Mphasis -Margin drag to hit bottom-line: Macquarie Research

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Mphasis
Margin drag to hit bottom-line
Event
 We attended the Mphasis Analyst Meet held in Mumbai and interacted with Mr
Ganesh Ayyar, CEO, and Mr. Ganesh Murthy, CFO. We are modestly revising
our TP to Rs510 (vs. Rs500) but retain our UP rating as we expect a muted
growth profile could weigh on stock price performance.


Impact
 FY11 margins to be below target band. Management expects to spur
growth in FY11 by making additional investments in the direct sales channel
and targeting new geographies. We believe the company would have to
sacrifice margins to pursue top-line opportunities. Mphasis CEO agrees that
FY11 margins for the company would be below its target range of 20-22%
(Macq: 20%). The current street estimate is 21.1% for EBIT margin, and we
expect consensus expectations to reset post the analyst meet.
 Supply side pressures handicap margin levers. An improved demand
outlook for the sector has resulted in higher attrition, especially for Tier 2
players. Mphasis saw a 30% attrition rate for its Apps, 25% for ITO and 70%
for its BPO business on a last twelve months (LTM) basis. This is higher than
industry peers and, coupled with higher offshore mix for the company, limits
scope for manoeuvring margins.
 Management has outlined four focus areas for the future. The company
shared its strategy of focusing on four key areas for achieving the next leg of
growth – (1) Direct Channel growth, (2) Enhanced Vertical focus, (3) Focus on
emerging markets, and (4) Incubation of 4 business units currently generating
less than US$20m. We believe Mphasis management has the required
capability but realisation of growth from these target areas would take time to
fructify. In the interim, structural weakness on margins and an increase in the
tax rate (from 9% in FY10 to 25% in FY12) would result in an EPS decline.

Earnings and target price revision
 Similar to the peer group, we have raised our revenue forecast due to an
improved demand outlook for the sector and favourable currency assumption.
We raise our FY11 and FY12 EPS by 10% and 11% as reduced margins blunt
the impact of higher revenues. Our new TP is Rs510.

Price catalyst
 12-month price target: Rs510.00 based on a DCF methodology.
 Catalyst: Pricing renegotiations from HP

Action and recommendation
 Retain UP, switch to HCLT. We believe Mphasis has the top-line growth
potential, but margin pressure and an increased tax rate implies an
unattractive profit outlook. The stock was up 8% post results in a relief rally
post 4Q FY10 (Oct year end) results on Nov. 22. We recommend investors to
book profits and switch to HCL Technologies (HCLT IN, Rs386.40,
Outperform, TP: Rs515) given its 30% EPS growth potential over FY10-12E.