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MphasiS: Poor show!

Jan 11, 2005

Performance summary
MphasiS-BFL has announced poor results for the third quarter of FY05 with the topline and bottomline declining sequentially by 1% and 15% respectively. What's more, the operating margins of the company have taken a severe hit owing to a disproportionate rise on the expenditure front. But for the higher other income and a larger tax write-back, the profit decline would have been worse.

Financial performance (Consolidated): A snapshot...
(Rs m) 2QFY05 3QFY05 Change 9mFY04 9mFY05 Change
Sales 1,930 1,918 -0.6% 4,218 5,606 32.9%
Expenditure 1,635 1,694 3.6% 3,595 4,854 35.0%
Operating profit (EBIT)** 295 224 -23.9% 623 752 20.7%
Operating profit margin (%) 15.3% 11.7% 14.8% 13.4%
Other income (9) 4 158 83 -47.3%
Profit before tax 286 229 -20.0% 781 835 6.9%
Tax (29) (40) 47 (101)
Profit after tax/(loss) 315 268 -14.9% 734 937 27.5%
Net profit margin (%) 16.3% 14.0% 17.4% 16.7%
No. of shares 77.4 78.0 35.5 78.0
Diluted earnings per share* (Rs) 16.2 13.8 12.6 16.0
P/E ratio (x) 16.2
* annualised** includes depreciation and amortisation of ESOPs

What is the company's business?
MphasiS is a mid-sized player in the Indian software sector. However, despite its small size, the company has carved a niche due to its broad range of quality offerings, especially in the BFSI segment (58% of 3QFY05 revenues). The company has a special focus in the BPO segment and, in FY04, merged the business of its BPO subsidiary, MsourcE, with itself. At the end of the latest quarter, MphasiS had 8,089 employees on its rolls, including 5,601 in the BPO segment.

What has driven performance in 3QFY05?
Poor performance of IT services continues:  IT services (61% of consolidated) continue to be the Achilles heel for MphasiS with revenues from the segment declining by 4% sequentially. This segment has continued with its streak of poor performances that begun around 8 quarters back (see adjoining chart). While MphasiS reported a 10% sequential growth in revenues from this segment in 2QFY05, almost 8% of this was from Kshema Technologies, which the company had acquired in 1QFY05. While billing rates remained constant during the quarter, revenues from both offshore (down 1% QoQ) and onsite (down 6% QoQ) services declined on a sequential basis. Even the ‘hot' BPO segment continued with its slew of poor performances even as the company carried on with its hiring-spree. Out of the near 800 employees added in 3QFY05, almost 600 came in the BPO segment, taking its base to 5,600.

Compared to revenue per employee of Rs 1.9 m for IT services, that for the BPO business stands at just Rs 0.6 m. Thus, the growth in revenues from the latter will just mean a reduced productivity levels and a declining quality of growth (as BPO commands lower margins than IT services).

Higher employee costs dent margins: Higher cost of employees on account of the strong addition to the base has led to the consolidated operating margins for 3QFY05 decline by a substantial 310 basis points. Now, if one were to consider EBIT (excluding amortisation of ESOPs), while IT services margins declined by 640 basis points to 29%, those for BPO improved by 220 basis points to 32%.

Margin impact on profits: The strong decline in operating margins has led to MphasiS report a sequential decline in net profits during 3QFY05. But for the higher other income (from negative in 2QFY05) and a larger tax-write-back (on account of tax credit in respect of past losses), the decline in net profits would have been worse.

Performance in the recent past...
4QFY04 1QFY05 2QFY05 3QFY05
Sales growth (%, QoQ) 6.8 10.7 9.8 (0.6)
Cost of sales (% of sales) 70.5 69.1 66.8 70.0
Selling expenses (% of sales) 6.2 7.1 7.6 7.5
G&A expenses (% of sales) 7.6 10.5 10.3 10.8
EBIT margins (%) 15.5 13.2 15.3 11.7
Profits growth (%, QoQ) (11.8) 40.4 (10.7) (14.9)
Employees (Nos.) 6,278 7,040 7,268 8,089

What to expect?
At the current price of Rs 260, the stock is trading at a price to earnings multiple of 16.2 times annualised 9mFY05 earnings, which is stretched from a medium term perspective. The stock has been hammered on the bourses today (trading 6% down currently) and this is fallout of the poor performance display by the company.

During presentation of its FY04 results, the management of the company had projected revenues and profits to rise by 35%-40% and 40%-45% in FY05. Considering the current momentum of growth, we believe that the company would not be able to meet these targets. We are particularly apprehensive on account of the company failing to grow its IT services business, despite the fact that it had acquired Kshema to fuel growth of this segment. One intriguing outcome of this result is that the BPO business has outperformed IT services on the margins front.While we do not believe that this is likely to be a trend in the future, the fact that profitability of the IT services segment is on a decline might put severe pressure on the margins of the consolidated entity.

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