Goldman Sach: Mphasis (MBFL.BO): Downgrade to Neutral as price nears TP

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Mphasis (MBFL.BO): Downgrade to Neutral as price nears TP
What’s changed
 We remove Mphasis from the Asia Pacific Buy List and downgrade it
to Neutral as the stock is close to our 12-month Director’s Cut-based
TP of Rs743, offering limited upside compared to other stocks in our
coverage. Since we added it to the Buy List on December 3, 2009,
Mphasis is down 5.7% vs. 11.9% rise in Sensex. In the past 12
months, the stock is down by 6% vs. Sensex up by 9.6%.

 Continuing uncertainty over pricing: While HP provides solid
revenue back up to Mphasis, we believe that there is likely to be a
continued overhang and uncertainty due to the periodical pricing
negotiations between HP and Mphasis. We forecast revenue CAGR
of 18% over FY11E-FY13E.
 Around 70% of Mphasis’ revenues come from HP, making the
revenue stream extremely reliant on HP and thus increasing the
concentration risk. During our IT services trip, Mphasis management
pointed to renewed sales efforts to grow the direct channel business
and reduce the proportion of revenues from HP.
 2011 strategy for direct channel critical: We believe that FY2011
will be the year of investment as Mphasis tries to improve its direct
sales efforts and broaden its service, vertical and geographic
footprint. We also expect Mphasis margins to be under pressure due
to increased wage costs, higher SG&A costs and expiring currency
hedges. We forecast margins to drop by 120 bp over FY11E-FY12E.
 Highest exposure to increased tax (by 1500 bps): We expect
Mphasis to be impacted significantly by the end of STPI tax benefits
with tax rates rising by 1500 bp over FY11E-FY13E. This will lead to
muted earnings growth of 8% over FY10-FY13E.
 Lowest EPS CAGR of 8%: We revise our revenue estimates by 4%-
5% to account for improved assurance on volumes from parent HP.
However, wage pressures and potential investment into the
business over the next one year could pose pressure on the
margins. Hence, we revise our EPS estimates by 0.1%/-1.2%/-1.7%
for FY11E-FY13E.
Valuation
 We maintain our 12-month Director’s Cut-based target price of
Rs743, implying 11% upside potential and a P/E of 12.2X on FY2012E
EPS vs. the sector average at 15.4X.
 We note that Mphasis is currently at the higer end of its 6-year
historical average. The stock trades at a discount of 20% to domestic
peers on FY12E. We believe that the valuation discount is justified
due to the challenging environment for mid cap IT companies, as
discussed previously, and also Mphasis’s vulnerability to pricing
cuts from HP and muted earnings growth.
Key risks
 Upside: Stable pricing, material rupee depreciation; Downside:
Higher-than-expected deterioration in pricing.