It's been a while since my last post. Hopefully, I will be more prompt in the future. I decided to pick an IT company for valuation and zeroed in on Mindtree (A random pick. No hidden intellectual curiosity here). I know very little about the company which will reduce if not eliminate my biases in the valuation.
Setting
up the Narrative
To
be honest, I am no expert on the IT industry. To get a better understanding of
the industry, I referred to various sources on the internet. I made the
following observations:
1. High Competition - The industry is characterized by high competition as
most of the big IT firms are global players. There are no significant barriers
to entry as well. Moreover, The IT companies already command a 55% market share
in the global outsourcing business according to NASSCOM.
Going forward, It will be difficult for the industry as a whole to grab more
chunk of the outsourcing business.
2. Diminishing Competitive Advantages- High competition will lead to lower pricing power and put pressure on the margins. Although the average industry operating margins are between 20-25%, I believe that these will begin to decline as labor arbitrage which is a leading competitive advantage of Indian IT industry gradually starts to dry out.
3.Country
Risk Exposure- Most Indian IT companies earn a significant portion of
their revenues outside India. Thus, they are essentially global corporations
which are incorporated in India but have more exposure to country risk of
geographies from which they derive their revenues. In the case of Mindtree, 87%
of its revenues come from US and Europe.
Incorporating
these observations and comparing Mindtree with the competition, My narrative
for Mindtree is as follows:
Mindtree
is an efficient IT company incorporated in India which primarily derives its
revenues from US and Europe. The growth of the company will be constrained due
to high competition and diminishing pricing power of the industry in which it
operates.
The Number Crunching ( Valuation Model link)
1.
Estimating Free Cash Flow to Firm
When
I started this valuation, Mindtree had just released their Q2 earnings (I got
lucky. Mindtree has a 100% stake in all its subsidiaries. So I took the
consolidated numbers without any trouble) . Thus, I updated my annual revenue,
depreciation and operating income numbers to Trailing Twelve month numbers. I
also had to convert operating leases to debt as these are essentially
contractual commitments. Thus, my after tax operating income after
operating lease adjustment is Rs. 7,533.74 Million. Subtracting out the Capex
of Rs 3,501 Million and Working Capital of Rs 941 Million, I arrive at FCFF of
Rs 2,284 Million.
The Capex figure also includes an average price for acquisitions
paid by the company. Since acquisitions are an expenditure today to derive
benefits in the future, I treat them as Capex and take a normalized number as
Mindtree does acquisitions intermittently. ( I couldn't take information for
all the acquisitions they have done as the price was not disclosed in some
transactions)
Growth
Rate in Operating Income and Growth Period
I
computed the fundamental growth rate in operating income i.e. a function of how
much and how efficiently Mindtree reinvests. With a reinvestment rate of 60%
and non-cash ROCE of 31%, the growth rate in operating income is 18.6%.
I
use a three stage FCFF model for the company. The high growth period is for 5
years. Although I believe that the competitive advatanges of IT industry in
India are fading, I expect them to do so gradually and not overnight.
2.
Estimating Cost of Capital
Cost
of Debt
Cost of Debt- Risk free
rate+Company default spread+Country default spread
= 5.44%+ 0.70%+ 2.20% = 8.34%
After Tax Cost of Debt = 8.34%*(1-33.99%)
= 5.51%
The
risk free rate is arrived at after subtracting out the default spread of 2.20%
from the 10 year G sec. Mindtree has a rating of AA, which further entails a
spread of 0.70%. Adding on the country default spread of 2.20% (corresponding
spread for Baa3 rating, which is the current rating for India), the cost of
debt is 8.34% .
Cost
of Equity
Cost of Equity- Risk free rate+
beta* ( Equity risk premium )
ERP = implied mature market
premium + country risk premium
= 5.44%+0.92* ( 6.19%+ 1.40% ) = 12.42%
I derive the cost of equity using CAPM. I use Aswath
Damodaran's global average unlevered beta for computer services firms and
adjust it for financial leverage to come up with a beta for 0.92 (Since the D/E
is just 1%, the unlevered and levered beta remain the same). The implied equity
risk premium for the US is 6.19%. For the country risk premium, I used a
location based CRP. Since Mindtree's revenues come from geographies across the
globe, I take a weighted average of CRP's across geographies wherein my weights
are the TTM revenues that the company obtains from each location.
Debt
and Equity Weights
The
debt and equity weights are 1% and 99%. The 1% debt weight is a result of
converting operating leases to debt even though it has alomost no debt on the
balance sheet.
Thus,
my cost of capital for the high growth phase is 12.37%.
Stable growth assumptions
I assume that the firm will enter into stable growth in Year 10. My assumptions for stable growth period are as follows:
1.
Growth Rate: I assume that the growth rate for the firm in
perpetuity will be equal to the risk free rate of 5.44%.
2.
Cost of Capital: The beta for the stock is 0.92. The debt
and equity weights will converge to industry average weights of 16.07% and
83.93%. Therefore, my cost of capital in perpetuity is 11.31%.
3.
Return on Capital: I have assumed a ROCE of 16.31%. I
expect Mindtree to generate an excess return in perpetuity as the business in
which they operate has an average spread of 15% between return of capital and
cost of capital globally. Since I believe they will not be a major player in
the market, I give them an excess return of only 5%. I am also assuming that
the dwindling competitive advantage of labor arbitrage in India will also get
offset by cost advantages in other geographies (Philippines and Poland are fast
becoming favorable outsourcing destinations). However, I am pretty unsure about
this number and do try to bring in that uncertainty in the Monte Carlo
simulation .
Estimating
Value of Firm and Equity
Discounting
the free cash flows for the next 10 years gives a firm value of Rs 1,07,194
Million. Subtracting out the debt of Rs 806 Million and adding on the cash and
liquid investments of Rs 4,834 Million gives the free cash flow to equity
holders of Rs 1,11,222 Million. Dividing by number of shares outstanding of
83.83 Million, the value per share is Rs 1326.76.
Factoring
in the uncertainty
1.
Market Implied Variables: Using Goal Seek, I set my value
equal to the market price and backed out two key drivers of my valuation
i.e. fundamental growth rate in the high growth phase and the ROCE in
perpetuity. The market implied fundamental growth rate is 20.90% and ROCE in
perpetuity is 24.22%. Although I believe that growth rate of 20.90% is
plausible, I believe that implied ROCE is too high in perpetuity as growing
competition will bring that number down.
2. Monte Carlo Simulation: To factor in changes
in my assumptions, I did a Monte Carlo simulation wherein I gave a uniform
distribution to the growth rate in high growth phase and a triangular
distribution to ROCE in perpetuity. After 1,000,000 trials, the median value
per share is Rs. 1350.53.
Bottom
line
Given
my narrative and numbers, Mindtree is overvalued. I
will be looking forward to the next earnings report for revaluing Mindtree
again and to check for any changes in my narrative.
