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Mindtree DCF Valuation
Krishna Mahale
7/7/2016
Usage Guide & Disclaimer
• This presentation contains animations and
hence, it is best consumed in full-screen mode
• Note that this material is not a
recommendation for investing or divesting
securities and shouldn’t be interpreted as
such, nor should the same be considered
while making any investments or
divestments in any security
Mindtree – DCF Valuation
• Where to get the data?:
– http://www.mindtree.com/about-us/investors
• Mindtree reports consolidated financial results at
quarterly frequencies
• The key sections are organized as:
– Press releases
– Fact sheet reports
– Financial results
– Investor presentations
– Earnings conference call transcript (deferred update, till
such time the recordings are available on numbers
mentioned in the Event Calendar)
Mindtree – DCF Valuation
Mindtree – DCF Valuation
• Other IT companies maintain such disclosures in similar fashion as mandated by SEBI:
– TCS: http://www.tcs.com/investors/Pages/default.aspx
– Infosys: https://www.infosys.com/investors/
– Wipro: http://www.wipro.com/investors/
– HCL Tech: http://www.hcltech.com/investors/results-reports
– Mphasis: http://www.mphasis.com/financial-results.html
– Hexaware: http://hexaware.com/investors/
– KPIT Tech: http://www.kpit.com/company/investors/home
– Zensar Tech: http://www.zensar.com/investors
– NIIT Technologies: http://www.niit-tech.com/investors
– Cyient: http://www.cyient.com/investors
– Persistent Systems: http://investors.persistent.com
– 3i infotech: http://3i-infotech.com/3i-infotech/investors-2/
– E-clerx: http://www.eclerx.com/Pages/Corp_Investors.aspx
– Hinduja Global Solutions: https://www.teamhgs.com/contact-us/investor-relations
– Firstsource Solutions: http://www.firstsource.com/us/investors-overview
• Google: <company name> <investor relations>
• You may also get in touch with the investor relations personnel of respective companies to receive
periodic alerts for staying on top of potential developments in your investee company
Mindtree – DCF Valuation
• Basic steps in data cleansing:
– Always use LTM estimates. E.g.:
• If Mindtree recently declared results for quarter ending June 2016, aggregate all
numbers for last four quarters including the quarter ending June 2016
– Always project in 12 month time windows
• So the immediate projection in the above instance should correspond to year ending
June 2017
– This is done in-order to avoid the problem of seasonality
• However, there are some professions that thrive on preparing quarterly forecasts. Note:
its your money not theirs 
– Always prepare pro-forma estimates
• Mindtree acquired three companies during the course of FY2016. However, the full-
impact of the combined entity will not be seen in FY2016, since, there would be certain
non-zero periods in FY2016 where the acquired company results will not be consolidated
• Accordingly, FY2016 pro-forma estimated should make adjustments for such periods
• This also applies to operational data, but in most situations, there will not be enough
information for making adjustments to operational disclosures
• For companies that own real estate, a notional rent expense should be deducted at
market value
• Provisions for bad debt should be reversed while arriving at pro-forma estimates
– Never assume potential acquisitions while building projections or arriving at a
valuation estimate
Mindtree – DCF Valuation
• First we split revenues by the underlying economic driver
– Non-linear revenues: Mostly includes IPs, scales independently of costs
– Linear revenues: Services driven, costs tightly coupled with revenues
• Secondly, Mindtree is a export oriented company. Hence, to the extent possible
the financial entries should be segregated by underlying currency.
Mindtree – DCF Valuation
• Basis for 1 year forward revenue projections:
– IT companies, have very high annuity component in revenues. E.g:
Mindtree reported revenue contribution from repeat customers in the
96-99% range at annual lags
– So, 1yr forward revenues would have a stable relationship with current
1 yr forward order book
• Mostly, this datapoint is not available. In this particular case, we used a
surrogate measure that we could locate in the earnings transcript “Like I
explained in the early part of this call, our annual growth rates have been
ahead of 15% over the last three years and we believe we will look at some
similar sort of growth trajectory in FY’17 as well” – Rostow Rawanan (CEO)
– However, the same cannot be used for projecting beyond the 1 year
time window
– Note that guidance, such as the one provided above are generally
expressed in constant currency terms, especially when no other
accompanying assumptions are provided
Mindtree – DCF Valuation
• How to project farther into the future?
– Its generally difficult for mid-tier IT Services companies to
make a blockbuster entry into new clients
– Transformational outsourcing assignments are highly
structured and generally advised by established consulting
firms
– The vendor assessment frameworks are extremely mature,
where the vendor is objectively scored around various
factors, mid-tier companies are generally pitted against
large global companies with supremely mature capabilities
– Hence, it is reasonable to assume that mid-tier IT Services
companies can only hope to grow through client-mining
Mindtree – DCF Valuation
• Client mining model:
– Segregate clients by revenue tranche
– Assume probabilities of client jumping to a higher tranche
– Assume linear expansion for clients not making the jump
– Test assumed growth against above assumptions as shown below
5%
10%
Mindtree – DCF Valuation
• As next step we’d link costs to projected revenues. Key cost components are:
– Labor costs (66% of revenue)
– Travel & conveyance (5%)
– Rent (2%)
– Electricity (1%)
– Hiring costs (1%)
– Depreciation (3%)
– Income taxes (22-23% of PBT)
• Following is a skeletal diagram showing interlinks between these cost items
Headcount
Labor costs
Travel
RentElectricity
Depreciation
Hiring
Mindtree – DCF Valuation
• Labor cost model
Mindtree – DCF Valuation
• Employee costs are sticky and cannot be controlled at levels. We model the same
as follows:
– Calculate change in required headcount
– Add expected attrition numbers to arrive at gross headcount addition
– Subtract trainees coming out of training program for gross new lateral hires
• The same translates to costs as follows:
– Employee cost(t+1) = employee cost(t) – cost of attrited employees (t+1) + cost of new lateral
hires (t+1) + trainee cost (t+1)
• More assumptions:
– Attrited employees leave at average employee wage rates for the company with certain
adjustments
• What can be controlled?
– Trainee costs
– Costs of new later hires
• Further the above approach also allows for:
– Computation of average employee seniority
– Calculation of severance costs
– Provision for notice periods
– …through referencing of employee movements & underlying costs
Mindtree – DCF Valuation
• Following are certain high level assumptions:
– We have loaded travel costs into employee CTC as travel budgets are tightly controlled in-line with
employee CTC
Mindtree – DCF Valuation
• Other key assumptions
Parameter Unit Value
Computers ( 3 years) $/FTE 1,500
Furniture, other –onsite (5) 4,000
Furniture, other –onsite (5) Rs/FTE 200,000
Onsite real estate Sqft/FTE 25
Offshore real estate Sqft/FTE 141.5
Onsite real estate rate $/sqft pa 20
Offshore real estate rate Rs/sqft pa 422.1
Variable overheads % revenue 7%
Mindtree – DCF Valuation
• Final set of key assumptions
– The currency assumptions are in-line with results of IMF authored paper on exchange rate
expectation formation (https://www.imf.org/external/pubs/ft/wp/2011/wp11116.pdf)
– Currency inflation and region growth forecasts are obtained from IMF World Economic Outlook
– Folks can also refer to Consensus Economics' (http://www.consensuseconomics.com) long term
consensus estimates of expected exchange rate movements (this is a paid subscription)
– Tax rates have been progressively increased in-line with the long term marginal tax rates in India
Mindtree – DCF Valuation
• This is how our final output looks like:
Mindtree – DCF Valuation
• Now we have free cash flows, so the next step is
to compute WACC
• Since, Mindtree’s debt is negligible in comparison
to its fair equity value, WACC = cost of equity
• Cost of equity can be computed using CAP-M
– CAP-M is in-fact derived through minimizing portfolio
variance
– The final formula is
• E(rp) is the expected cost of equity
• rf is risk free return
• E(rm ) is the expected return of universal portfolio
Mindtree – DCF Valuation
• To estimate cost of equity we need to estimate the parameters in CAP-M
– Universal portfolio can be proxied with an index portfolio like Nifty50
– Risk free rate can be obtained as the yield on zero coupon 10 year GOI bonds minus the credit
default spreads for GOI
– GOI default spreads can be approximated using India sovereign rating issued by established
rating agencies
– So, β (0.2838) is in-fact the slope of Mindtree’s returns vs. Nifty50 returns as shown below
y = 0.2838x + 0.7236
R² = 0.003
-300.0
-200.0
-100.0
0.0
100.0
200.0
300.0
-20.0 -15.0 -10.0 -5.0 0.0 5.0 10.0 15.0 20.0
Mindtreereturns
Nifty returns
Mindtree vs. Nifty returns
Parameter Unit Value
Beta 0.2838
Risk free rate pa 6.5%
Expected difference in Nifty and
risk-free returns
pa 9.11%
Expected cost of equity pa 9.1%
Should we use this value of cost of equity?
Mindtree – DCF Valuation
• As an alternative, instead of using WACC, we can also compute the returns implied
by Mindtree’s CMP (i.e. the IRR)
– The IRR is the rate of return at which the present value of future cash flows equals Market EV
• How to arrive at Market EV:
– Market EV = Market cap + Dividends paid out after most recent results + debt – cash
– Market cap = Current market price X outstanding shares
– Debt and cash positions can be determined from recent balance sheets
– Note that debt and cash means all external liabilities & assets of non-operational nature including
MTM value of outstanding hedges
• A quick test is to find out if the items are dependent or independent of the size of business
• However, its best to expense out some liabilities that are unfunded
At discounting rate of 8% pa the present value of future cash flows
is Rs109,302 mn, so we can conclude that the IRR is approx. 8% pa
How do we interpret 8% pa IRR?
Mindtree - DCF Valuation
• In summary we followed the following process to estimate
Mindtree’s equity value
– Understood revenue split and assessed potential future growth rates
for Mindtree
– The revenues were linked to Mindtree’s costs using Mindtree’s
revenue model which is mostly headcount linked
– Next we made some assumptions regarding some key macroeconomic
variables
– Finally, we computed Mindtree’s WACC which was found to be
inadequate for further analysis given the scrip’s relative illiquidity
– As an alternative, we tried to figure out expected returns if we were to
invest in Mindtree’s equity at CMP
– As an alternative, we can also refer to Mindtree’s valuation w.r.t. a
comparable peerset to arrive at potential inferences regarding
Mindtree’s equity value
Thank You

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DCF valuation framework for IT services

  • 2. Usage Guide & Disclaimer • This presentation contains animations and hence, it is best consumed in full-screen mode • Note that this material is not a recommendation for investing or divesting securities and shouldn’t be interpreted as such, nor should the same be considered while making any investments or divestments in any security
  • 3. Mindtree – DCF Valuation • Where to get the data?: – http://www.mindtree.com/about-us/investors • Mindtree reports consolidated financial results at quarterly frequencies • The key sections are organized as: – Press releases – Fact sheet reports – Financial results – Investor presentations – Earnings conference call transcript (deferred update, till such time the recordings are available on numbers mentioned in the Event Calendar)
  • 4. Mindtree – DCF Valuation
  • 5. Mindtree – DCF Valuation • Other IT companies maintain such disclosures in similar fashion as mandated by SEBI: – TCS: http://www.tcs.com/investors/Pages/default.aspx – Infosys: https://www.infosys.com/investors/ – Wipro: http://www.wipro.com/investors/ – HCL Tech: http://www.hcltech.com/investors/results-reports – Mphasis: http://www.mphasis.com/financial-results.html – Hexaware: http://hexaware.com/investors/ – KPIT Tech: http://www.kpit.com/company/investors/home – Zensar Tech: http://www.zensar.com/investors – NIIT Technologies: http://www.niit-tech.com/investors – Cyient: http://www.cyient.com/investors – Persistent Systems: http://investors.persistent.com – 3i infotech: http://3i-infotech.com/3i-infotech/investors-2/ – E-clerx: http://www.eclerx.com/Pages/Corp_Investors.aspx – Hinduja Global Solutions: https://www.teamhgs.com/contact-us/investor-relations – Firstsource Solutions: http://www.firstsource.com/us/investors-overview • Google: <company name> <investor relations> • You may also get in touch with the investor relations personnel of respective companies to receive periodic alerts for staying on top of potential developments in your investee company
  • 6. Mindtree – DCF Valuation • Basic steps in data cleansing: – Always use LTM estimates. E.g.: • If Mindtree recently declared results for quarter ending June 2016, aggregate all numbers for last four quarters including the quarter ending June 2016 – Always project in 12 month time windows • So the immediate projection in the above instance should correspond to year ending June 2017 – This is done in-order to avoid the problem of seasonality • However, there are some professions that thrive on preparing quarterly forecasts. Note: its your money not theirs  – Always prepare pro-forma estimates • Mindtree acquired three companies during the course of FY2016. However, the full- impact of the combined entity will not be seen in FY2016, since, there would be certain non-zero periods in FY2016 where the acquired company results will not be consolidated • Accordingly, FY2016 pro-forma estimated should make adjustments for such periods • This also applies to operational data, but in most situations, there will not be enough information for making adjustments to operational disclosures • For companies that own real estate, a notional rent expense should be deducted at market value • Provisions for bad debt should be reversed while arriving at pro-forma estimates – Never assume potential acquisitions while building projections or arriving at a valuation estimate
  • 7. Mindtree – DCF Valuation • First we split revenues by the underlying economic driver – Non-linear revenues: Mostly includes IPs, scales independently of costs – Linear revenues: Services driven, costs tightly coupled with revenues • Secondly, Mindtree is a export oriented company. Hence, to the extent possible the financial entries should be segregated by underlying currency.
  • 8. Mindtree – DCF Valuation • Basis for 1 year forward revenue projections: – IT companies, have very high annuity component in revenues. E.g: Mindtree reported revenue contribution from repeat customers in the 96-99% range at annual lags – So, 1yr forward revenues would have a stable relationship with current 1 yr forward order book • Mostly, this datapoint is not available. In this particular case, we used a surrogate measure that we could locate in the earnings transcript “Like I explained in the early part of this call, our annual growth rates have been ahead of 15% over the last three years and we believe we will look at some similar sort of growth trajectory in FY’17 as well” – Rostow Rawanan (CEO) – However, the same cannot be used for projecting beyond the 1 year time window – Note that guidance, such as the one provided above are generally expressed in constant currency terms, especially when no other accompanying assumptions are provided
  • 9. Mindtree – DCF Valuation • How to project farther into the future? – Its generally difficult for mid-tier IT Services companies to make a blockbuster entry into new clients – Transformational outsourcing assignments are highly structured and generally advised by established consulting firms – The vendor assessment frameworks are extremely mature, where the vendor is objectively scored around various factors, mid-tier companies are generally pitted against large global companies with supremely mature capabilities – Hence, it is reasonable to assume that mid-tier IT Services companies can only hope to grow through client-mining
  • 10. Mindtree – DCF Valuation • Client mining model: – Segregate clients by revenue tranche – Assume probabilities of client jumping to a higher tranche – Assume linear expansion for clients not making the jump – Test assumed growth against above assumptions as shown below 5% 10%
  • 11. Mindtree – DCF Valuation • As next step we’d link costs to projected revenues. Key cost components are: – Labor costs (66% of revenue) – Travel & conveyance (5%) – Rent (2%) – Electricity (1%) – Hiring costs (1%) – Depreciation (3%) – Income taxes (22-23% of PBT) • Following is a skeletal diagram showing interlinks between these cost items Headcount Labor costs Travel RentElectricity Depreciation Hiring
  • 12. Mindtree – DCF Valuation • Labor cost model
  • 13. Mindtree – DCF Valuation • Employee costs are sticky and cannot be controlled at levels. We model the same as follows: – Calculate change in required headcount – Add expected attrition numbers to arrive at gross headcount addition – Subtract trainees coming out of training program for gross new lateral hires • The same translates to costs as follows: – Employee cost(t+1) = employee cost(t) – cost of attrited employees (t+1) + cost of new lateral hires (t+1) + trainee cost (t+1) • More assumptions: – Attrited employees leave at average employee wage rates for the company with certain adjustments • What can be controlled? – Trainee costs – Costs of new later hires • Further the above approach also allows for: – Computation of average employee seniority – Calculation of severance costs – Provision for notice periods – …through referencing of employee movements & underlying costs
  • 14. Mindtree – DCF Valuation • Following are certain high level assumptions: – We have loaded travel costs into employee CTC as travel budgets are tightly controlled in-line with employee CTC
  • 15. Mindtree – DCF Valuation • Other key assumptions Parameter Unit Value Computers ( 3 years) $/FTE 1,500 Furniture, other –onsite (5) 4,000 Furniture, other –onsite (5) Rs/FTE 200,000 Onsite real estate Sqft/FTE 25 Offshore real estate Sqft/FTE 141.5 Onsite real estate rate $/sqft pa 20 Offshore real estate rate Rs/sqft pa 422.1 Variable overheads % revenue 7%
  • 16. Mindtree – DCF Valuation • Final set of key assumptions – The currency assumptions are in-line with results of IMF authored paper on exchange rate expectation formation (https://www.imf.org/external/pubs/ft/wp/2011/wp11116.pdf) – Currency inflation and region growth forecasts are obtained from IMF World Economic Outlook – Folks can also refer to Consensus Economics' (http://www.consensuseconomics.com) long term consensus estimates of expected exchange rate movements (this is a paid subscription) – Tax rates have been progressively increased in-line with the long term marginal tax rates in India
  • 17. Mindtree – DCF Valuation • This is how our final output looks like:
  • 18. Mindtree – DCF Valuation • Now we have free cash flows, so the next step is to compute WACC • Since, Mindtree’s debt is negligible in comparison to its fair equity value, WACC = cost of equity • Cost of equity can be computed using CAP-M – CAP-M is in-fact derived through minimizing portfolio variance – The final formula is • E(rp) is the expected cost of equity • rf is risk free return • E(rm ) is the expected return of universal portfolio
  • 19. Mindtree – DCF Valuation • To estimate cost of equity we need to estimate the parameters in CAP-M – Universal portfolio can be proxied with an index portfolio like Nifty50 – Risk free rate can be obtained as the yield on zero coupon 10 year GOI bonds minus the credit default spreads for GOI – GOI default spreads can be approximated using India sovereign rating issued by established rating agencies – So, β (0.2838) is in-fact the slope of Mindtree’s returns vs. Nifty50 returns as shown below y = 0.2838x + 0.7236 R² = 0.003 -300.0 -200.0 -100.0 0.0 100.0 200.0 300.0 -20.0 -15.0 -10.0 -5.0 0.0 5.0 10.0 15.0 20.0 Mindtreereturns Nifty returns Mindtree vs. Nifty returns Parameter Unit Value Beta 0.2838 Risk free rate pa 6.5% Expected difference in Nifty and risk-free returns pa 9.11% Expected cost of equity pa 9.1% Should we use this value of cost of equity?
  • 20. Mindtree – DCF Valuation • As an alternative, instead of using WACC, we can also compute the returns implied by Mindtree’s CMP (i.e. the IRR) – The IRR is the rate of return at which the present value of future cash flows equals Market EV • How to arrive at Market EV: – Market EV = Market cap + Dividends paid out after most recent results + debt – cash – Market cap = Current market price X outstanding shares – Debt and cash positions can be determined from recent balance sheets – Note that debt and cash means all external liabilities & assets of non-operational nature including MTM value of outstanding hedges • A quick test is to find out if the items are dependent or independent of the size of business • However, its best to expense out some liabilities that are unfunded At discounting rate of 8% pa the present value of future cash flows is Rs109,302 mn, so we can conclude that the IRR is approx. 8% pa How do we interpret 8% pa IRR?
  • 21. Mindtree - DCF Valuation • In summary we followed the following process to estimate Mindtree’s equity value – Understood revenue split and assessed potential future growth rates for Mindtree – The revenues were linked to Mindtree’s costs using Mindtree’s revenue model which is mostly headcount linked – Next we made some assumptions regarding some key macroeconomic variables – Finally, we computed Mindtree’s WACC which was found to be inadequate for further analysis given the scrip’s relative illiquidity – As an alternative, we tried to figure out expected returns if we were to invest in Mindtree’s equity at CMP – As an alternative, we can also refer to Mindtree’s valuation w.r.t. a comparable peerset to arrive at potential inferences regarding Mindtree’s equity value