3i Infotech – 2QFY2011 Result Update- Angel Broking

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3i Infotech – 2QFY2011 Result Update

Angel Broking maintains a Buy on 3i Infotech with a Target Price of Rs78.

For 2QFY2011, 3i Infotech reported dismal set of numbers with meager

1.0% qoq top-line growth. Due to improvement in operating margin, net profit

grew by 4.6% qoq in 2QFY2011 to `64cr as against `61.2cr in 1QFY2011.

Muted revenue growth due to ramp down in transaction services: For 2QFY2011,

3i Infotech posted mere 1.0% qoq top-line growth to `643.4cr (v/s our estimate of

`666.3cr), primarily on the back of steep ramp down in volumes in the

transaction services segment (largely in the US), which declined by 10.9% qoq.

Growth was, however, led by the IT solutions segment, which posted 8.4% qoq

revenue growth to `426.4cr.

Margin up 92bp: EBITDA margin grew by 92bp qoq to 20.4% mainly due to

improved business mix, with the higher-margin IT solutions segment (IT products

and IT services) posting a 200bp qoq increase in gross margin to 66.2%.

Outlook and valuation: Management has revised down its guidance for FY2011

from 10–14% yoy revenue growth to 5% due to unanticipated drop in cheque

processing volumes. At the CMP of `66, the stock is trading at attractive

valuations in the mid-cap space at 4.8x only due to overhang related to high

current debt-to-equity of 1.8x. Overall, we expect this to come down to 1.48x in

FY2012 on the back of sizeable quarterly operating profits of ~`130cr and

maintenance capex need of `15cr–16cr only, even after factoring in all the earnouts,

debt and repayment of various tranche of FCCB. We expect revenue growth

to remain subdued at 4% yoy in FY2011 and pick up only in FY2012 with 9% yoy

growth. Thus, we value 3i Infotech at 75% discount to Infosys’ FY2012 target P/E

of 23x, i.e. 5.8x. We maintain Buy on the stock with a revised Target Price of `78.

Muted revenue growth

For 2QFY2011, 3i Infotech posted disappointing performance. The top line grew

by merely 1.0% qoq, led by 8.4% qoq revenue growth (decline of 1.2% yoy) in the

IT solutions segment (the erstwhile products segment and the IT services segment

are clubbed under the IT solutions business segment from 1QFY2011). Growth in

the IT solutions segment was overshadowed by a 10.9% qoq decline in the

transaction services segment (majorly in the US), which is witnessing significant

ramp down since the latter part of 1QFY2011. The decline in the transaction

services segment was, however, compensated by growth in emerging markets,

which now contribute nearly 43% to revenue. The company did not witness any

ramp downs in the standalone IT products segment (part of the IT solutions

segment) during 2QFY2011.

The IT solutions segment is currently witnessing good traction. During 2QFY2011,

the segment reported 8.4% qoq growth in revenue to `426.4cr as against

`393.5cr in 1QFY2011 and it now contributes 66% (62% in 1QFY2011) to the

company’s overall revenue. Further, the company has signed few major deals in

this segment with Indian clients, including a healthcare agency for providing endto-

end IT infrastructure solutions and a leading scientific research organisation for

providing storage and datacenter solutions.

The transaction services segment is currently witnessing a huge decline in volumes.

During the quarter, the segment posted a 10.9% qoq decline in revenue to `217cr

as against `243.5cr in 1QFY2011, mainly due to volume loss (rather than client

loss) witnessed in the US. The segment now contributes 34% to the company’s

overall revenue as against 38% in 1QFY2011.

During the quarter, the revenue break-up in terms of geographies shifted slightly

towards emerging markets, contributing 43% to revenue as against 37% in

1QFY2011, due to significant ramp down in the US-based transaction services

segment. However, the company has signed a three-year deal with an electricity

and gas company of North America for offering remittance processing services.

Margin performance

During the quarter, 3i Infotech’s gross as well as EBITDA margins improved by

50bp qoq and 90bp qoq, respectively, on the back of change in the business mix.

Contribution from the IT solutions segment, which has high gross and EBITDA

margins of 41.1% and 21%, respectively, improved by 200bp qoq to 66%.

On the other hand, the transaction services segment, which has low gross and

EBITDA margins of 25.5% and 17%, respectively, faced business loss due to a

steep drop in volumes related to cheque processing witnessed by large banks such

as JP Morgan, Wachovia and Wells Fargo.

Client metrics

During the quarter, revenue contribution from ICICI Group, 3i Infotech’s top client,

improved significantly. However, revenue from the top 10 clients significantly

declined to 15% in 2QFY2011 as compared to 22% in 2QFY2010 on account of

ramp down in revenue from the transaction services segment.

Investment rationale

Dynamic debt management feasible: The stock has underperformed the broader

markets as well as the Indian IT service pack because of the overhang related to

stretched balance sheet with current debt-to-equity of 1.8x. 3i Infotech has grown

inorganically over 2006–2008 by acquiring boutique businesses. These businesses

have scaled up to their target levels, resulting in need for earn-out payments. This

has primarily led to increased leverage despite sizeable equity dilution of `500cr.

Going forward, the left-out earn-out liability is only `47.5cr and `25cr for

2HFY2011 and FY2012 vis-à-vis `253cr and `74cr for FY2010 and 1HFY2011,

respectively. We expect this to be easily financed by internal accruals as the

company is generating quarterly operating cash of ~`130cr and does not have

any incremental capex needs. Also, we expect the tranche-I of FCCB repayment,

which is due to be matured in March 2011, to be refinanced. Overall, we expect

the debt-to-equity ratio to ease at 1.48x in FY2012, even after factoring in all the

earn-outs, debt repayment related to US $105mn loan form Axis Bank as well as

repayment of various tranche of FCCB.

Outlook and valuation

Management has revised down its guidance for FY2011 from 10–14% yoy revenue

growth to 5% yoy growth on the back of unanticipated drop in cheque processing

volumes. We expect revenue growth to remain subdued at 4% yoy in FY2011 and

pick up only in FY2012 with 9% yoy growth. On the profitability front, we expect

operating margin to be stable as the company’s improving business mix will

cushion any headwinds such as wage inflation and rupee appreciation. At the CMP

of `66, the stock is trading at attractive valuations in the mid-cap space at 4.8x

only. Hence, we value the company at 75% discount to Infosys’ FY2012 target P/E

of 23x, i.e. 5.8x. We maintain Buy with a revised Target Price of `78.