a good sign, given the fact that retaining good talent is such an imperative in a people-intensive industry such as software and suggests that the company has been able to provide its employees with a clear career path and has been able to build a brand name for itself as a good place to work.

Scope for further margin expansion

MindTree managed to break-even at the EBITDA and net profit level in FY2004. Due to the fact that it is a relatively young company in the Indian IT space, having commenced operations in FY2000, losses were incurred in the initial years due to start-up costs that are there in any business. However, from FY2004, when the company broke-even, the EBITDA as well as net
profit margins have consistently expanded. This has been partly due to scale benefits, an increasing offshore proportion of revenues and leverage on selling, general and administrative (SG&A) expenses. These expenses have fallen steadily over the past few years, from 33.8% of sales in FY2004 to 22.2% in 9MFY2007. Going forward, the company expects these expenses to be more or less in this range.

However, it should be noted that the average work experience of employees at MindTree is around 4.7 years. This is considerably higher than that of the top-tier software companies, which maintain this at around 2.5 to 3 years. As a result, going forward, there is some scope for the company to reduce this and move further down the employee pyramid. This will have the beneficial impact of reducing the average cost per employee and consequently, a benign impact on the margins.

Investment Concerns

Client concentration

MindTree has a high degree of client concentration, as can be seen in the revenue contribution of the largest clients of the company. The company's 'Top-5' clients contributed to 50.6% of the company's revenues in FY2004, 40.1% in FY2005, 38.4% in FY2006 and 32.2% in 9MFY2007.

Although this has been reducing over the past few years, it is still considerably higher than those of the top-tier software companies. Infosys, for example, derives 18.9% of its revenues from its 'Top-5' clients, while the figure for Wipro is even better, at 15.1%. The top client contributed 14.3% of MindTree's revenues in FY2006. Thus, if for whatever reason, these major clients' IT spends get adversely impacted, then the company could get negatively impacted.

Risk of volatility in the R&D space

MindTree derived 23.5% of its total revenues from R&D Services in FY2006. This segment, while having significant growth potential, is subject to volatility. We saw an example of this towards the turn of the century, when, dogged by massive over-investments in capacities and the bursting of the telecom and technology bubble post the hype, the global telecommunications
industry witnessed a bust period. This impacted even reputed companies like Wipro. Thus, the impact of such a slowdown would likely be more severe on a mid-sized company like MindTree.

Political risks

Offshore outsourcing has been the subject of much heated political debate in the US and the UK. Elements in those countries have often targeted offshoring, since it leads to a loss of jobs in their countries. Thus, there is always the risk of political pressure that might, temporarily at least, impact the growth of offshoring. While we believe that, over the long-term, sound economics will win over politics, the risk does exist in the short-to-medium term.

Outlook and Valuations

Going forward, there is no doubt that the Indian IT Services industry is poised for strong growth. Offshoring as a concept is yet in the growth phase and Indian software companies with quality management teams, scale, domain expertise, a broad array of services and strong execution skills will be the major beneficiaries of this growth story. We believe that MindTree, with its strong management team, ever-increasing breadth of offerings, strong relationships with marquee clients, IP-led R&D Services business strategy and improving client metrics will be able to hold its own as a mid-sized Indian software company against the top-tier majors.

At the higher end of the price band of Rs 425, the MindTree issue comes at a P/E of 18.1x annualised 9MFY2007 earnings on the expanded equity capital. We believe that these valuations are reasonable for the strong growth that the company is witnessing and thus, recommend investors to 'subscribe' to the issue.