Mphasis BFL- Several headwinds to EPS growth; SELL.: Kotak Sec

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Mphasis BFL (MPHL)
Technology
Several headwinds to EPS growth in FY ending Oct 2011E; SELL. With the postresults
bounce (a reversal of pre-results underperformance driven by Street’s fears of a
poor quarter) behind us, we believe it is prudent to focus on the EPS growth headwinds
facing Mphasis in FY2012E. Margins face pressure from a stronger Re, lower cash flow
hedging gains and tight supply environment in addition to the structural pricing
pressure. Increase in ETR is likely to pressure EPS growth further. Reiterate SELL.




A closer look at Mphasis’ FY2012E EPS growth challenge
Even as we expect strong (though not industry-leading anymore) revenue growth for Mphasis in
FY2012E (year ending Oct 31, 2011), we see several headwinds to EPS growth. Most of these
headwinds are margin related, with a sharp increase in tax rates acting as an additional dampener.
We discuss some of these in detail below

􀁠 Tight supply side environment – we see relative revenue growth as the only margin lever
available to the Indian IT companies over the next few quarters. High attrition at Mphasis –
30% for apps, 25% for ITO, and 70% for BPO on a ttm basis – does not help matters, either.
Also, the company has little leeway on the utilization front on the apps and BPO side.

􀁠 Stronger Re and high cash-flow hedging gains base – high offshore centricity of revenues
makes Mphasis’ margins more sensitive to the movement of the Rupee. Even as the company
has done a good job on hedging, the high cash-flow hedging gains (booked in the revenue line)
base for FY2011 will serve as a pressure point on margins in FY2012E, in our view. The
company’s underlying ex-forex margins for FY2011 stood at 22.8% versus the 25.1% reported;
exit (Oct 2010 quarter) margins, on a similar basis, were 22.3% versus 23.8% reported.

􀁠 HP pricing – a wild-card, but expected to be down on a directional basis, the bi-annual price
renegotiation with HP (70% of revenues) is a structural margin headwind.

􀁠 Step-up in sales and marketing spend – renewed and increasing focus on driving revenue
growth from the non-HP channel (the company expects this channel to grow faster in the next
fiscal versus the HP channel) would demand a step-up in S&M spends, which have been at the
lower end of the industry range for several quarters now.

􀁠 Tax rates – with little SEZ presence, Mphasis faces a sharp increase in ETR beginning the Apr
2011 quarter; the company has itself guided for an 18.5% ETR for FY ending Oct 2011E versus
9.9% for FY ending Oct 2010.


Broadly maintain earnings estimates, EPS of Rs46.4/49.4 for FY2011E/12E
We maintain the broad underlying assumptions (robust revenue growth, underlying margin
pressure) driving our earnings model. Changes to our earnings estimates are primarily driven
by a revision in our Re/US$ estimates - we now model a Re/US$ rate of 45.3 for FY2012E
and 44.8 for FY2013E versus 46.3 and 45.7 earlier. We note that our Re/US$ assumptions
for Mphasis are higher than that for the other companies as we adjust for expected cashflow
hedging gains through a higher currency assumption. Our EPS estimates for
FY2012/13E broadly remain the same and stand at Rs46.4 (Rs45.6 earlier) and Rs49.4
(Rs49.5 earlier). Exhibit 1 depicts the key changes to our earnings model for the company.

We remain unconvinced, fundamentally; reiterate SELL
At the cost of repeating ourselves, we see several challenges ahead for Mphasis – (1)
Mphasis has captured a fair share of HP revenues and further share gains would be limited,
in our view. Growing non-HP base of revenues would need sharp S&M step-up, which
would have an impact on the margins, (2) Re appreciation – hedging gains for Mphasis may
not last for long – margins may come under pressure once benefits of these hedges wear off
and (3) sharp increase in tax rates in FY2012E from 9.9% for year ending Oct 2010.
Seemingly inexpensive valuations on a P/E basis should be weighed against the revenue
growth/margin risks and sharp increase in tax rates in FY2012E. We reiterate our SELL
recommendation with an unchanged target price of Rs550/share.