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MphasiS
Expect limited upside
We believe management's focus on driving the Non-HP business (~30% of
revenues) implies risk to the recent high growth from HP business (~70%) and to
overall margins, considering the incremental investment. Given recent stock
outperformance, we see lower potential upside and initiate coverage with a Hold
We see risk to revenue growth momentum
We believe that the revenue growth momentum MphasiS derives through its parent, Hewlett-
Packard (about 70% of MphasiS revenues in FY10), is slowing, given the recent decline in
growth yoy (in contrast to growth in non-HP business) and management’s greater focus on
the non-HP (direct) business. In our view, achieving high growth in the direct business will be
a challenge considering large-cap peers have a considerable head start and given MphasiS’
relative underinvestment here. We expect a CAGR of 22% for USD revenue (excl. cash-flow
hedges) in FY11-13F (on April-end), which is a little lower than our estimates for some of the
other large-cap Indian IT peers, which derive growth mainly from their direct businesses.
However, our forecast is higher than the estimates for our other Indian IT midcaps.
Margin headwinds higher for MphasiS versus large cap peers, in our view
We believe margin headwinds for MphasiS are getting higher with: 1) a semi-annual
renegotiation cycle for HP channel revenues and resulting volume discounts during times of
rising demand; 2) greater focus on the direct business and the ensuing rise in sales and
marketing expenses; 3) increasing supply-side issues given MphasiS’s high attrition (trailing
12 months, or TTM) of 30% and 25% in the application and ITO businesses respectively in
4QFY10 (up from 20% and 25% qoq) and high dependence on laterals.
We see limited upside and initiate with a Hold
With likely risk to growth momentum in revenues and margins, as explained above, we
expect MphasiS’s growth to lag that of its large cap peers in our coverage over the medium
term. After recent strong share price gains, we initiate coverage at Hold with a target price of
Rs690, derived by applying a 12x PE to four quarters’ EPS ending April 2013F (about 40%
discount to our target PE valuation for Infosys, given the earnings risk we see). However, we
prefer MphasiS over the other midcap Indian IT companies in our universe and would see
any significant correction as a buying opportunity
The basics
Catalysts for share price performance
We expect the key near-term catalysts to be:
Despite our lower revenue growth expectation for MphasiS over FY11-13 (April-end) versus its
Indian IT large-cap peers, we believe MphasiS’s revenue growth should be better than that of
its mid-cap peers.
CY11F IT budget finalisation with higher growth in outsourcing and offshoring for the Indian IT
Industry.
Cognizant’s guidance for CY11 (in February 2011) and Infosys’s guidance for FY12 in April
2011. While building in its typical conservatism, we expect Infosys to take a more confident
stance on FY12 guidance.
Renewal opportunity of large outsourcing deals worth US$174bn over the next eight quarters
starting in 4QCY10. With HP’s much higher scale in IT service business globally, we believe
MphasiS, through HP, would gain relatively more than its mid cap peers from this large
renewal opportunity.
Earnings momentum
Despite our outlook of strong demand momentum for IT services in the coming years, we
expect MphasiS’s revenue growth momentum to be little lower than the Indian IT large cap
peers considering a likely slowdown in volume growth from the HP channels and low scale in
the direct business.
We expect MphasiS’s margins to decline over the medium term, with continuing pressure on
billing rates in the HP channels, higher investment in the direct business and higher supplyside
issues. Besides, higher tax rates will likely impact EPS growth in FY11F and FY12F.
We assume US dollar revenue (excluding cash-flow hedges), rupee EBITDA and rupee EPS
CAGRs of 21%, 12% and 6%, respectively for FY10-FY13 (October-end).
Valuation and target price
With the risks to momentum in revenue growth and margins outlined above, we expect MphasiS’
growth to lag that of its large cap peers in our coverage universe over the medium term. Even the
recent stock out performance offers limited upside. Hence we initiate coverage with a Hold rating
and a target price of Rs690, applying a 12x PE multiple to four quarters’ EPS ending April 2013F
(roughly a 40% discount to our PE valuation for the Indian IT industry benchmark, Infosys).
How we differ from consensus
Our FY11F and FY12F EPS are 3-4% lower than Bloomberg consensus due to our lower EBITDA
estimates.
Risks to central scenario
We assume declining volume growth momentum for HP channel revenues, hence any
acceleration here would be a positive surprise.
Any corporate event, including de-listing of MphasiS by HP, which has a 61% stake, could
drive up the share price. (Although HP has not suggested this).
Better margin performance than we assume is an upside risk.
A sharp rupee depreciation vs the US dollar would be more beneficial to MphasiS than its
peers considering its higher proportion of offshore revenues.
Faster-than-expected economic recovery in the US/Europe would be beneficial to MphasiS.
However, we believe that in such a scenario, the upside potential would be greater for peers
considering their higher bases in the direct business within US/Europe.
Fiscal austerity and resulting protectionism measures in western economies is a downside
risk.
Revenue growth momentum at risk
Given the likely risk to the recent high growth in the HP channel business and the lower
base outside of the HP channel (the direct business), we expect MphasiS’s revenue growth
rates to lag large cap Indian IT peers in the medium term.
We believe that the revenue growth momentum MphasiS derives through its parent, Hewlett-
Packard (about 70% of MphasiS revenues in FY10), is slowing, given the recent decline in growth
yoy (in contrast to growth in non-HP business) and management’s greater focus on the non-HP
(direct) business. In our view, achieving high growth in the direct business will be a challenge
considering large-cap peers have a considerable head start and given MphasiS’ relative
underinvestment here. We expect a CAGR of 22% for USD revenue (excl. cash-flow hedges) in
FY11-13F (on April-end), which is a little lower than our estimates for some of the other large-cap
Indian IT peers, which derive growth mainly from their direct businesses. However, our forecast is
higher than the estimates for our other Indian IT midcaps.
Growth momentum from HP business slowing down
MphasiS derives around 70% of its revenues from different HP channels: 1) go-to-market, which
contributes around 40% of revenues; 2) migration, which represents roughly 20%; and 3) internal
work, which constitutes some 10% (please see Table 3 for details). Migration and internal channel
revenues are based on a fixed rate card which is renewed every six months. The go-to-market
channel revenues are based on market-driven prices.
MphasiS derives close to 65% of its revenues from application services, 12% from BPO services
and 23% from ITO (Infrastructure outsourcing). We estimate that HP accounts for more than 95%
of the ITO business, over 40% of BPO revenue and in excess of 60% of the application business.
We believe that MphasiS’s positioning in most services is driven by HP channels, indicating its low
pricing power during times of rising demand.
The potential for volume growth from HP channels remains high considering that the overall
addressable size of HP channel revenues is significantly higher than MphasiS’s current HP
channel revenues. We believe the company’s high revenue growth phase from its HP channel is
behind it, given just 18-20% growth in HP channels in FY10 (some large-cap peers reported 18-
19% USD revenue growth for the 12-month period ending 30 September 2010) and increasing
management focus on the non-HP business. Management even suggests that parent HP is
stepping up offshoring to best shore locations other than India (including China, Latin America and
Eastern Europe). This indicates potential volume growth pressure in the HP channels considering
MphasiS’s negligible presence in these locations.
According to management, the company’s verticals, including technology and OEMs (original
equipment manufacturers), manufacturing, retail and telecom, which together contribute 44% of
revenues) are relatively higher, dependent on HP channel revenues vs the company average. Our
macro analysis indicates that telecom and OEMs (more than 25% of MphasiS’s total revenue) are
unlikely to create high growth opportunities for Indian IT firms.
Semi-annual rate renegotiation cycle poses risk
The semi-annual renegotiation cycle for billing rates relating to HP channel revenues poses a risk
to revenue growth and profitability, in our view. The renegotiation in 3QFY10 resulted in a fixed
rate card for non-go-to-market services (28-30% of revenues) vs the earlier cost-plus method,
which implies that MphasiS cannot pass on cost inflation. We see this as negative, as during
times of recovery, supply-side pressure rises to meet increasing demand. Secondly, as per the
renegotiation, a structural discount will be passed on to the parent for the go-to-market services
(about 40% of revenues), implying that MphasiS needs to further improve productivity gains to
maintain margins. This led to a significant decline of about 10% qoq in offshore billing rates in
3QFY10 alone for the application business, while offshore rates for ITO in 1QFY10 were down by
a significant 18% qoq.
We therefore believe that profitability is at risk although volume growth potential in HP channels
remains high. However, any further downward revision to offshore billing rates in applications and
ITO is unlikely to be significant.
Increasing focus on Non-HP business seems unlikely to yield results
Post reporting US$1.1bn worth of revenues in FY10, MphasiS has now articulated a strategy to
drive the next US$1bn revenues through i) a higher focus in emerging geographies outside of the
US, Europe, Australia and New Zealand; ii) leveraging its strength in BFSI (contributing around
40-42% of revenues) for its direct business across geographies besides cross selling domain
expertise in other verticals; iii) non-linear initiatives within healthcare and payment solutions, and
iv) M&A initiatives.
We believe the above strategies are unlikely to give the required scale for growth considering the
competitive pressure and MphasiS’s lower scale in BFSI, emerging geographies and non-linear
initiatives. Secondly, we believe these strategies not only require more investment in sales and
marketing, but also gross margins in some of these initiatives (eg increasing focus in emerging
geographies) are likely to be lower considering the low revenue productivity in these markets.
Even relating to non-linear initiatives, we believe the current scale of MphasiS is immaterial versus
peers despite its rich solution offerings, such as in the healthcare vertical
We believe that MphasiS’s revenue growth rates are unlikely to outperform those of peers from
here on, considering the likely decline in growth momentum from HP channel revenues as well as
increasing focus on driving direct business (where we MphasiS will face high competitive
challenges).
Increasing margin headwinds
Besides the increasing risk we see to revenue momentum in the medium term, we suspect
current margins will prove unsustainable given the various headwinds MphasiS faces.
We believe that margin headwinds MphasiS faces are increasing, with i) the semi-annual
renegotiation cycle with HP and resulting volume discount during times of rising demand, ii)
management’s greater focus on direct business and ensuing rise in sales and marketing costs,
and iii) increasing supply-side issues with MphasiS’s high attrition (TTM) of 30% and 25% in
application and ITO respectively in 4QFY10 (up from 20% and 25% qoq) and greater dependence
on laterals.
Semi-annual rate negotiation cycle with HP
Another semi annual cycle is due in beginning of 1HFY11. The quantum of downward rate
revision may not be big given the sharp revision in the last cycle (2Q-3QFY10). However we still
consider this a negative, as HP channel business represents the largest contributor of revenues
for MphasiS, and the company therefore faces rate pressure at a time of rising demand for the
industry.
S&M spend to remain high to support the diversification strategy
MphasiS is now looking to diversify revenues beyond the HP channel from FY11. MphasiS’s S&M
spend is lower than Indian IT peers due to high revenue contribution coming from HP channel
business. However, with management’s increased focus on direct business and likely decline in
growth momentum in the HP channel (as explained earlier), a greater investment in sales and
marketing is likely to be required.
We believe this transition is already underway, and that MphasiS’s low base of direct business
means higher front end investments would be required to drive long-term revenue growth.
Therefore, besides billing rate pressure from HP (as discussed earlier), front-end investment in
sales and marketing will likely place an additional burden on margins. Peers with much higher
bases in direct business will have made such investments earlier, and should therefore see the
results that much earlier, through higher volume growth and resulting economies of scale.
Supply-side issues increasing
One of the reasons for MphasiS’s lower gross margins versus peers despite its high offshore
revenues, is its high dependence on laterals and subcontractors. We believe this is detrimental for
MphasiS, as its attrition within lateral employees is the highest within the industry. MphasiS’s
4QFY10 attrition on a trailing twelve months basis (TTM) was 30% and 25% in application and
ITO respectively (up from 20% and 25% qoq). We believe that management is now open to out-
of-turn promotions as well as other measures to control the attrition, which will have an additional
impact on margins. Recently, MphasiS has introduced its own RSU (restricted stock units)
scheme, replacing the earlier RSUs of HP (where the cost was borne by HP). With this, we
believe that effect on margins from RSU charges will be incremental from FY11. Second, the
weighting on revenue growth vs EPS growth has increased as one of the conditions for RSU
vesting for senior employees. We think this also indicates increasing revenue growth challenges
and likely risk to margins.
Headroom in other potential margin levers is lower
Besides the pressure on margins from parameters discussed above, we believe that headroom in
other margin levers, including utilisation rates and G&A (general and administration) costs, is
lower for MphasiS than for peers. Within G&A, despite robust CAGR of 7.3% in revenues from
1QFY08-4QFY10, the G&A increase was just 3% over the same period. G&A costs declined from
6.4% of revenues in 1QFY08 to 4.1% of revenues in 4QFY10. This was largely through facility
consolidation as well as other efficiencies. With most of the major gains from these measures
behind us, we expect minimal further benefits through G&A cost efficiencies going forward.
Even on utilisation rates, we believe that headroom for improvement in some of the businesses,
including application and BPO, is lower considering MphasiS’s current high attrition rates.
Initiate with Hold
With the risk to revenue growth momentum outlined earlier, we expect MphasiS’s revenue
and EBITDA growth rates to lag its large cap peers going forward. Considering recent
strong stock performance, we expect limited upside from current levels; initiate at Hold
Our target price of Rs690 is based on applying a 12x PE to four quarters’ EPS ending April 2013F
(40% discount to our fair value multiple for the Indian IT industry bench mark, Infosys, similar to its
last 12m average discount), which we believe is fair considering the relatively high risk to earnings
we see (despite material business flowing through parent HP) versus large cap peers with their
much bigger bases and higher growth in their direct businesses. However we prefer MphasiS over
the other midcap Indian IT companies in our universe considering its higher revenue visibility,
higher cash generation and better ROIC, on our forecasts. We would see any significant
correction as a buying opportunity.
Key upside to our recommendation/target price are i) any acceleration in volume growth from HP;
ii) any corporate event including delisting of MphasiS by parent HP; iii) better margin performance
than we assume; iv) a sharp rupee depreciation versus the US dollar and v) faster than expected
economic recovery in developed markets. Downside risks are: 1) a sharp rupee appreciation; 2) a
further deterioration in the macro environment in western economies and 3) fiscal austerity and
resulting protectionism measures in western economies.
Management team
US-headquartered HP Group, through its group company EDS, owns a 60.5% equity stake in
MphasiS. Acquisition of the controlling stake in MphasiS by EDS was driven by a motive to
accelerate the offshoring of the HP-EDS services business to India. This resulted in HP channel
revenues contributing as much as ~70% of MphasiS’s revenues. While MphasiS’ day-to-day
operations are run by a team of professionals under the leadership of Mr Ganesh Ayyar (CEO and
Managing Director), the board of directors includes five directors (out of nine) from HP Group.
Before joining MphasiS as CEO in January 2009, Mr Ganesh Ayyar has spent over 18 years in
HP Group. With MphasiS’ working capital management lagging that of large-cap peers, as well as
its inorganic plans, its dividend payout ratio has been lower at around 8-10%.
India Equity Research Reports, IPO and Stock News
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MphasiS
Expect limited upside
We believe management's focus on driving the Non-HP business (~30% of
revenues) implies risk to the recent high growth from HP business (~70%) and to
overall margins, considering the incremental investment. Given recent stock
outperformance, we see lower potential upside and initiate coverage with a Hold
We see risk to revenue growth momentum
We believe that the revenue growth momentum MphasiS derives through its parent, Hewlett-
Packard (about 70% of MphasiS revenues in FY10), is slowing, given the recent decline in
growth yoy (in contrast to growth in non-HP business) and management’s greater focus on
the non-HP (direct) business. In our view, achieving high growth in the direct business will be
a challenge considering large-cap peers have a considerable head start and given MphasiS’
relative underinvestment here. We expect a CAGR of 22% for USD revenue (excl. cash-flow
hedges) in FY11-13F (on April-end), which is a little lower than our estimates for some of the
other large-cap Indian IT peers, which derive growth mainly from their direct businesses.
However, our forecast is higher than the estimates for our other Indian IT midcaps.
Margin headwinds higher for MphasiS versus large cap peers, in our view
We believe margin headwinds for MphasiS are getting higher with: 1) a semi-annual
renegotiation cycle for HP channel revenues and resulting volume discounts during times of
rising demand; 2) greater focus on the direct business and the ensuing rise in sales and
marketing expenses; 3) increasing supply-side issues given MphasiS’s high attrition (trailing
12 months, or TTM) of 30% and 25% in the application and ITO businesses respectively in
4QFY10 (up from 20% and 25% qoq) and high dependence on laterals.
We see limited upside and initiate with a Hold
With likely risk to growth momentum in revenues and margins, as explained above, we
expect MphasiS’s growth to lag that of its large cap peers in our coverage over the medium
term. After recent strong share price gains, we initiate coverage at Hold with a target price of
Rs690, derived by applying a 12x PE to four quarters’ EPS ending April 2013F (about 40%
discount to our target PE valuation for Infosys, given the earnings risk we see). However, we
prefer MphasiS over the other midcap Indian IT companies in our universe and would see
any significant correction as a buying opportunity
The basics
Catalysts for share price performance
We expect the key near-term catalysts to be:
Despite our lower revenue growth expectation for MphasiS over FY11-13 (April-end) versus its
Indian IT large-cap peers, we believe MphasiS’s revenue growth should be better than that of
its mid-cap peers.
CY11F IT budget finalisation with higher growth in outsourcing and offshoring for the Indian IT
Industry.
Cognizant’s guidance for CY11 (in February 2011) and Infosys’s guidance for FY12 in April
2011. While building in its typical conservatism, we expect Infosys to take a more confident
stance on FY12 guidance.
Renewal opportunity of large outsourcing deals worth US$174bn over the next eight quarters
starting in 4QCY10. With HP’s much higher scale in IT service business globally, we believe
MphasiS, through HP, would gain relatively more than its mid cap peers from this large
renewal opportunity.
Earnings momentum
Despite our outlook of strong demand momentum for IT services in the coming years, we
expect MphasiS’s revenue growth momentum to be little lower than the Indian IT large cap
peers considering a likely slowdown in volume growth from the HP channels and low scale in
the direct business.
We expect MphasiS’s margins to decline over the medium term, with continuing pressure on
billing rates in the HP channels, higher investment in the direct business and higher supplyside
issues. Besides, higher tax rates will likely impact EPS growth in FY11F and FY12F.
We assume US dollar revenue (excluding cash-flow hedges), rupee EBITDA and rupee EPS
CAGRs of 21%, 12% and 6%, respectively for FY10-FY13 (October-end).
Valuation and target price
With the risks to momentum in revenue growth and margins outlined above, we expect MphasiS’
growth to lag that of its large cap peers in our coverage universe over the medium term. Even the
recent stock out performance offers limited upside. Hence we initiate coverage with a Hold rating
and a target price of Rs690, applying a 12x PE multiple to four quarters’ EPS ending April 2013F
(roughly a 40% discount to our PE valuation for the Indian IT industry benchmark, Infosys).
How we differ from consensus
Our FY11F and FY12F EPS are 3-4% lower than Bloomberg consensus due to our lower EBITDA
estimates.
Risks to central scenario
We assume declining volume growth momentum for HP channel revenues, hence any
acceleration here would be a positive surprise.
Any corporate event, including de-listing of MphasiS by HP, which has a 61% stake, could
drive up the share price. (Although HP has not suggested this).
Better margin performance than we assume is an upside risk.
A sharp rupee depreciation vs the US dollar would be more beneficial to MphasiS than its
peers considering its higher proportion of offshore revenues.
Faster-than-expected economic recovery in the US/Europe would be beneficial to MphasiS.
However, we believe that in such a scenario, the upside potential would be greater for peers
considering their higher bases in the direct business within US/Europe.
Fiscal austerity and resulting protectionism measures in western economies is a downside
risk.
Revenue growth momentum at risk
Given the likely risk to the recent high growth in the HP channel business and the lower
base outside of the HP channel (the direct business), we expect MphasiS’s revenue growth
rates to lag large cap Indian IT peers in the medium term.
We believe that the revenue growth momentum MphasiS derives through its parent, Hewlett-
Packard (about 70% of MphasiS revenues in FY10), is slowing, given the recent decline in growth
yoy (in contrast to growth in non-HP business) and management’s greater focus on the non-HP
(direct) business. In our view, achieving high growth in the direct business will be a challenge
considering large-cap peers have a considerable head start and given MphasiS’ relative
underinvestment here. We expect a CAGR of 22% for USD revenue (excl. cash-flow hedges) in
FY11-13F (on April-end), which is a little lower than our estimates for some of the other large-cap
Indian IT peers, which derive growth mainly from their direct businesses. However, our forecast is
higher than the estimates for our other Indian IT midcaps.
Growth momentum from HP business slowing down
MphasiS derives around 70% of its revenues from different HP channels: 1) go-to-market, which
contributes around 40% of revenues; 2) migration, which represents roughly 20%; and 3) internal
work, which constitutes some 10% (please see Table 3 for details). Migration and internal channel
revenues are based on a fixed rate card which is renewed every six months. The go-to-market
channel revenues are based on market-driven prices.
MphasiS derives close to 65% of its revenues from application services, 12% from BPO services
and 23% from ITO (Infrastructure outsourcing). We estimate that HP accounts for more than 95%
of the ITO business, over 40% of BPO revenue and in excess of 60% of the application business.
We believe that MphasiS’s positioning in most services is driven by HP channels, indicating its low
pricing power during times of rising demand.
The potential for volume growth from HP channels remains high considering that the overall
addressable size of HP channel revenues is significantly higher than MphasiS’s current HP
channel revenues. We believe the company’s high revenue growth phase from its HP channel is
behind it, given just 18-20% growth in HP channels in FY10 (some large-cap peers reported 18-
19% USD revenue growth for the 12-month period ending 30 September 2010) and increasing
management focus on the non-HP business. Management even suggests that parent HP is
stepping up offshoring to best shore locations other than India (including China, Latin America and
Eastern Europe). This indicates potential volume growth pressure in the HP channels considering
MphasiS’s negligible presence in these locations.
According to management, the company’s verticals, including technology and OEMs (original
equipment manufacturers), manufacturing, retail and telecom, which together contribute 44% of
revenues) are relatively higher, dependent on HP channel revenues vs the company average. Our
macro analysis indicates that telecom and OEMs (more than 25% of MphasiS’s total revenue) are
unlikely to create high growth opportunities for Indian IT firms.
Semi-annual rate renegotiation cycle poses risk
The semi-annual renegotiation cycle for billing rates relating to HP channel revenues poses a risk
to revenue growth and profitability, in our view. The renegotiation in 3QFY10 resulted in a fixed
rate card for non-go-to-market services (28-30% of revenues) vs the earlier cost-plus method,
which implies that MphasiS cannot pass on cost inflation. We see this as negative, as during
times of recovery, supply-side pressure rises to meet increasing demand. Secondly, as per the
renegotiation, a structural discount will be passed on to the parent for the go-to-market services
(about 40% of revenues), implying that MphasiS needs to further improve productivity gains to
maintain margins. This led to a significant decline of about 10% qoq in offshore billing rates in
3QFY10 alone for the application business, while offshore rates for ITO in 1QFY10 were down by
a significant 18% qoq.
We therefore believe that profitability is at risk although volume growth potential in HP channels
remains high. However, any further downward revision to offshore billing rates in applications and
ITO is unlikely to be significant.
Increasing focus on Non-HP business seems unlikely to yield results
Post reporting US$1.1bn worth of revenues in FY10, MphasiS has now articulated a strategy to
drive the next US$1bn revenues through i) a higher focus in emerging geographies outside of the
US, Europe, Australia and New Zealand; ii) leveraging its strength in BFSI (contributing around
40-42% of revenues) for its direct business across geographies besides cross selling domain
expertise in other verticals; iii) non-linear initiatives within healthcare and payment solutions, and
iv) M&A initiatives.
We believe the above strategies are unlikely to give the required scale for growth considering the
competitive pressure and MphasiS’s lower scale in BFSI, emerging geographies and non-linear
initiatives. Secondly, we believe these strategies not only require more investment in sales and
marketing, but also gross margins in some of these initiatives (eg increasing focus in emerging
geographies) are likely to be lower considering the low revenue productivity in these markets.
Even relating to non-linear initiatives, we believe the current scale of MphasiS is immaterial versus
peers despite its rich solution offerings, such as in the healthcare vertical
We believe that MphasiS’s revenue growth rates are unlikely to outperform those of peers from
here on, considering the likely decline in growth momentum from HP channel revenues as well as
increasing focus on driving direct business (where we MphasiS will face high competitive
challenges).
Increasing margin headwinds
Besides the increasing risk we see to revenue momentum in the medium term, we suspect
current margins will prove unsustainable given the various headwinds MphasiS faces.
We believe that margin headwinds MphasiS faces are increasing, with i) the semi-annual
renegotiation cycle with HP and resulting volume discount during times of rising demand, ii)
management’s greater focus on direct business and ensuing rise in sales and marketing costs,
and iii) increasing supply-side issues with MphasiS’s high attrition (TTM) of 30% and 25% in
application and ITO respectively in 4QFY10 (up from 20% and 25% qoq) and greater dependence
on laterals.
Semi-annual rate negotiation cycle with HP
Another semi annual cycle is due in beginning of 1HFY11. The quantum of downward rate
revision may not be big given the sharp revision in the last cycle (2Q-3QFY10). However we still
consider this a negative, as HP channel business represents the largest contributor of revenues
for MphasiS, and the company therefore faces rate pressure at a time of rising demand for the
industry.
S&M spend to remain high to support the diversification strategy
MphasiS is now looking to diversify revenues beyond the HP channel from FY11. MphasiS’s S&M
spend is lower than Indian IT peers due to high revenue contribution coming from HP channel
business. However, with management’s increased focus on direct business and likely decline in
growth momentum in the HP channel (as explained earlier), a greater investment in sales and
marketing is likely to be required.
We believe this transition is already underway, and that MphasiS’s low base of direct business
means higher front end investments would be required to drive long-term revenue growth.
Therefore, besides billing rate pressure from HP (as discussed earlier), front-end investment in
sales and marketing will likely place an additional burden on margins. Peers with much higher
bases in direct business will have made such investments earlier, and should therefore see the
results that much earlier, through higher volume growth and resulting economies of scale.
Supply-side issues increasing
One of the reasons for MphasiS’s lower gross margins versus peers despite its high offshore
revenues, is its high dependence on laterals and subcontractors. We believe this is detrimental for
MphasiS, as its attrition within lateral employees is the highest within the industry. MphasiS’s
4QFY10 attrition on a trailing twelve months basis (TTM) was 30% and 25% in application and
ITO respectively (up from 20% and 25% qoq). We believe that management is now open to out-
of-turn promotions as well as other measures to control the attrition, which will have an additional
impact on margins. Recently, MphasiS has introduced its own RSU (restricted stock units)
scheme, replacing the earlier RSUs of HP (where the cost was borne by HP). With this, we
believe that effect on margins from RSU charges will be incremental from FY11. Second, the
weighting on revenue growth vs EPS growth has increased as one of the conditions for RSU
vesting for senior employees. We think this also indicates increasing revenue growth challenges
and likely risk to margins.
Headroom in other potential margin levers is lower
Besides the pressure on margins from parameters discussed above, we believe that headroom in
other margin levers, including utilisation rates and G&A (general and administration) costs, is
lower for MphasiS than for peers. Within G&A, despite robust CAGR of 7.3% in revenues from
1QFY08-4QFY10, the G&A increase was just 3% over the same period. G&A costs declined from
6.4% of revenues in 1QFY08 to 4.1% of revenues in 4QFY10. This was largely through facility
consolidation as well as other efficiencies. With most of the major gains from these measures
behind us, we expect minimal further benefits through G&A cost efficiencies going forward.
Even on utilisation rates, we believe that headroom for improvement in some of the businesses,
including application and BPO, is lower considering MphasiS’s current high attrition rates.
Initiate with Hold
With the risk to revenue growth momentum outlined earlier, we expect MphasiS’s revenue
and EBITDA growth rates to lag its large cap peers going forward. Considering recent
strong stock performance, we expect limited upside from current levels; initiate at Hold
Our target price of Rs690 is based on applying a 12x PE to four quarters’ EPS ending April 2013F
(40% discount to our fair value multiple for the Indian IT industry bench mark, Infosys, similar to its
last 12m average discount), which we believe is fair considering the relatively high risk to earnings
we see (despite material business flowing through parent HP) versus large cap peers with their
much bigger bases and higher growth in their direct businesses. However we prefer MphasiS over
the other midcap Indian IT companies in our universe considering its higher revenue visibility,
higher cash generation and better ROIC, on our forecasts. We would see any significant
correction as a buying opportunity.
Key upside to our recommendation/target price are i) any acceleration in volume growth from HP;
ii) any corporate event including delisting of MphasiS by parent HP; iii) better margin performance
than we assume; iv) a sharp rupee depreciation versus the US dollar and v) faster than expected
economic recovery in developed markets. Downside risks are: 1) a sharp rupee appreciation; 2) a
further deterioration in the macro environment in western economies and 3) fiscal austerity and
resulting protectionism measures in western economies.
Management team
US-headquartered HP Group, through its group company EDS, owns a 60.5% equity stake in
MphasiS. Acquisition of the controlling stake in MphasiS by EDS was driven by a motive to
accelerate the offshoring of the HP-EDS services business to India. This resulted in HP channel
revenues contributing as much as ~70% of MphasiS’s revenues. While MphasiS’ day-to-day
operations are run by a team of professionals under the leadership of Mr Ganesh Ayyar (CEO and
Managing Director), the board of directors includes five directors (out of nine) from HP Group.
Before joining MphasiS as CEO in January 2009, Mr Ganesh Ayyar has spent over 18 years in
HP Group. With MphasiS’ working capital management lagging that of large-cap peers, as well as
its inorganic plans, its dividend payout ratio has been lower at around 8-10%.
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