Macquarie Research -Mphasis :Addendum confirms investor fears

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Mphasis
Addendum confirms investor fears
Event
 On Thursday after market close Mphasis released quarterly data on segment
revenue, profitability and billing rates. These regular quarterly metrics were
not made available post the 1Q results (Oct year end) declared last week.
 Following poor 1Q results and investor angst over disclosure issues the stock
has corrected 30%. The additional information provided now confirms the
margin pressure in the business coming from parent HP. We also note that
these metrics would no longer be reported beyond next three quarters. Retain
Underperform.

Impact
 Pricing pressure continues across segments. Offshore pricing for
Application services and ITO which constitute 64% and 24% of Mphasis
revenues have seen a 5% sequential decline for 1Q. BPO billing rates were
flat for 1Q. Further pressure on these cannot be ruled out (See Fig 2).
 Application Services suffers heavily in 1Q. US$ revenues declined by 10%
sequentially for the segment due to 5% decline in pricing and 300bps decline
in utilization. Furthermore gross margins dipped by 630bps in 1Q to 24.6% (vs
30.9% in 4Q). This segment constitutes 64% of revenues and 60% of profits
(for utilization and pricing trends please see Figs 1& 2).
 Still remain bearish on margins. Our negative investment view on Mphasis
is based on structural weakness in margins. Though, the company has
reported 300bp QoQ margin dip to 18% we believe further reduction in
margins is likely over the next 12 months. Our revised 17% EBIT margin
forecast is below the management guidance of 18% (for margin trends please
see Fig 3).
 Our detailed thesis on margins and analysis of the de-listing angle can be
accessed at Mphasis – Parental Control; Retain Underperform, 28 Feb 2011
(LINK)
Earnings and target price revision
 No change.
Price catalyst
 12-month price target: Rs380.00 based on Other methodology.
 Catalyst: Pricing renegotiations with HP
Action and recommendation
 Retain UP. Switch to HCLT which we estimate to have 33% earnings growth
during FY11-13E and benefit from rise in discretionary spend.