Polaris Software: Margin improvement impressive but sustainability a concern:: Kotak Sec,

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Margin improvement impressive but sustainability a concern. Polaris reported
revenues of US$83.6 mn (+6% qoq), in line with our estimates, but surprised positively
on margins. EBITDA margins improved 220 bps sequentially versus our expectation of
flat margins. We retain our negative stance on the stock given our concerns on
weak positioning and margin sustenance due to (1) rupee appreciation headwinds,
(2) increasing supply side cost pressures. Maintain SELL and target price of Rs180/share.


Modest revenue growth – given the demand unconstrained environment
Polaris reported revenues of US$83.6 mn (+6% qoq, +19.5% yoy), in line with our expectations.
A 6% US$ revenue growth when the industry is operating in a demand unconstrained
environment is just about par for the course, in our view. We expect the Tier-II pack including
Polaris to lag the Tier-I companies on revenue growth in the current growth phase for the Indian IT
industry. Cut back in investments and running on a very thin bench during the downturn may
have robbed companies like Polaris to participate in the strong growth phase. Under-investments
during the downturn and not being ready for the growth phase is evident from the management
commentary that they were unable to fulfill demand for the past two quarters.
Strong margin performance – but sustainability is the question
A sharp 220 bps improvement in margins versus our expectation of flat margins drove
outperformance at EBITDA and net income level. Company reported an EBITDA of Rs606 mn
(+26% qoq) and net income of Rs484 mn (+3.5% qoq). Although a 220 bps improvement in
margins is commendable, sustainability of the same is a question. The industry is operating in a
supply constrained environment and cost pressures on the employee front are bound to have an
impact on margins. The company recruited more than 900 people in 2QFY11, mostly during the
end of the quarter which would keep the margins under pressure in the next quarter. Appreciating
Re is another major concern – rupee has appreciated 4.6% in 3QFY11 till date vs 2QFY11.
Mid-sized companies including Polaris have a greater sensitivity to the movement of Re/US$.
Weak positioning and margin sustainability concerns drive our negative view
We increase our EPS estimates for FY2011E/FY2012E to Rs19.4 and Rs19.8 from Rs19.1 and
Rs18.8 earlier. Increase in estimates is driven by increase in OPM assumptions for FY2011E/
FY2012E by 60 and 20 bps given the better-than-expected performance. Despite building in 20%
revenue growth in FY2012E, the EPS broadly remains same due to
(1) increase in tax rates,
(2) pressure on margins due to rupee and
(3) supply side constraints.

Weak positioning in multivendor
situations and questions on margin sustainability drives our negative view on Polaris. Retain
SELL rating with a target price of Rs180/share.