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Mphasis BFL (MPHL)
Technology
Cut earnings and target price; rehash our structural discomfort with the stock. A
shocker of an earnings report for the Jan 2011 quarter should drive massive estimate
cuts across the Street, as it has in our case. More than this, however, we would advise
investors to focus on the structurally high earnings risk that Mphasis’ quasi-captive
business model entails – this should have a bearing on the stock’s relative valuation
multiples, always. We reiterate our SELL rating; target price reduced to Rs420.
Mphasis BFL
Stock data Forecasts/Valuations 2011 2012E 2013E
Bottom line – Mphasis is a quasi-captive and valuations should reflect that
The revenue shock that Mphasis’ Jan 2011 quarter results gave the market should drive home a
couple of important points that we have been highlighting consistently – (1) Mphasis’ fortunes
remain tied to HP’s services business performance, off-shoring potential of such business, and HP’s
inclination to push the offshore model. Fact remains that Mphasis derives 70% of its revenues
from the HP channel and has not invested enough in harnessing the non-HP channel over the past
few years, and (2) HP’s offshore presence is already meaningful and hence a no-holds-barred
sustained revenue growth expectation from the HP channel is fraught with a lot of risk.
Looking back a tad, it was not difficult to get excited about Mphasis’ revenue performance
through the downturn – a phase when the company outperformed every other industry player on
revenue growth for a good period of time. The issue is that the excitement soon turned into
unbridled optimism on the HP channel remaining a huge engine of growth for many years to
come. We always found the rationale unconvincing (and kept highlighting the same) on account
of two factors – (1) a large portion of HP’s services revenues came from Government contracts and
hardware/software support – off-shoring potential of such segments is low, and (2) HP’s offshore
presence (Mphasis and HP-India) started reaching levels (in terms of % of total global workforce)
where peers like IBM and Accenture started to hit a wall in terms of offshore growth.
Margin performance over the past few quarters and cost break-up (low gross margins, low SG&A)
also reflect the quasi-captive nature of Mphasis’ business. The company has little control over HP
channel profitability – bi-annual pricing reviews (Mphasis has those with HP and these have
resulted only in a price cut every time thus far) are not typical of standard third-party IT
outsourcing contracts in the industry. It is important to note that despite the sharp margin fall over
the past few quarters, margins may not have bottomed out for the company – there are strong
headwinds in the form of expected strong wage inflation for the industry, step-up in S&M spend,
potential of further price cuts in the HP business, and incremental RSU expenses (the company,
under a new policy, would be issuing restricted stock units to select employees from now on).
To reiterate – target multiples on Mphasis should reflect the earnings risk arising from the quasicaptive
nature of the business. Arguments of an MNC-subsidiary premium have little merit.
Argument that bad results are a prelude to de-listing has little meaning
We concede – from an HP standpoint, having Mphasis listed in India makes little sense. HP
delisted Digital for precisely the same reason. HP has two subsidiaries or captives in India (HP
India and Mphasis) and having one listed makes little sense. However, this argument held as
true 3 years back as it holds today. We believe that viewing the poor Jan 2011 results as a
prelude to an eventual buyback would be missing a key point – the poor results are a
function of structural challenges with the business model, as discussed in detail on the
previous page.
Key highlights from the earnings call
Management indicated that disclosure of one-off milestone-booking revenues in the Oct
2010 quarter would have equated to a forward guidance and hence they did not disclose
the same in the previous quarter. We disagree, such a disclosure would have been a
comment on past performance; of course, it would have served the Street well on
formulating estimates for the Jan 2011 quarter but would not have been a forwardlooking
guidance, even in spirit, in our view.
The company suggested ‘sluggishness’ in business from the HP channel – it has so far
worked with the Enterprise Services segment of HP and indicated that it would need to
(and is working on) garner business from other segments within HP to deliver growth in
the HP channel revenues. The company has set up a dedicated sales team to drive this
effort.
Selective price cuts in the HP channel impacted revenues for only 2 months in the Jan
2011 quarter and full impact would be visible only in the Apr 2011 quarter. Next review
with HP is due in the May-June 2011 timeframe.
Attrition remains high at around 29% in the apps segment, and 25% in ITO.
The company has formulated a new RSU plan and would start granting Mphasis RSUs to
the management team from the Apr 2011 quarter. We note that the senior management
of Mphasis used to receive HP RSUs earlier. The company indicated that some RSUs have
already been granted on Feb 1 – these have a vesting period of 2 years and the company
would charge the RSU expense to the P&L over this timeframe.
Increase in DSO was on account of a change in invoicing procedure at HP and receivable
days should normalize in the next quarter.
Expects ETR of 24-25% post STP tax exemption expiry (March 2011, unless extended in
the budget).
Earnings revisions – massive cuts
We have revised downwards our revenue estimates for fiscal year-ending Oct 2011 and Oct
2012 by 11% and 12% to US$1.2 bn and US$1.4 bn, respectively. Note that our revenue
estimates for the current year assumes a recovery of revenues lost on account of holiday
shutdowns in the Jan 2011 quarter and a 5% CQGR on top of that for the next three
quarters. Our EBITDA margin estimates for the two years stand at 18.4% and 17.6%, down
440 bps and 450 bps, respectively. Revised EPS estimates for fiscal year-ending Oct 2011
and Oct 2012 stand at Rs37. 3/share and Rs38.1/share, respectively, a 24-25% cut versus
earlier estimates.
We cut our target price on the stock to Rs420/share and reiterate our SELL rating. Our TP
implies a PE multiple of 11X on Oct-12 EPS.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Mphasis BFL (MPHL)
Technology
Cut earnings and target price; rehash our structural discomfort with the stock. A
shocker of an earnings report for the Jan 2011 quarter should drive massive estimate
cuts across the Street, as it has in our case. More than this, however, we would advise
investors to focus on the structurally high earnings risk that Mphasis’ quasi-captive
business model entails – this should have a bearing on the stock’s relative valuation
multiples, always. We reiterate our SELL rating; target price reduced to Rs420.
Mphasis BFL
Stock data Forecasts/Valuations 2011 2012E 2013E
Bottom line – Mphasis is a quasi-captive and valuations should reflect that
The revenue shock that Mphasis’ Jan 2011 quarter results gave the market should drive home a
couple of important points that we have been highlighting consistently – (1) Mphasis’ fortunes
remain tied to HP’s services business performance, off-shoring potential of such business, and HP’s
inclination to push the offshore model. Fact remains that Mphasis derives 70% of its revenues
from the HP channel and has not invested enough in harnessing the non-HP channel over the past
few years, and (2) HP’s offshore presence is already meaningful and hence a no-holds-barred
sustained revenue growth expectation from the HP channel is fraught with a lot of risk.
Looking back a tad, it was not difficult to get excited about Mphasis’ revenue performance
through the downturn – a phase when the company outperformed every other industry player on
revenue growth for a good period of time. The issue is that the excitement soon turned into
unbridled optimism on the HP channel remaining a huge engine of growth for many years to
come. We always found the rationale unconvincing (and kept highlighting the same) on account
of two factors – (1) a large portion of HP’s services revenues came from Government contracts and
hardware/software support – off-shoring potential of such segments is low, and (2) HP’s offshore
presence (Mphasis and HP-India) started reaching levels (in terms of % of total global workforce)
where peers like IBM and Accenture started to hit a wall in terms of offshore growth.
Margin performance over the past few quarters and cost break-up (low gross margins, low SG&A)
also reflect the quasi-captive nature of Mphasis’ business. The company has little control over HP
channel profitability – bi-annual pricing reviews (Mphasis has those with HP and these have
resulted only in a price cut every time thus far) are not typical of standard third-party IT
outsourcing contracts in the industry. It is important to note that despite the sharp margin fall over
the past few quarters, margins may not have bottomed out for the company – there are strong
headwinds in the form of expected strong wage inflation for the industry, step-up in S&M spend,
potential of further price cuts in the HP business, and incremental RSU expenses (the company,
under a new policy, would be issuing restricted stock units to select employees from now on).
To reiterate – target multiples on Mphasis should reflect the earnings risk arising from the quasicaptive
nature of the business. Arguments of an MNC-subsidiary premium have little merit.
Argument that bad results are a prelude to de-listing has little meaning
We concede – from an HP standpoint, having Mphasis listed in India makes little sense. HP
delisted Digital for precisely the same reason. HP has two subsidiaries or captives in India (HP
India and Mphasis) and having one listed makes little sense. However, this argument held as
true 3 years back as it holds today. We believe that viewing the poor Jan 2011 results as a
prelude to an eventual buyback would be missing a key point – the poor results are a
function of structural challenges with the business model, as discussed in detail on the
previous page.
Key highlights from the earnings call
Management indicated that disclosure of one-off milestone-booking revenues in the Oct
2010 quarter would have equated to a forward guidance and hence they did not disclose
the same in the previous quarter. We disagree, such a disclosure would have been a
comment on past performance; of course, it would have served the Street well on
formulating estimates for the Jan 2011 quarter but would not have been a forwardlooking
guidance, even in spirit, in our view.
The company suggested ‘sluggishness’ in business from the HP channel – it has so far
worked with the Enterprise Services segment of HP and indicated that it would need to
(and is working on) garner business from other segments within HP to deliver growth in
the HP channel revenues. The company has set up a dedicated sales team to drive this
effort.
Selective price cuts in the HP channel impacted revenues for only 2 months in the Jan
2011 quarter and full impact would be visible only in the Apr 2011 quarter. Next review
with HP is due in the May-June 2011 timeframe.
Attrition remains high at around 29% in the apps segment, and 25% in ITO.
The company has formulated a new RSU plan and would start granting Mphasis RSUs to
the management team from the Apr 2011 quarter. We note that the senior management
of Mphasis used to receive HP RSUs earlier. The company indicated that some RSUs have
already been granted on Feb 1 – these have a vesting period of 2 years and the company
would charge the RSU expense to the P&L over this timeframe.
Increase in DSO was on account of a change in invoicing procedure at HP and receivable
days should normalize in the next quarter.
Expects ETR of 24-25% post STP tax exemption expiry (March 2011, unless extended in
the budget).
Earnings revisions – massive cuts
We have revised downwards our revenue estimates for fiscal year-ending Oct 2011 and Oct
2012 by 11% and 12% to US$1.2 bn and US$1.4 bn, respectively. Note that our revenue
estimates for the current year assumes a recovery of revenues lost on account of holiday
shutdowns in the Jan 2011 quarter and a 5% CQGR on top of that for the next three
quarters. Our EBITDA margin estimates for the two years stand at 18.4% and 17.6%, down
440 bps and 450 bps, respectively. Revised EPS estimates for fiscal year-ending Oct 2011
and Oct 2012 stand at Rs37. 3/share and Rs38.1/share, respectively, a 24-25% cut versus
earlier estimates.
We cut our target price on the stock to Rs420/share and reiterate our SELL rating. Our TP
implies a PE multiple of 11X on Oct-12 EPS.
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