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Mphasis – 4QFY2010 Result Update
Angel Broking maintains a Buy on Mphasis with a Target Price of Rs862.
Mphasis reported mixed performance for 4QFY2010 with revenue and PAT
coming in better than street as well as our estimate, though margin slippage was
higher than expected. The company yet again reported strong revenue growth
comparable to tier-I IT companies. Hence, we continue to prefer Mphasis from
our mid-cap IT coverage universe and maintain a Buy on the stock.
Revenue outperformance continues: The company reported revenues of
US $296mn (v/s our estimate of US $290mn) registering 7.5% qoq growth and
backed by strong volume growth of 7.7% and 4.7% in the ITO and application
services business, respectively. In rupee terms, revenue grew 5.1% qoq to
`1,345cr on the back of stronger rupee and driven by the ITO and application
services business, which grew 5.8% and 6.5% qoq, respectively.
EBITDA margin slips: Weak utilisation in the ITO business due to strong intake of
freshers and higher SG&A expenses led to EBITDA margins slipping by 88bp to
23.8%, overshadowing the efficiency gains in the application and BPO business.
Outlook and valuation: The ITO business has emerged the growth driver for the
company recording 6.5% qoq growth. The application business has also been
growing on the back of strong traction in the anchor vertical, viz. banking and
financial services. We expect this strong volume-led growth momentum to persist
and estimate the company’s dollar revenue to post 19.3% CAGR over
FY2010-12. On the operating front, we expect the company to face margin
headwinds with EBITDA clocking mere 13% CAGR vis-à-vis strong revenue CAGR
of 18.3% over the mentioned period. At the CMP, the stock is trading inexpensive
at 10.6x FY2012E EPS despite registering revenue growth and profitability
comparable to tier-I companies like HCL Tech and Wipro. We maintain a Buy on
the stock, with a Target Price of `862 valuing it at 15x FY2012E EPS, which is at
35% discount to Infosys’ Target PE of 23x.
Volume-led growth continues
Mphasis reported revenues of US $296mn (v/s our estimate of US $290mn) for
4QFY2010 v/s US $276mn in 3QFY2010, registering 7.5% qoq growth, backed
by overall volume growth of 4.9% qoq. Volumes increased led by the ITO segment,
which reported 7.7% qoq growth followed by the application services segment,
which clocked 4.7% qoq growth. The BPO segment recorded mere 0.8% qoq
growth in volume.
In rupee terms, revenue grew 5.1% qoq to `1,345cr (v/s our expectation of
`1,326cr) as against `1,279cr in 3QFY2010 led by the robust 6.5% and 5.8% qoq
revenue growth registered by the ITO (23.1% to revenues) and application
segments (64.9% to revenues) at `874cr and `310cr, respectively. The BPO
segment remained a laggard recording (0.1%) qoq growth in revenues. Total
revenues include hedging reserve impact of `27.2cr.
Segment-wise, the application development (27.7% to revenues) and application
maintenance (36.9% to revenues) business witnessed qoq growth of 7.6% and
3.6%, respectively. The infrastructure management business (17.9% to revenues)
grew 4.5% qoq on strong 7.7% volume growth. The transaction processing
business (6% to revenues) grew a whopping 15.3% qoq, while the knowledge
processing business (1.2% to revenues) witnessed 17.3% qoq decline. The BPO
segment de-grew marginally qoq because of the ongoing transition of work from
Mphasis to HP’s captive. Importantly, this ramp down has almost bottomed out in
the BPO segment.
The company’s anchor banking and financial services vertical (41.8% to revenues)
continued its uptrend registering qoq growth of 2.1%. However, in 4QFY2010,
growth was driven primarily by the telecom vertical (13.3% to revenues), which
registered robust growth of 53.3% qoq because of addition of one major client
and due the base effect of a one-time outage in one of the telecom client’s facility.
The logistics, airline and transportation (6% to revenues) vertical also bolstered
growth, moving up 1.8% qoq. The healthcare and pharma vertical (7.9% to
revenues) remained flat, whereas the manufacturing & retail (12.9% to revenues)
and technology and OEM verticals (18.1% to revenues) were laggards declining
5% and 1.8% qoq, respectively.
EBITDA margin slips
Segment-wise, the application services segment registered 140bp improvement in
gross margins at 30.9% v/s 29.5% in 3QFY2010, as utilisation (including trainees)
increased to 75% from 73% in the last quarter coupled with improvement in onsite
billing to $72/hr from $71/hr in 3QFY2010. Gross margin of the BPO segment
increased by 270bp qoq at 17.4% v/s 14.7% in 3QFY2010 owing to the
substantial increase in utilisation (including trainees) to 74% from 71% in
3QFY2010. Gross margin of the ITO services segment declined by 460bp qoq to
34.9% v/s 39.5% in 3QFY2010 due to strong fresher net additions, which dragged
down utilisation by a significant 700bp to 66% from 73% in 3QFY2010. Thus, the
overall increase in gross margin was limited to 30bp to 30.2% v/s 29.9% in
3QFY2010.
Overall, Mphasis recorded 89bp qoq (221bp yoy) contraction in EBITDA margin to
23.8% (v/s our estimate of 24.2%) in 4QFY2010 as against 24.7% in 3QFY2010.
EBITDA margin contracted despite the expansion in gross margins was due to the
absence of one-off i.e. the refund from Karnataka Bank of `13cr savings in G&A
as in 3QFY10 and higher S&M expenses to monetise the direct HP channel.
Mphasis reported nearly flat pricing across all the business segments. The
overhang of pricing renegotiations was shunned by the company on account of
recording better price points across its anchor business segment i.e. the application
services segment improved its onsite billing rate to US $72/hr from US $71/hr in
3QFY2010. Offshore pricing of the segment was flat at US $20/hr. The ITO
services segment’s offshore pricing slipped to US $20/hr from US $21/hr in
3QFY2010 due to absence of one-off revenues as in 3QFY2010. The BPO pricing
remained flat qoq at US $7/hr.
Improved wallet share in HP channel
During the quarter, Mphasis witnessed 22 new client wins mainly in the BFSI,
healthcare and pharma verticals. The company is now focusing on direct channel
strategy to win clients. The direct channel business is going strong recording
growth of 8% qoq in 4QFY2010. The company added 18 clients in the application
services business during the quarter.
In 4QFY2010, the client pyramid saw qualitative movement. The company
witnessed addition of one client each in the over US $20mn and US $10mn
categories through the HP channel; five additions in the over US $1mn category
(three through the HP channel and two through the direct channel). The direct
channel witnessed migration of one client from the over US $5mn category to the
over US $1mn category in 4QFY2010.
Hiring spree continues to brace strong pipeline
The company recorded strong net additions in the ITO business at 836 employees
in 4QFY2010 itself out of the 3,254 net addition in employees for FY2010. In
addition, the company has ~800 open billable positions in ITO, which envisages
robust demand pipeline for infrastructure management services. Application
business also recorded decent net addition of 296 employees with 1,600 open
billable positions left to be filled in the near term.
Investment arguments
Proven track record of growing at par with biggies
The company has been an outperformer in the mid cap IT space with revenues
growing at a scorching pace almost comparable to tier-I IT companies, which grew
by 6-11.5% qoq in the recent quarter. The company has been the beneficiary of
strong parentage i.e. HP helping it to buck the industry trend. This has helped it
reach the billion dollar revenue milestone in FY2010. Going forward, we expect
the company to continue its volume-led growth momentum with 19.4% CAGR over
FY2010-12, in dollar revenues.
Pricing uncertainty behind
The company has enjoyed superior volume growth due to its Master-level
Service Agreement with HP, while simultaneously facing the brunt of this
dependence in the form of rounds of renegotiations. This price uncertainty has
been a major overhang, which has led to the stock being a market
underperformer. However, in 4QFY1010, the company managed to garner better
price points in its anchor business i.e. application services, which expanded it to
US $72/hr from US $71/hr in 3QFY2010 and maintained the price points across
all other business segment. We believe that the further round of downward
renegotiation look unlikely as majority of its business from HP i.e. go-to-market,
will be market driven. We have assumed a flat pricing scenario for the company
considering the flat-to-positive pricing environment for the industry.
Strong cash pile and free cash-flows to aid growth via M&A’s
As on date, Mphasis has a strong cash position of `1,638cr. The company has
also been generating strong cash-flows upwards of `150cr quarterly on the back
of better profitability than other mid caps, which will further enhance its capability
to go in for strategic buyouts. Management is scouting for acquisitions in the size
of US $50–100mn annual revenue run rate to further bolster growth. Thus, a
healthy balance sheet position and strong free cash-flows will aid the company in
carrying out attractive buyouts in turn enhancing its services and vertical portfolio.
Outlook and valuation
Mphasis has been consistently outperforming its peers as it has emerged a major
beneficiary of HP’s restructuring exercise. The ITO business has emerged the
growth driver registering almost double-digit qoq growth. The application business
has also been growing on the back of strong traction in the anchor vertical, viz.
banking and financial services. We expect this strong volume-led growth
momentum to persist and estimate the company’s dollar revenue to post 19.3%
CAGR over FY2010-12. On the operating front, we expect the company to face
margin headwinds because of a stronger rupee, competitive wage inflation and
continued S&M spending to tap more clients via the direct channel overshadowing
the gains accruing from higher utilisation and sustainable G&A. Hence, we expect
EBITDA to clock mere 13% CAGR over the period vis-à-vis strong revenue growth
of 18.3%.
At the CMP, the stock is trading inexpensive at 10.6x FY2012E EPS despite
registering revenue growth and profitability comparable to tier-I companies like
HCL Tech and Wipro. We maintain a Buy on the stock, with a Target Price of `862
valuing it at 15x FY2012E EPS, which is at 35% discount to Infosys’ Target PE of
23x.
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