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MPHASIS Plumbing new low; our concerns vindicated
Results disappoint on multiple fronts
Mphasis results came in with a lot of negative surprises validating our long
drawn concerns. In a strong demand environment, quarterly revenue decline of
8% in USD terms and 3% decline in operating margins summarizes the
performance. Further, we see changes in the disclosure policy, non-disclosure of
provision reversals and one-off revenues in previous quarter impacting the
company reputation. Revenues were reported at INR 12.3 bn, down 8.3% Q-o-Q
and net profits at INR 2.3 bn, down 20.2% Q-o-Q. Decrease in operating profits
and higher effective tax led to this profit decline.
EBITDA margins have crashed and growth visibility low
Pricing cuts, low volumes and high attrition have taken toll on margins. Pricing
cuts in the 5-10% range given to select clients in the HP channel (effective
December 2010), revenue decline from both HP and direct channels by 9.8% and
2.8% sequentially led to this margin decline. Over the past 18 months, EBITDA
margins (adjusted for hedging gains) have decline by 870bps to 17.6%. Further,
Mphasis’ emphasis on growing direct business indicates growth visibility from HP
being low (also witnessed from HP’ services revenue trend).
Transformation from HP channel to direct business to strain margins
Mphasis is currently focusing on growing its non-HP business. However, this
transformation will require increase in sales spend, which could strain margins
further. Also, its initiative to incubate two new businesses, product engineering
services and payment solutions, will require a step up in investments.
Drawing parallel with Digital Globalsoft case
We track the news and events related to Digital Globalsoft’s delisting and see
similar trend in Mphasis’ performance. Digital’s operating margins declined by 10%
in a year as HP’s interest took precedence in operations (refer page 2 for details).
Outlook and valuations: Our concerns vindicated; maintain ‘REDUCE’
We have revised our earnings downward by 25% and 26% for FY12E and FY13E,
respectively at INR 38.7 and 40.2. On the revised estimate, the stock trades at a
P/E of 11.6x and 11.2x, FY12E and FY13E respectively. The decline in the stock
price by 29% post result captures most of the negatives and limits downside
hereon. However, we would wait to see improvement in direct business and
disclosure policy before any upgrade in recommendation. We maintain
‘REDUCE/ Sector Underperformer’ on the stock.
Drawing parallel with Digital’s delisting
We tracked the Digital Globalsoft’s (Digital) news and events that led to sharp
movements in the company’s share price prior to its delisting (see chart 1 below). We
note in the case of Digital, the merger ratio of HP Services arm with Digital was adverse
to the interests of minority shareholders in June 2003. However, due to minority holders
demand the company’s eventual delisting in March 2004 happened at INR 850/share at
50% premium to SEBI prescribed formula at that point of time (average of weekly high
and low of closing prices in the 26 weeks preceding the announcement in November
2003). We list below some observations with regards to the financial performance before
the delisting of Digital.
Digital’s margins declined appreciably during FY03 prior to delisting: We note
that the financial performance of Digital as seen from the table 2 below deteriorated
sharply. Digital’s operating margins declined significantly during FY03 from 38% at the
start of the year to 30% by Q1FY04. Net profit growth during the same period remained
muted, leading to the stock declining by almost 50% from INR 750 levels.
This is our key concern for Mphasis, though the company works with HP-EDS based on
specified rate card. However, recent margin performance of the company bears similarity
with that of Digital’ margin trend.
EBITDA margins have crashed, which was always a worry
Adjusting for the hedging gains and provision reversals EBITDA margins for Mphasis
have declined to 17.6%. Over the past 18 months, the operating margins for the
company have declined by 870bps. This has been particularly driven by cuts in billing
rate and increase in sales and marketing efforts.
Key highlights
• Topline well below estimate: Revenue, at INR 12.3 bn (our estimate INR 13.7
bn), declined 8.3% sequentially. Net profit was down 20.2% Q-o-Q to INR 2.3 bn. In
USD terms, revenue, at USD 271 mn, slipped 8.5% Q-o-Q.
• Gross profit, at INR 3.6 bn, dipped 19.0% Q-o-Q and 13.5% Y-o-Y. Gross margin, at
28.9%, was down 380bps Q-o-Q due to lower utilisation rate in ITO, applications and
BPO segments and hiring of domain experts for new businesses.
EBITDA margins: Mphasis’ EBITDA, at INR 2.6 bn, declined 19.7% Q-o-Q.
Reported EBITDA margin declined 290bps to 22.9%, However, adjusting for the
reversal of provisions in cost of revenues, EBITDA margin stood at 18.8%, down
330bps.
• Net profit, at INR 2.2 bn, slipped 20.2% sequentially. Net margin declined 270bps
sequentially and stands at 18.4%, primarily on account of lower operating profits.
Tax rate for the quarter stood at 11.5% against 9.6% in Q4FY11.
• All verticals decline sequentially: Banking & capital markets (BCM) declined
11.1% while insurance, information technology, communication & entertainment
(ICE) and emerging industries were down 5.7%, 9.0%, and 4.7% Q-o-Q,
respectively.
• Strong employee addition: Employee addition was higher in applications (726)
than in BPO (335) and ITO (8), during the quarter. The employee headcount
currently stands at 41,059. Attrition remains a concern, with TTM attrition
rates for applications and ITO being 29% and 25%, respectively.
• Client addition: Mphasis added 18 new clients, 5 from the HP channel and 13 from
direct channels. 1 in BCM, 2 in insurance, 4 in ICE and 11 in emerging industries.
• Client metrics deteriorating: The number of clients contributing revenue in excess
of USD 1 mn stood at 119 (115 in Q4). USD 10 mn plus (declined by 1) and USD 20
mn plus (flat) client counts stand at 22 and 14 in the respective categories. The top
client’s (HP) revenue declined 8.3% Q-o-Q. Similar trend was seen in Top 5 and Top
10 clients where revenue declined 5.0% and 10.4% Q-o-Q, respectively.
• Hedging: Mphasis has hedges worth USD 480 mn, AUD 40 mn and GBP 40 mn.
• DSO increased by 11 days to 94 from 83 in the previous quarter.
• Cash and equivalents: The company’s cash generation remains healthy, with cash
and equivalents balance at INR 17.8 bn against INR 16.4 bn in the previous quarter.
Company Description
Mphasis is a tier-II and one of the top 10-IT integrated software services vendors in
India. The company provides IT services, mainly focused on banking, financial services,
and insurance segments. It has one of the largest BPO practices in India, providing
voice- and transaction-based services. In June 2006, Electronic Data Systems (EDS)
bought a majority stake in Mphasis and now, its total holding stands at 60.61%. EDS is
now acquired by Hewlett Packard (HP). The company has total employee strength of
41,059 (23,936 plus in IT services and around 15,661 in BPO services).
Investment Theme
HP as the owner, issues such as size and scale, market access, and enhanced capabilities
in offshore delivery are improving at healthy pace. Incremental business for Mphasis is
likely to come from direct working with HP clients and that now contributes 68% to its
revenues. However, with HP being the major client and shareholder as well, the
dependency risk has increased substantially along bill rate pressure that is being
witnessed currently. We see inadequate investments to grow non-HP business to impact
the growth rates going forward as HP business is also undergoing rationalisation.
Further, sharp increase in effective tax rates will restrict the growth rate at net profit
level over the next two years.
Key Risks
Key risks to our investment theme include: (a) no further bill rate pressure from HP; (b)
fast scale-up of non-HP business; and (c) depreciation of rupee against USD, GBP, and
EUR.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
MPHASIS Plumbing new low; our concerns vindicated
Results disappoint on multiple fronts
Mphasis results came in with a lot of negative surprises validating our long
drawn concerns. In a strong demand environment, quarterly revenue decline of
8% in USD terms and 3% decline in operating margins summarizes the
performance. Further, we see changes in the disclosure policy, non-disclosure of
provision reversals and one-off revenues in previous quarter impacting the
company reputation. Revenues were reported at INR 12.3 bn, down 8.3% Q-o-Q
and net profits at INR 2.3 bn, down 20.2% Q-o-Q. Decrease in operating profits
and higher effective tax led to this profit decline.
EBITDA margins have crashed and growth visibility low
Pricing cuts, low volumes and high attrition have taken toll on margins. Pricing
cuts in the 5-10% range given to select clients in the HP channel (effective
December 2010), revenue decline from both HP and direct channels by 9.8% and
2.8% sequentially led to this margin decline. Over the past 18 months, EBITDA
margins (adjusted for hedging gains) have decline by 870bps to 17.6%. Further,
Mphasis’ emphasis on growing direct business indicates growth visibility from HP
being low (also witnessed from HP’ services revenue trend).
Transformation from HP channel to direct business to strain margins
Mphasis is currently focusing on growing its non-HP business. However, this
transformation will require increase in sales spend, which could strain margins
further. Also, its initiative to incubate two new businesses, product engineering
services and payment solutions, will require a step up in investments.
Drawing parallel with Digital Globalsoft case
We track the news and events related to Digital Globalsoft’s delisting and see
similar trend in Mphasis’ performance. Digital’s operating margins declined by 10%
in a year as HP’s interest took precedence in operations (refer page 2 for details).
Outlook and valuations: Our concerns vindicated; maintain ‘REDUCE’
We have revised our earnings downward by 25% and 26% for FY12E and FY13E,
respectively at INR 38.7 and 40.2. On the revised estimate, the stock trades at a
P/E of 11.6x and 11.2x, FY12E and FY13E respectively. The decline in the stock
price by 29% post result captures most of the negatives and limits downside
hereon. However, we would wait to see improvement in direct business and
disclosure policy before any upgrade in recommendation. We maintain
‘REDUCE/ Sector Underperformer’ on the stock.
Drawing parallel with Digital’s delisting
We tracked the Digital Globalsoft’s (Digital) news and events that led to sharp
movements in the company’s share price prior to its delisting (see chart 1 below). We
note in the case of Digital, the merger ratio of HP Services arm with Digital was adverse
to the interests of minority shareholders in June 2003. However, due to minority holders
demand the company’s eventual delisting in March 2004 happened at INR 850/share at
50% premium to SEBI prescribed formula at that point of time (average of weekly high
and low of closing prices in the 26 weeks preceding the announcement in November
2003). We list below some observations with regards to the financial performance before
the delisting of Digital.
Digital’s margins declined appreciably during FY03 prior to delisting: We note
that the financial performance of Digital as seen from the table 2 below deteriorated
sharply. Digital’s operating margins declined significantly during FY03 from 38% at the
start of the year to 30% by Q1FY04. Net profit growth during the same period remained
muted, leading to the stock declining by almost 50% from INR 750 levels.
This is our key concern for Mphasis, though the company works with HP-EDS based on
specified rate card. However, recent margin performance of the company bears similarity
with that of Digital’ margin trend.
EBITDA margins have crashed, which was always a worry
Adjusting for the hedging gains and provision reversals EBITDA margins for Mphasis
have declined to 17.6%. Over the past 18 months, the operating margins for the
company have declined by 870bps. This has been particularly driven by cuts in billing
rate and increase in sales and marketing efforts.
Key highlights
• Topline well below estimate: Revenue, at INR 12.3 bn (our estimate INR 13.7
bn), declined 8.3% sequentially. Net profit was down 20.2% Q-o-Q to INR 2.3 bn. In
USD terms, revenue, at USD 271 mn, slipped 8.5% Q-o-Q.
• Gross profit, at INR 3.6 bn, dipped 19.0% Q-o-Q and 13.5% Y-o-Y. Gross margin, at
28.9%, was down 380bps Q-o-Q due to lower utilisation rate in ITO, applications and
BPO segments and hiring of domain experts for new businesses.
EBITDA margins: Mphasis’ EBITDA, at INR 2.6 bn, declined 19.7% Q-o-Q.
Reported EBITDA margin declined 290bps to 22.9%, However, adjusting for the
reversal of provisions in cost of revenues, EBITDA margin stood at 18.8%, down
330bps.
• Net profit, at INR 2.2 bn, slipped 20.2% sequentially. Net margin declined 270bps
sequentially and stands at 18.4%, primarily on account of lower operating profits.
Tax rate for the quarter stood at 11.5% against 9.6% in Q4FY11.
• All verticals decline sequentially: Banking & capital markets (BCM) declined
11.1% while insurance, information technology, communication & entertainment
(ICE) and emerging industries were down 5.7%, 9.0%, and 4.7% Q-o-Q,
respectively.
• Strong employee addition: Employee addition was higher in applications (726)
than in BPO (335) and ITO (8), during the quarter. The employee headcount
currently stands at 41,059. Attrition remains a concern, with TTM attrition
rates for applications and ITO being 29% and 25%, respectively.
• Client addition: Mphasis added 18 new clients, 5 from the HP channel and 13 from
direct channels. 1 in BCM, 2 in insurance, 4 in ICE and 11 in emerging industries.
• Client metrics deteriorating: The number of clients contributing revenue in excess
of USD 1 mn stood at 119 (115 in Q4). USD 10 mn plus (declined by 1) and USD 20
mn plus (flat) client counts stand at 22 and 14 in the respective categories. The top
client’s (HP) revenue declined 8.3% Q-o-Q. Similar trend was seen in Top 5 and Top
10 clients where revenue declined 5.0% and 10.4% Q-o-Q, respectively.
• Hedging: Mphasis has hedges worth USD 480 mn, AUD 40 mn and GBP 40 mn.
• DSO increased by 11 days to 94 from 83 in the previous quarter.
• Cash and equivalents: The company’s cash generation remains healthy, with cash
and equivalents balance at INR 17.8 bn against INR 16.4 bn in the previous quarter.
Company Description
Mphasis is a tier-II and one of the top 10-IT integrated software services vendors in
India. The company provides IT services, mainly focused on banking, financial services,
and insurance segments. It has one of the largest BPO practices in India, providing
voice- and transaction-based services. In June 2006, Electronic Data Systems (EDS)
bought a majority stake in Mphasis and now, its total holding stands at 60.61%. EDS is
now acquired by Hewlett Packard (HP). The company has total employee strength of
41,059 (23,936 plus in IT services and around 15,661 in BPO services).
Investment Theme
HP as the owner, issues such as size and scale, market access, and enhanced capabilities
in offshore delivery are improving at healthy pace. Incremental business for Mphasis is
likely to come from direct working with HP clients and that now contributes 68% to its
revenues. However, with HP being the major client and shareholder as well, the
dependency risk has increased substantially along bill rate pressure that is being
witnessed currently. We see inadequate investments to grow non-HP business to impact
the growth rates going forward as HP business is also undergoing rationalisation.
Further, sharp increase in effective tax rates will restrict the growth rate at net profit
level over the next two years.
Key Risks
Key risks to our investment theme include: (a) no further bill rate pressure from HP; (b)
fast scale-up of non-HP business; and (c) depreciation of rupee against USD, GBP, and
EUR.
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