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Mphasis BFL (MPHL)
Technology
Heavy dose of disappointment; poor quarter validates our stance. Mphasis’ Jan
2011 quarter earnings report served a twin dose of disappointment on two axes –
(1) earnings – sharp qoq decline in revenues, margins, and PAT, and (2) quality of
disclosures. We remain Cautious on revenue/margin fundamentals for the company.
Earnings disappointment should dilute optimistic earnings estimates on the Street and
impact PE multiples on the stock as well. We reiterate our SELL rating.
Jan 2011 quarter results – disappointing, all the way
8% qoq decline in US$ revenues in a strong demand environment for the industry, 470 bps qoq
EBITDA margin decline, and 30% qoq net income decline – does not make for a good reading and
should hopefully dent the deep-held view on ‘HP-parentage driven highly predictable business
model’ of some sections of the Street. Revenues of US$267 mn for the quarter (down 8% qoq, up
just 7% yoy) came in 14% below estimate; EBITDA, adjusted for provision reversals of Rs434 mn
for the quarter, was down 28% qoq and 33% lower than our estimate. EBITDA margin at 17.4%
(16.2% excluding the forex gains) was down 470 bps qoq. Recurring (adjusted for cost reversals)
EPS for the quarter was Rs8.7/share and this included Rs1.5/share forex gain contribution. DSO
(including unbilled revenues) increased sharply to 94 days from 83 in the previous quarter.
Quality of disclosures – something to worry about
Disappointing results aside, quality of disclosures disappointed as well – (1) management now
indicates that a part of revenue decline can be attributed to non-recurrence of US$9 mn one-off
revenues in the Oct 2010 quarter from the parent HP – this was never disclosed earlier – either in
last quarter’s earnings call or later; the company had its first-ever analyst meet as well in the
interim, (2) substantial cost reversal during the quarter – roughly Rs434 mn (or 350 bps of
reported EBITDA margins) – interestingly, the company has also disclosed similar cost reversals for
the Oct 2010 and Jan 2010 quarters – this was never disclosed in the quarterly reports for these
respective quarters, and (3) quarterly metrics disclosures continue to go down in quantity as well
as quality – the company has stopped giving pricing metrics, revenue break-up metrics, etc.
Remain convinced of our negative stance, fundamentally; SELL
We have long been highlighting revenue growth and margin sustenance challenges for Mphasis
and the company’s Jan 2011 earnings report vindicates our stance in more ways than one. We
find Street’s optimism on revenue growth potential from the HP channel a bit on the euphoric
side. We also see challenges to margin sustenance – Jan 2011 reported margins still include a 120
bps kicker from hedging gains, and SG&A as % of revenues continues to remain lower than even
some captives. We see downgrades and de-rating ahead. Estimates/TP under review. SELL.
Multiple factors impacted revenues for Jan 2011 quarter
Mphasis’ revenues (adjusted for reported hedging gains) declined 8% or US$23 mn qoq to
US$267 mn. Revenues declined both at the HP channel as well as non-HP clients. Revenue
decline was driven by multiple factors –
non-recurrence of US$$9 mn one-off revenues from the HP channel in Oct 2010 quarter
– this factor was unknown to us (and presumably the Street as well) and not built into our
estimate for the quarter,
annual maintenance shutdown at HP – impacted revenues by 3.5%, and
pricing decline at HP as well as non-HP clients – the company has stopped disclosing
pricing metrics and we shall seek details on this in the earnings call on Feb 25, 2011.
We do not share Street’s optimism on HP channel’s revenue growth potential
Movement of work offshore from some of HP/EDS’ large extant relationships helped
Mphasis report strong revenue performance through the downturn. However, the company
has trailed the industry on revenue growth since the beginning of the recovery – amply
reflected in its 7.4% yoy revenue growth number for the Jan 2011 quarter versus 20-30%
for most other players in the industry.
We had highlighted our views on potential risk of over-estimating revenue growth potential
from HP in our Sep 8, 2010 note ‘Is the Street overestimating the revenue growth potential
of HP?’ and we maintain our stance. We believe that Mphasis has already captured a fair
share of HP’s services portfolio. Further market share gains may be moderate, in our view.
We believe that the HP’s services revenues of US$35 bn, relative to Mphasis’ current revenue
base (~US$1 bn) needs to be viewed in the context of the large revenue base HP derives
from (1) hardware/software support services, (2) national and state governments, (3) onsite
infrastructure management, (4) presence of HP India service centre, HP’s other offshore
subsidiary. We note that the combined strength of HP’s two offshore subsidiaries is now
close to 65,000, 30%+ of HP’s global services headcount – IBM and Accenture have similar
or lower proportion of their headcount in India.
Margin decline is not a one-quarter story
Mphasis’ EBITDA margins (adjusted for forex gain) have declined from 28.5% (Apr 09) to
16.2% (Jan 11) in just seven quarters (see Exhibit 2). The margin decline story would
continue to play as we see several headwinds including (1) continuing tight supply-side
situation in the industry, (2) HP pricing decline – with a bi-annual pricing review, the pricing
for HP channel (~70% of revenues) would remain a structural margin headwind, (3) lower
cash flow hedging gains, and (4) step-up in sales and marketing spends as Mphasis invests in
growing non-HP business; we note that Mphasis’ SG&A expenses as % of revenues remains
the lowest on the Street.
Shall review estimates post earnings call; expect downgrades
We shall review our earnings estimates and target price on the stock post the earnings call.
We see downside risks to our lowest-on-the-Street EPS estimates of Rs48.9 and Rs50.7 for
fiscal years ending Oct 2011 and Oct 2012, respectively. Street estimates face a larger
downside risk and we also foresee some multiple de-rating. Reiterate our SELL rating on the
stock.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Mphasis BFL (MPHL)
Technology
Heavy dose of disappointment; poor quarter validates our stance. Mphasis’ Jan
2011 quarter earnings report served a twin dose of disappointment on two axes –
(1) earnings – sharp qoq decline in revenues, margins, and PAT, and (2) quality of
disclosures. We remain Cautious on revenue/margin fundamentals for the company.
Earnings disappointment should dilute optimistic earnings estimates on the Street and
impact PE multiples on the stock as well. We reiterate our SELL rating.
Jan 2011 quarter results – disappointing, all the way
8% qoq decline in US$ revenues in a strong demand environment for the industry, 470 bps qoq
EBITDA margin decline, and 30% qoq net income decline – does not make for a good reading and
should hopefully dent the deep-held view on ‘HP-parentage driven highly predictable business
model’ of some sections of the Street. Revenues of US$267 mn for the quarter (down 8% qoq, up
just 7% yoy) came in 14% below estimate; EBITDA, adjusted for provision reversals of Rs434 mn
for the quarter, was down 28% qoq and 33% lower than our estimate. EBITDA margin at 17.4%
(16.2% excluding the forex gains) was down 470 bps qoq. Recurring (adjusted for cost reversals)
EPS for the quarter was Rs8.7/share and this included Rs1.5/share forex gain contribution. DSO
(including unbilled revenues) increased sharply to 94 days from 83 in the previous quarter.
Quality of disclosures – something to worry about
Disappointing results aside, quality of disclosures disappointed as well – (1) management now
indicates that a part of revenue decline can be attributed to non-recurrence of US$9 mn one-off
revenues in the Oct 2010 quarter from the parent HP – this was never disclosed earlier – either in
last quarter’s earnings call or later; the company had its first-ever analyst meet as well in the
interim, (2) substantial cost reversal during the quarter – roughly Rs434 mn (or 350 bps of
reported EBITDA margins) – interestingly, the company has also disclosed similar cost reversals for
the Oct 2010 and Jan 2010 quarters – this was never disclosed in the quarterly reports for these
respective quarters, and (3) quarterly metrics disclosures continue to go down in quantity as well
as quality – the company has stopped giving pricing metrics, revenue break-up metrics, etc.
Remain convinced of our negative stance, fundamentally; SELL
We have long been highlighting revenue growth and margin sustenance challenges for Mphasis
and the company’s Jan 2011 earnings report vindicates our stance in more ways than one. We
find Street’s optimism on revenue growth potential from the HP channel a bit on the euphoric
side. We also see challenges to margin sustenance – Jan 2011 reported margins still include a 120
bps kicker from hedging gains, and SG&A as % of revenues continues to remain lower than even
some captives. We see downgrades and de-rating ahead. Estimates/TP under review. SELL.
Multiple factors impacted revenues for Jan 2011 quarter
Mphasis’ revenues (adjusted for reported hedging gains) declined 8% or US$23 mn qoq to
US$267 mn. Revenues declined both at the HP channel as well as non-HP clients. Revenue
decline was driven by multiple factors –
non-recurrence of US$$9 mn one-off revenues from the HP channel in Oct 2010 quarter
– this factor was unknown to us (and presumably the Street as well) and not built into our
estimate for the quarter,
annual maintenance shutdown at HP – impacted revenues by 3.5%, and
pricing decline at HP as well as non-HP clients – the company has stopped disclosing
pricing metrics and we shall seek details on this in the earnings call on Feb 25, 2011.
We do not share Street’s optimism on HP channel’s revenue growth potential
Movement of work offshore from some of HP/EDS’ large extant relationships helped
Mphasis report strong revenue performance through the downturn. However, the company
has trailed the industry on revenue growth since the beginning of the recovery – amply
reflected in its 7.4% yoy revenue growth number for the Jan 2011 quarter versus 20-30%
for most other players in the industry.
We had highlighted our views on potential risk of over-estimating revenue growth potential
from HP in our Sep 8, 2010 note ‘Is the Street overestimating the revenue growth potential
of HP?’ and we maintain our stance. We believe that Mphasis has already captured a fair
share of HP’s services portfolio. Further market share gains may be moderate, in our view.
We believe that the HP’s services revenues of US$35 bn, relative to Mphasis’ current revenue
base (~US$1 bn) needs to be viewed in the context of the large revenue base HP derives
from (1) hardware/software support services, (2) national and state governments, (3) onsite
infrastructure management, (4) presence of HP India service centre, HP’s other offshore
subsidiary. We note that the combined strength of HP’s two offshore subsidiaries is now
close to 65,000, 30%+ of HP’s global services headcount – IBM and Accenture have similar
or lower proportion of their headcount in India.
Margin decline is not a one-quarter story
Mphasis’ EBITDA margins (adjusted for forex gain) have declined from 28.5% (Apr 09) to
16.2% (Jan 11) in just seven quarters (see Exhibit 2). The margin decline story would
continue to play as we see several headwinds including (1) continuing tight supply-side
situation in the industry, (2) HP pricing decline – with a bi-annual pricing review, the pricing
for HP channel (~70% of revenues) would remain a structural margin headwind, (3) lower
cash flow hedging gains, and (4) step-up in sales and marketing spends as Mphasis invests in
growing non-HP business; we note that Mphasis’ SG&A expenses as % of revenues remains
the lowest on the Street.
Shall review estimates post earnings call; expect downgrades
We shall review our earnings estimates and target price on the stock post the earnings call.
We see downside risks to our lowest-on-the-Street EPS estimates of Rs48.9 and Rs50.7 for
fiscal years ending Oct 2011 and Oct 2012, respectively. Street estimates face a larger
downside risk and we also foresee some multiple de-rating. Reiterate our SELL rating on the
stock.
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