Mphasis Ltd--Challenges persist - HOld:: Emkay

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Mphasis Ltd

Challenges persist

HOLD

CMP: Rs 599                                        Target Price: Rs 600

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n     Post the expected bounce back in Mphasis’s stock price after ‘no negative surprises’ in Oct’10, we find little reason to turn more constructive on the stock

n     Op mgns should head further lower driven by supply side pressures, US$/INR appreciation and need to increase S&M investments as co increases focus on non HP business  

n     Cut our Oct’11/Oct’12E EPS by 5%/0.5% to Rs 49.8/54.7 (primarily on reset in US$/INR at Rs 44/$) despite building in higher revenues (22%/21%YoY) 

n     Valuations appear inexpensive at 12/11x FY12/13E EPS, however need to be weighed against ~2.8% EPS CAGR over F11-13E with downside risks to revenue, mgn assumptions

Business Challenges persist

Mphasis’s stock price had been under pressure in the run up to Oct’10 results given

expectations of extremely weak results by certain sections of the street and thereby we

expected a positive reaction to a ‘not so negative Oct’10 results’. Although Oct’10

results were not disappointing in our view, we note that the net profit beat on our

expectations was driven by higher forex gains and lower taxes. Further co’s revenue

growth during the quarter was primarily led by recovery in revenues from an Asia Pac

telco account. We see the trend of declining margins continuing for Mphasis

(despite the fact that Mphasis’s margins have been on a downtrend for nearly 6 quarters

now) on several counts namely (1) higher impact of supply side pressures for Mphasis

(given higher offshore proportion of business at ~66% V/s ~50% for Tier 1 peers), (2)

possible reduction in pricing from HP (decision on the biannual Nov’10 round of pricing

renegotiations to emerge by Dec’10 end), and (3) increased investments both on

sales/marketing as well as delivery as company focuses on growing non HP business

more aggressively going ahead. Mphasis management has already indicated that it

would find it difficult to maintain EBIT margins between it’s guided range of 20-

22% and expects to achieve operating margins of ~18-21% for FY12. We note that

we build in EBIT margins of 20.2%/19.5% for FY12/13 respectively.

Earnings growth muted going forward

We have tweaked our earnings model for (1) higher revenues (we now model in

revenue growth ex hedging gains of 25%/21% for FY ending Oct’11/Oct’12, which by no

means is conservative), (2) lower EBITDA margins ( we build in EBITDA margins at

22.9%/22.2% for FY ending Oct’11/Oct’12 respectively V/s 24.5%/23.2% earlier, as we

reset our US$ /INR assumptions to Rs 44/$ V/s Rs 46/45 earlier for Oct’11/Oct’12)

driving a 5%/0.5% cut in our earnings estimates to Rs 49.8/54.7 respectively. We note

that our earnings estimates build in forex gains of ~Rs 3/share for Oct’11 as compared

to ~Rs 8.5 in FY ended Oct’10.

Valuations appear inexpensive, however are fair in our view

After a nearly 35% underperformance post our downgrade in Nov’09, valuations no

doubt appear inexpensive at 12x/11x Oct’11/Oct’12E earnings however we believe they

are fair given an anemic 2.8% EPS CAGR over FY11-13E (albeit sharp increase in tax

rates a major factor here) and the downside risks to revenue/margin assumptions.

Retain HOLD with a revised target price of Rs 600 (V/s Rs 630 earlier)