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MphasiS: Finally, all-round growth! - Views on News from Equitymaster
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MphasiS: Finally, all-round growth!
Jan 12, 2006

Performance summary
MphasiS announced its results for the third quarter and nine-month period ended December 2005 late on Tuesday evening. In a welcome change from the past, both the business segments of the company – IT services and BPO - showed decent sequential growth. Savings in SG&A expenses as a percentage of revenues has driven a strong 140 basis points margin expansion. However, due entirely to a forex loss, the impact of the improved margins was totally wiped out, resulting in the bottomline growing at a sluggish pace on a sequential basis. For the nine-month period, the performance has been decent as well.

Financial performance (Consolidated): A snapshot…
(Rs m) 2QFY06 3QFY06 Change 9mFY05 9mFY06 Change
Sales 2,274 2,424 6.6% 5,606 6,896 23.0%
Expenditure 1,779 1,863 4.7% 4,569 5,448 19.2%
Operating profit (EBDIT)* 495 562 13.5% 1,037 1,448 39.6%
Operating profit margin (%) 21.8% 23.2%   18.5% 21.0%  
Other income 30 (16) -153.3% 83 72 -13.2%
Depreciation 123 138 12.5% 285 378 32.6%
Profit before tax 403 408 1.3% 835 1,142 36.7%
Tax 1 (1)   (101) (5)  
Profit after tax/(loss) 402 408 1.7% 937 1,147 22.5%
Net profit margin (%) 17.7% 16.8%   16.7% 16.6%  
No. of shares 78.6 160.5   78.6 160.5  
Diluted earnings per share** (Rs)         9.5  
P/E ratio (x)***         17.1  
* includes amortisation of ESOPs   ** annualised   *** P/E ratio calculated on a trailing 12-month basis

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, particularly in the BFSI segment. The company has a special focus on the BPO segment, which contributes to around 32% of the total revenues. In recent times, MphasiS has been relying heavily on acquisitions for growth and has acquired companies in areas such as platform-based healthcare BPO (Eldorado Computing) and consulting (Princeton Consulting). During the period between FY01 and FY05, MphasiS’ revenues and net profits have grown at compounded rates of 29% and 35% respectively.

What has driven performance in 3QFY06?
Finally, BPO pulls its weight: After three successive quarters of sequential decline, MphasiS’ BPO business finally saw a decent quarter of growth in 3QFY06. This business grew at a rate of 7.6% sequentially, despite pressure on the average billing rates. This is indicative of the fact that the growth in this quarter has been due to strong volume growth and not pricing improvements, which have, in fact, restricted the growth to a lower level. For the nine-month period, the BPO segment grew at a slow pace of 4.7% YoY, reflecting the effect of the 3 successive quarters of negative growth. MphasiS recruited 863 people in the BPO business, giving an indication that the order pipeline is healthy. We had mentioned in the previous quarter as well that, given the employee intake of 1,222 in this business last quarter, the effects could be seen this quarter and that is what has happened. The Bharti deal would have started billing from this quarter and going forward, this order is expected to be a key contributor to growth.

The IT services segment has continued its growth path this quarter, with revenues growing by 6.1% sequentially. This was helped mainly by volume growth and increased breadth of services, as billing rates remained flat, at about US$ 63 per hour for onsite and US$ 21 per hour for offshore. The offshore-onsite mix also improved this quarter in the IT services business, with a slight shift offshore. This was reflected in the volume growth, with offshore volumes growing by almost double-digits, and onsite volumes in low single digits. Utilisation rates rose for onsite employees to 87% from 86% in 2QFY06. Offshore utilisation rates on the other hand, reduced to 71% from 74% (including trainees). MphasiS recruited 496 employees in the IT services segment.

Total headcount in the BPO segment now stands at 7,404 and in the IT services business at 3,467, giving the company a total headcount of 10,871. MphasiS added 11 new clients during the quarter, 9 in IT services and 2 in BPO.

Lower costs send margins soaring: Operating margins in 3QFY06 rose by a strong 140 basis points. This was mainly due to savings in SG&A expenses. As a percentage of revenues, these reduced from 15.7% in 2QFY06 to 14.4% this quarter. The total cost of sales was also constant at 67.9% of revenues.

Forex loss pares margin benefit: Due entirely to a forex loss of Rs 25.9 m in 3QFY06, the beneficial impact of the higher operating margins was completely neutralized at the net level. This resulted in the bottomline growing at just 1.7% sequentially, a sharp contrast from the 19.2% sequential growth seen in 2QFY06.

Performance in the recent past…
  4QFY05 1QFY06 2QFY06 3QFY06
Sales growth (%, QoQ) 6.9 7.1 3.5 6.6
Cost of sales (% of sales) 69.1 71.4 67.9 67.9
Selling expenses (% of sales) 7.3 7.0 6.0 5.6
G&A expenses (% of sales) 9.4 8.9 9.7 8.8
EBDIT margins (%) 18.3 17.8 21.8 23.2
Profits growth (%, QoQ) 15.3 8.8 19.2 1.7
Employees (Nos.) 8,375 8,173 9,512 10,871

What to expect?
At the current price of Rs 155, the stock is trading at a price to earnings multiple of 9.7 times our estimated FY08 earnings. At current levels, the stock appears to be a valuation play. It must be noted that sentiment on the stock has been poor ever since Barings’ stake sale in the company was called off. However, MphasiS does appear to have regained some momentum in its IT services segment in terms of organic growth, after being primarily dependent on acquisitions earlier.

In the BPO segment as well, MphasiS has returned to growth after 3 quarters of de-growth. The Bharti deal is expected to contribute in a big way going forward, as India’s largest GSM-based cellular services provider maintains its growth momentum in the fast growing but highly competitive Indian telecom services industry. The strong hiring in the BPO business this quarter as well as in the previous quarter suggests that MphasiS BFL is seeing renewed traction in this business. It remains to be seen as to how the company’s business strategy of differentiating itself from other players by focusing on platform-based BPO (Eldorado), consulting (Princeton), BPO and application development and maintenance (ADM) in terms of service lines and financial services, retail, transport and high-tech industries in terms of verticals plays out in an industry that is consolidating and becoming increasingly unkind to mid-sized players.

We had recommended a ‘Buy’ on MphasiS in February 2005 at Rs 130 with a target price of Rs 180 in the medium to long-term. We believe that this is a high risk-high return tier-2 play in the software sector and investors with an appetite for high risk can consider holding on to the stock.

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