What LTI-Mindtree merger means for two IT firms, their existing investors

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The LTI-Mindtree merged entity offers strong long-term prospects and analysts feel it could enjoy a premium to larger peers Infosys and TCS. But near-term risks are high, they said, especially with Sanjay Jalona leaving Larsen & Toubro Infotech (LTI). Integration in this high-attrition environment can bring key challenges, analysts said.

While finding the prevailing valuations rich, they are either neutral or negative on the two stocks, fearing short term volatility ahead.

The swap ratio of 73 LTI shares for every 100 Mindtree shares is neutral to both companies at the current share price. This, analysts said, will result in the issuance of 12 crore new LTI shares to Mindtree’s shareholders and a 41 per cent dilution for LTI’s shareholders.

Motilal Oswal has retained a ‘neutral’ rating on both stocks as it sees near-term risks offsetting the long-term opportunity accruing from the larger entity.

“We view the departure of CEO & MD Jalona as a key concern for LTI as he has been the key architect of its growth over the last seven years since he joined as CEO. Given his long tenure, he has built a leadership team and has a reputation of close coordination. While Debashis Chatterjee has done exceptionally well in retaining and rebuilding Mindtree after its founding team exited the company, we will watch out for any exits at LTI, which can have a bearing in the near term,” it said.

Chatterjee is the MD & CEO of Mindtree.

Edelweiss also sees risks of senior level and high-performer attrition in a tight supply market. It sees client attrition in short cycle deals, with possibility of increased competition.

“While the companies have been operating under L&T’s parentage, cultural alignment will be work in progress (Mindtree scores slightly higher on some of the supply side metrics). While LTI’s CEO exit may be construed as a risk, let’s not miss an equally high CEO approval score as well as a track record of MTCL’s turnaround (both operational and growth). While the near-term noise may create volatility, the foundation for ‘tier- 1’ IT growth leadership has been set,” it said.

In a note, Girish Pai, Head of Equity Research at Nirmal Bang Institutional Equities, said if current execution of both companies holds up, it could outpace Tier-1 set growth over the next 10 years.

“Also, with both revenue and cost synergies, we believe there is potential for net margin gap between LTIM and TCS/Infosys (currently at 300-500 bps) to narrow, leading to faster than peer set earnings growth. Further, along with higher margins, if it can maintain its current high RoIC post-merger (ex-goodwill), we believe the market will accord a PE premium to even TCS/Infosys in this period. That is more a longer term story,” Pai said.

But in the next 6-12 months, Pai said he would remain underweight on the IT sector and believe that both the companies, which are trading at rich multiples, will see downside.

The merger move is seen as giving the combined business an opportunity to consolidate position in the banking, financial services and insurance (BFSI) vertical, enhance scale in high growth verticals like high-tech and consumer packaged goods, retail, and expand into new verticals such as travel, transport and hospitality.

“While the merged entity will be a force to reckon with in the longer term, we believe at current valuation, a purchase may give sub-optimal long-term returns. Advise better entry points. We do not have official coverage on LTI currently but have a ‘Sell’ rating on Mindtree with a target of Rs 3,120,” Pai said.

Emkay Global said it has put its target prices for LTI and Mindtree as well as its ratings on the two stocks under ueview, as it assess the short/long-term impact of the proposed merger on earnings (revenue growth and margin profile of the combined entity) and leadership transition. This brokerage had an earlier hold rating on both Mindtree (Rs 4,400) and LTI (Rs 6,350).

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