Buy 3i Infotech – 3QFY2011 Result Update- Angel Broking

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3i Infotech – 3QFY2011 Result Update

Angel Broking recommends a Buy on 3i Infotech with a Target Price of Rs. 68.

For 3QFY2011, 3i Infotech reported dismal numbers due to the drop in cheque

volumes in the US yet again. However, management expects transaction

processing volumes to stabilise and return to 5-7% yoy growth in FY2012 and IT

Solution to gain strong momentum. At the CMP of `56, the stock is trading at

dearth cheap valuations of 4.1x. We recommend a Buy on the stock, with a

Target Price of `68, valuing the company at 5x FY2012E EPS of `13.5.

Subdued revenue performance due to ramp down in transaction services: For

3QFY2011, 3i Infotech reported 0.9% qoq decline in revenues to `637.8cr,

primarily on the back of ramp down in volumes in the transaction services

segment (largely in the US), which declined by 1.0% qoq. The IT Solutions

segment also remained flat registering merely 0.2% qoq growth.

Margins decline: For 3QY2011, the company’s EBITDA margin declined by

108bp qoq to 19.3%, mainly due to the one-time cost incurred in the IT Solutions

segment on account of consolidation activities and slightly higher SG&A spend.

Outlook and valuation: Management maintained its 5% yoy revenue growth

guidance for FY2011 even as cheque processing volumes continue to languish in

the US. However, wholesale cheque processing volumes are expected to revive

and post 5-7% yoy growth in FY2012. We expect revenue growth to remain

subdued at 4.5% yoy in FY2011 and pick up only in FY2012 with 8.5% yoy

growth. The stock is trading at cheap valuations of 4.1x FY2012 EPS and 0.9x

FY2011E BVPS due to the overhang of high debt-to-equity ratio of 1.7x. However,

we expect the ratio to cool off to 1.48x by FY2012 with strong quarterly operating

profit of over `130cr and maintenance capex requirement of only `12-13cr. Thus,

we have valued 3i at a steep 80% discount to Infosys’ FY2012 Target P/E of 25x,

at 5x. Hence, we recommend a Buy on the stock, with a Target Price of `68.

Dismal revenue performance

For 3QFY2011, 3i Infotech posted disappointing performance. Top-line declined

by 0.9% qoq to `637.8cr primarily on the back of the 3.0% qoq decline in

revenues from the transaction services segment (majorly in the US) and a mere

0.2% growth in revenues from the IT Solution (the erstwhile Products segment and

the IT Services segment) segment

The company’s IT Solutions segment is currently witnessing modest traction. For

3QFY2011, the segment reported 0.2% qoq and 19.4% yoy growth in revenues to

`427.3cr as against `426.4cr in 1QFY2011 and contributed 72% to the

company’s overall revenue v/s 66% in 2QFY2011. Further, the company has

signed few major deals in this segment with clients in the South Asia geography,

including a healthcare agency for providing system integration and IT

infrastructure management and a leading banking and financial company for

facility management services. Also, the company is witnessing good traction in

deals from the emerging markets and Western Europe geographies. In this

segment, typical deal sizes for the company are in the range of US $0.5–4mn.

The transaction services segment maintained its trend of decline in volumes in this

quarter as well with revenues declining by 3.0% qoq to `210.5cr as against

`217.0cr in 1QFY2011, mainly due to volume loss (rather than client loss)

witnessed in the US. The segment contributed 28% to the company’s overall

revenue as against 34% in 2QFY2011. Going ahead, management expects no

further decline in volumes and expects it to be flat over the next couple of quarters.

The company has also signed few deals in this segment amounting to

US $11.4mn, including a deal with a financial company in North America for

remittance processing services and a leading banking company in India for

digitisation services. Typical deal sizes in this segment are in the range of

US $4–5mn. The company foresees 5-7% yoy growth in revenues in this segment

in FY2012.

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

towards emerging markets, contributing 44% to revenue as against 43% in

2QFY2011, due to continuous ramp down in the US-based transaction services

segment.

The company’s order book, which posted qoq decline in 2QFY2011, grew by

3.2% qoq to `1,732cr against `1,679cr in 2QFY2011. The order book is majorly

driven by deals signed in the IT solution segment in Western Europe and emerging

markets.

Margin performance

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

47bp and 108bp qoq to 40.9% and 19.3% respectively, on the back of increase in

cost in the IT Solutions segment, reduction in volumes in Transaction services and

slightly higher SG&A expenses. However, PAT margin improved by 5bp qoq to

10.0% on the back of higher other income and tax refund resulting in nil tax

outflow of `0.12cr as against tax paid to the amount of `5.7cr in 2QFY2011.

Gross margin of the IT Solution segment declined by 339bp qoq to 45.6% due to

consolidation activities taking place in 3QFY2011, resulting in one-time costs.

However, gross margin of the Transaction Services segment improved by 352bp

qoq to 29.1% (even when volumes declined) as there is a lot of variable cost

components in this segment and the company moved a lot of work offshore which

aided margins.

Client metrics

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

client, declined to 5% as against 7% in 2QFY2011, but management highlighted

that there was no ramp down, but the effect of the portfolio shift. However,

revenue contribution from the top-5 and 10 clients remained stable qoq to 10%

and 15%, respectively.

Investment rationale

Dynamic debt management to ease out debt-to-equity: The stock has

underperformed the broader markets as well as the Indian IT service pack because

of the overhang related to a stretched balance sheet with current debt-to-equity of

1.7x. 3i Infotech grew 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

`47.5cr and `25cr for 4QFY2011 and FY2012 vis-à-vis `253cr and `74cr for

FY2010 and YTD FY2011, respectively. In addition, tranche-I of FCCB repayment,

which is due to mature in March 2011, is a combination of US $20mn of principal

repayment and US $8mn of accrued interest. We expect both of these short-term

liquidity needs to be refinanced via its internal accruals i.e. cash of ~`190cr and

free cash flow of `24cr is expected to be generated in 4QFY2011 (after accounting

for US $8mn of additional interest paid). In FY2012, the company has to repay

`300cr of long-term loans and `25cr earn-out payment. We expect this to be paid

partially via internal accruals of ~`245cr out of free operating cash flows

(including annual capex of `50cr) of `258cr and rest of `80cr via debt refinancing.

We expect this dynamic debt management to ease out the debt-to-equity ratio to

1.48x by end of FY2012.

Outlook and valuation

Management has revised downwards its revenue guidance for FY2011 from

10-14% yoy growth to 5% on the back of unanticipated drop in cheque processing

volumes. However, it expects the wholesale cheque processing business to revive

and outlines growth of 5-7% yoy in FY2012. In case of IT solution, the company is

witnessing strong comeback in demand for both IT services and products. Hence,

we expect revenue growth to remain subdued at 4.5% yoy in FY2011 and pick up

only in FY2012 with 8.5% yoy growth. On the profitability front, for FY2012 we

expect operating margin to inch up to19.9% v/s19.8% in FY2011, as the

company’s improving business mix is expected to provide cushion from headwinds

such as wage inflation and rupee appreciation. At the CMP of `56, the stock is

trading at attractive valuations in the mid-cap space at 4.1x FY2012E EPS of

`13.6. Hence, even while valuing it at a steep discount of 80% to Infosys’ FY2012E

target P/E of 25x, i.e. at 5x, the inexpensive valuations and moderate business

growth should see an upside in the stock. Hence, we maintain a Buy on the stock,

with a Target Price of `68, valuing the company at 5x FY2012E EPS of `13.5.