Sell CYIENT -Target: RS.539 :: Kotak Sec,report

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CYIENT LTD (CYIENT)
PRICE: RS.578 RECOMMENDATION: SELL
TARGET PRICE: RS.539 FY16E P/E: 14.6X
Headline numbers came above estimates. However, revenue growth and
margin improvement were largely led by early recognition of revenues in
Softential. Excluding this, revenues grew marginally in CC terms. We have
been uncomfortable with the attached quarterly volatility in revenue
growth. The management has indicated a general pick-up in sentiments and
a good pipeline. Our earnings estimates for FY15 stand at Rs.32 (Rs.29.7) per
share and for FY16 at Rs.39.7 (Rs.35.3) per share. We have consolidated
Rangsons' financials WEF February 2015. Our FY16 - based PT stands revised
to Rs.539 (v/s Rs.452). Current valuations are at 14.6x FY16 estimates, which
are in line with some of the larger peers. Post the recent spike in price, we
downgrade the stock to SELL (REDUCE earlier). While the recent revenue
growth is encouraging, we believe that, the current valuations discount
most of the potential positives. Cash / cash equivalent is expected to be
about Rs.52 per share by FY16 end

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Strong growth - led by early completion of projects
 Headline revenues grew by 5.3% in CC terms, which was above estimates.
 The growth came in largely on the back of early realisation of revenues in
Softential. The projects were expected to be completed in 4Q but likely concluded
in 3Q. Softential revenues grew by more than 70% QoQ to $9mn.
 The previous quarter had also seen a near 40% increase in Softential's revenues
QoQ.
 Consequently, DNO revenues in 3Q grew by 15.7% QoQ in INR terms.
 Engineering services reported a marginal de-growth QoQ due to seasonality

 Cyient's revenue growth has been volatile on a quarterly basis and we would
like to see more stability in the same.
 Cyient bagged 23 (19) new accounts during 3Q of which, 8 were in the ENGG
vertical and the balance in DNO (Data Transformation, Network and Operations).
Engineering vertical
 The vertical de-grew marginally QoQ largely due to seasonality (4.9% growth in
2Q, 4.6% in 1Q).
 Within ENGG, aerospace contributes about 55% of revenues, rail transportation
20%, heavy engineering 15% and others, the balance.
 Cyient continues to be recognised for its expertise by clients like Pratt & Whitney,
Rio Tinto and Alstom.
 Cyient is now focusing on newer services like additive manufacturing, data
analytics, and smart tooling
 Within Aerospace, Cyient is seeing good growth in analytics, we understand.
There is a strong pipeline in the Aerospace vertical.
 The demand is coming more from the after-market segment even as the design
business is witnessing softer trends. Clients are looking at value engineering with
a view to reduce the total cost of development and this is leading to increased
business for companies like IEL.
 The engineering services budget of large aircraft companies like Boeing are
about 5-6% of revenues (i.e about $3bn-$5bn) and within this, the addressable
market for IEL is about 25%.
 Within the transportation segment, rolling stock segment is doing well, but there
are some near term challenges in some signalling contracts. Railways are also a
high growth area for IEL with global rail industry expected to grow by 3.6%
CAGR.
 The off-road as well as the medical devices businesses are seeing good demand,
pre-dominantly from North America.
 The semi-conductor business had seen challenges in FY14, which are now behind.
Cyient is seeing flow of new business in design services, which should lead
to higher growth in the future for the company.
 In terms of services, the company is seeing positive traction in business for services
such as value engineering, localization and product realization
Data Transformation, Network and Operations (DNO) vertical
 This business saw revenues grow by 15.7% QoQ in CC terms. Excluding
Softential, revenues grew by about 7% QoQ in CC terms. 2Q had seen an
11.8% growth, partly led by 40% rise in Softential's revenues.
 In DNO, the Utilities vertical is seeing increased flow of business and the opportunity
pipeline has also improved. There is a trend towards more off-shoring by
clients, which is expected to help in improving margins for IEL.
 Smart Grid initiatives, distributed generations and consolidation of utilities continue
to be the key trends in the utilities industry.
 Communications business also reported a double-digit growth. Within the Communications
vertical, momentum is seen on consulting and OSS segments.
 Telecom infrastructure is seeing good traction with high levels of investment being
made in both, fiber and LTE/4G, not only in Europe, but across the globe.
 4G rollout and cloud adoption are expected to be the growth areas.

 The integration of Softential is progressing along expected lines. Cyient consolidated
Invati's financials from October 15th and it contributed about Rs.4mn to
revenues.
 With Nokia's mapping and location-based business not getting taken over by
Microsoft, it may lose focus from Nokia.
 This may benefit Tom Tom, the largest client for IEL in D&A. Revenues from Tom
Tom continue to grow strongly.
 Within this vertical, more than 40% of revenues come from telecom, 30% from
content engineering and the balance from utilities.
 The Energy & Natural Resources vertical is witnessing soft demand trends.
 While the revenue growth has improved, we have been concerned over to the
relatively higher proportion of projects-based business in Cyient, which had impacted
revenue growth in some of the earlier quarters also. We will watch out
for the scale-ups in these accounts in 4Q and beyond.
Acquisition of Rangsons
 Cyient has acquired 74% stake in Rangsons, an electronics system design and
manufacturing (ESDM) services company, in an all cash deal. The deal size is not
available.
 The company is a qualified supplier to global OEMs across defense and aerospace,
medical, automotive, telecommunications, and industrial segments.
 The relationship will help Cyient expand its core business while deepening partnerships
with OEM customers, we believe.
 The acquisition will also help Cyient to position itself as a strong offset partner.
Further, integrated end-to-end capabilities would strengthen the company's contribution
to the 'Make in India' program announced recently by the union government.
 Nearly 80% of the revenues come from the SI space.
 Rangsons had revenues of about $66mn in 2014 with EBIDTA margins of about
10%-12%.
 We have consolidated the financials WEF 4QFY15 (2 months) and expect the
acquisition to be earnings accretive.
EBIDTA margins higher QoQ; along expected lines
 EBITDA margins for the quarter were higher QoQ QoQ, partly due to the early
recognition of revenues and partly due to rupee / efficiencies.
 Margins had seen a sharp rise in 2QFY15 also as some of the high margin contracts
in Softential was pre-poned and revenues from the same were recognized
in 2Q.
 Margins in 1Q were impacted by the initial investments (purchases and sub-contractors)
in a new multi-year contract initiated by the company. These expenses
had receded in 2Q and 3Q was free of these costs.
 3Q also contained higher bought - out items which formed 8% of revenues as
against 6.5% in 2Q. This may come down in 4Q.
 We believe that, margins, on an organic basis, should improve if there are no
one-off investments, going forward.
 The consolidation of Rangsons, will impact overall margins slightly, atleast in
FY16.

Employee strength - surprising reduction
 The employee strength reduced by 18 QoQ. DNO saw engineer strength reduce
by 172.
 The quarterly annualized attrition rose to 22.7%.
 The management has indicated that, it has removed about 296 employees from
the rolls during the quarter. These employees had already left voluntarily employees.
 Additionally, names of about 140 employees will be struck off the rolls in 4Q.
 While we have accommodated these changes, we find this surprising and would
watch out employee additions in 4Q and beyond.
Earnings estimates changed
 We have changed our FY15 and FY16 earnings expectations. We have assumed
the exchange rate at 61 / USD for FY15 and 60.5 / USD for FY16.
 We have also consolidated Rangsons' financials WEF February 2015.
 USD revenues are expected to grow by 25% and 23% in FY15 and FY16, respectively.
Softential financials have been consolidated WEF FY15 and that
should add about 5% to the revenues in FY15.
 Rangsons should also bring in about $12mn of revenues in FY15. Thus, organic
USD revenue growth in FY15 is expected to be 15%.
 Organic growth in FY16 is expected to be about 11%.
 Margins are expected to be lower in FY15 and FY16, as compared to FY14 levels.
 Operational improvements like utilization, offshoring and pyramid correction,
along with the absence of one-offs (for FY16), are expected to only partly offset
the negative impact of salary hikes and rupee and consolidation of acquisitions.
 PAT is expected to rise to Rs.3.58bn in FY15 and Rs.4.43bn in FY16. Cyient is
already a high tax paying company and with initiation of additional SEZ facilities,
tax rates are expected to come down in FY15 and FY16.
 EPS for FY15 and FY16 work out to Rs.32 and Rs.40, respectively.
 We expect the company to have net cash of about Rs.52 per share by FY16 end.
Valuations
 Management continues to see opportunities across both the businesses.
 However, revenue growth remains volatile with negative implications for margins.
This also impacts sentiments. The company needs to make the revenue
growth more consistent and predictable.
 We have accorded higher valuations to the stock v/s earlier, based on the improved
growth trajectory.
 The stock has risen sharply in the past few weeks. At the current levels, our
FY16 estimates are discounted by about 14.6x, which is in line with some of the
larger peers. This discounts most of the potential positives, we believe.
 Thus, we recommend downgrade the stock to SELL.
 A sustained improvement in the margins and a stable revenue growth trajectory
will make us more positive on the stock. Lower levels can be utilised to buy the
stock with a medium term perspective.
Concerns
 A sharp appreciation in the rupee from our assumed levels will impact earnings
estimates negatively for the company.
 A delayed recovery in major user economies could impact revenue growth of
Cyient.

LINK
http://www.kotaksecurities.com/pdf/dmb/MorningInsight16012015kl.pdf