Revenue synergies to be the key focus in merger of L-;T Infotech, Mindtree: IIFL Capital Services

15 Nov 2022 , 10:17 AM

Both companies have complementary capabilities, verticals and client exposures, which according to analysts at IIFL Capital Services will open up multiple upsell and cross-sell opportunities. The transaction will be done through issuance of LTI shares to MTCL shareholders in the ratio of 73:100. L&T will hold 68.73% of LTI after the merger. In a merger of this proportion, managing leadership transition is the biggest risk. Among major leadership announcements, Debashis Chatterjee has been appointed as the CEO of the merged entity; Sudhir Chaturvedi and Venugopal Lambu as Co-Head of Sales and Marketing; Nachiket Deshpande as COO and Vinit Teredesai as CFO. Based on IIFL Capital Services’ pro-forma earnings for the merged-co, without factoring in synergies or leakages, the merged-co stock would be trading at FY24 estimated P/E of 26.4x, versus FY22-24 estimated EPS CAGR of 21%.

Entering into Top-5 Indian IT Service companies by market capitalization

The combined entity would have a total revenue base of ~USD3.9 billion (LTM), reducing the gap with Top-5 Indian IT Service companies. This would potentially improve their prospects to bid for and win much larger deals. In the past three years, both companies have won very few USD100 million deals. However, signs of scale benefits had already started showing with the companies recently winning a large deal jointly by combining their capabilities. The market capitalization of the merged-co, at current price, would be bigger than that of Tech Mahindra, given the higher profitability.

Complementary offerings to enable cross-selling/upselling

There is limited overlap between LTI and MTCL by vertical — LTI specializes in sectors like Banking, Insurance, Oil & Gas and Manufacturing, while MTCL offers more services to sectors like Technology, Retail and Travel. Hence, the combined entity will have a diversified vertical exposure, similar to that of large-cap IT Service companies, with BFSI (~35% of LTM revenues) being the largest vertical, followed by Retail and Technology (each at ~24%). Further, capability wise, MTCL is stronger in front-end customer experience and transformation, though LTI has muscle in core modernization, including Cloud and Analytics. The merger will also result in significant reduction in client concentration risks emanating from their top clients, each contributing <15% of the merged-co revenues.

LTI and MTCL operate at similar margins

While at the time of MTCL’s acquisition, gap in the respective operating margin profile was close to 600 basis points, it has completely converged to around 18-19% for both companies (for FY23, as per IIFL Capital Services’ estimates). Most of the inefficiencies in the cost structures have been potentially removed, and segment-level profitability is now in the top quartile among peers. Analysts at IIFL Capital Services believe this augurs well for potential cost realignments. While integration costs will go up, potential synergies from Facilities, Travel etc., could offset this.

Employee attrition remains key

In any merger of this proportion, managing leadership transition and culture are the single- biggest integration risk to the entire process. Since the merger announcement, there have been a handful of resignations at both the companies, including Sanjay Jalona (CEO, LTI). Any further potential attrition at the management level would be a key risk to this merger process. Separately, with both Sudhir Chaturvedi and Venugopal Lambu being appointed President of Marketing, analysts at IIFL Capital Services would closely watch out for the pace of decision-making in closing businesses, given the co-head structure in sales and marketing, even if based in different regions.

Limited room for slippages in integration, given premium valuations

Management has shied away from quantifying potential revenue or cost synergies until now. However, they continue to focus on revenue synergies from cross-selling and upselling opportunities. They remain confident that cultures in both the companies are largely aligned now, and attrition may not be a major risk. IIFL Capital Services’ pro-forma earnings model for LTI-MTCL merged-co, without factoring in either synergies or leakages, implies 16%/21% USD revenue/EPS CAGR over FY22-24.

With the post-merger share count of ~296 million, the merged-co would be trading at 26.4X on FY24 estimated P/E, based on current market prices of LTI and MTCL – a ~10% premium to average mid-cap peers, leaving limited room for any slippages in the merger integration process.