Mphasis – 1QFY2011 Result ; Buy Target Rs. 623 -Angel Broking

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Mphasis – 1QFY2011 Result Update

Angel Broking maintains a Buy on Mphasis with a Target Price of Rs. 623.

Mphasis reported dismal performance for 1QFY2011 with revenue and PAT

coming in way below street as well as our estimates. The company

underperformed its tier-1 IT peers considerably. At the CMP, the stock is trading at

10.1x FY2012E EPS of `44.5 with a strong cash position of `1,785.5cr, which

warrants no further downside. Hence, we value the company at 14x FY2012E EPS

with a Target Price of `623 and recommend Buy from current levels.

Revenue underperforms after long: Mphasis reported revenue of US $271mn

(v/s our estimate of US $306mn) in 1QFY2011, registering an 8.4% qoq decline.

This underperformance can be attributed to 1) unanticipated higher number of

days of customer closure at HP (5 days onsite and 4 days offshore), impacting

revenue by 3.5% qoq; 2) selective price cuts of 5–10% in some of the HP channel

accounts, impacting revenue by 1.2% qoq; 3) absence of milestone payment as in

4QFY2010, impacting revenue by 3% qoq; and 4) unfavourable exchange impact

of 0.7% qoq. In INR terms, revenue declined by 8.3% qoq to `1,233.5cr

EBITDA margin slips: EBITDA margin during the quarter slipped by 290bp qoq to

20.9% due to whopping decline of 300bp qoq and 500bp qoq in utilisation in the

application business and BPO business to 72% and 69%, respectively, along with

pricing cut in selective accounts.

Outlook and valuation: Management indicated that the quarter witnessed many

one-off impacts. This along with transformational initiatives by the company led to

such a dismal performance. Mphasis has a healthy deal pipeline with 1,252 open

billable positions in the application business and another 471 in the ITO business.

Management expects the direct channel (32% to revenue) and HP business

outside enterprise solution (which is currently ~2% of revenue from HP channel)

to drive growth. We maintain Buy on the stock with a Target Price of `623,

valuing it at 14x FY2012E EPS.

Dismal revenue performance

Mphasis reported dismal set of numbers for 1QFY2011, with revenue declining by

8.4% qoq to US $271mn. This underperformance can be attributed to

1) unanticipated higher number of days of customer closure at HP (5 days onsite

and 4 days offshore), impacting revenue by 3.5% qoq; 2) selective price cuts of

5–10% in some of the HP channel accounts, impacting revenue by 1.2% qoq;

3) absence of milestone payment as in 4QFY2010, impacting revenue by 3% qoq;

and 4) unfavourable exchange impact of 0.7% qoq. In INR terms, revenue stood at

`1,233.5cr, down 8.3% qoq.

Mphasis recorded decline across all its verticals, with banking and capital markets

(contributed 25.8% to revenue) and IT, communication and entertainment

(contributed 27.9% to revenue) falling by 11.1% and 9% qoq, respectively.

Even the insurance vertical (contributed 9.5% to revenue) and the emerging

industries vertical (contributed 36.8% to revenue) registered a qoq decline of 5.7%

and 4.7%, respectively.

Segment wise, the application development (contributed 26.4% to revenue) and

application maintenance (contributed 37.4% to revenue) businesses witnessed a

qoq decline of 12.0% and 6.5%, respectively. The infrastructure management

business (contributed 20.1% to revenue) grew by 3.8% qoq. The transaction

processing business (contributed 6.1% to revenue) declined by 6.3% qoq, while the

knowledge processes business (contributed 1.0% to revenue) witnessed a 28.2%

qoq decline. The BPO segment (contributed 9% to revenue) fell by whopping

34.8% qoq due to the ongoing transition of work from Mphasis to HP’s captive.

EBITDA margin slips

Overall, Mphasis recorded a 290bp qoq contraction in EBITDA margin to

20.9% (v/s our estimate of 23.2%) in 1QFY2011 as against 23.8% in 4QFY2010.

EBITDA margin slipped because of major gross margin decline of 560bp qoq in

the IT, communication and entertainment vertical, followed by the 460bp qoq

and 260bp qoq drop in the emerging industries vertical and the insurance

vertical, respectively.

The primary reasons for the decline were 1) a steep dip of 300bp and 500bp in

utilisations for the application and BPO businesses to 72% and 69%, respectively,

due to customer closures as well as bench creation; and 2) selective price cuts of

5–10% impacting revenue as well margins by 100bp. All this affected the

company’s gains due to write-back of `17.6cr in SGA expenses.

Client metrics

Mphasis has been focusing on direct channel strategy to win clients; however, in

this quarter, direct channel revenue dipped as well by 2.8% qoq. Nevertheless,

overall, the company added 18 new clients in 1QFY2011.

Mphasis witnessed addition of two clients each in the over US $1mn and US $5mn

categories through the direct channel. Also, one client was added in the over

US $20mn category through HP channel. The HP channel witnessed migration

of two clients from the over US $5mn category to the over US $1mn category

during the quarter.

Hiring spree continues in the application business

Mphasis recorded strong net additions in the application business of 726

employees in 1QFY2011 itself, out of total net addition of 1,097. In addition, the

company has ~471 open billable positions in the ITO vertical, which envisages

decent demand pipeline for infrastructure management services. In case of the

application business, the open billable position stands at 1,252.

Outlook and valuation

Management indicated that the quarter witnessed many one-off impacts.

This along with transformational initiatives, such as 1) vertilisation 2) tapping

emerging markets 3) entering new ventures and 4) exploring HP-non enterprise

business, led to such a dismal performance by the company. Mphasis has a

healthy deal pipeline with 1,252 open billable positions in the application business

and another 471 in the ITO business. Management expects the direct channel

(32% of revenue) and HP business outside enterprise solution (which is currently

~2% of revenue from HP channel) to drive growth. At the CMP, the stock is trading

at 10.1x FY2012E (October 2012) EPS of `44.5 with a strong cash position of

`1,785.5cr, which warrants no further downside. Hence, we recommend Buy from

the current levels with a Target Price of `623, valuing the company at 14x

FY2012E EPS (i.e., at 38% discount to Infosys’ target multiple of 22x).