MphasiS: In times to come...

MphasiS BFL is one of the very few Indian software companies that have outperformed the BSE-Sensex in FY04. However, when one considers the performance of the company vis-à-vis the Sensex in calender year 2004 (January 2004 till date), the stock has clearly under-performed the index. Let us take a brief look at MphasiS and see where the company is headed in times to come.

Note: Returns are calculated on Rs 100 invested.

MphasiS boasts of a management that has been visionary in its approach of taking the company towards higher echelons of growth. Sensing the huge growth opportunity in the IT-enabled services (ITES) space much ahead of most of the domestic software majors, MphasiS made a stride forward through its subsidiary, MsourcE. This business now accounts for over 31% of the company's revenues, up substantially from less than 2% in FY01. However, MphasiS does not have a focused approach towards the ITES space alone. It has a broad range of services in its portfolio that comprises of application development and maintenance, IT consulting and enterprise-wide application integration (EAI).

If we consider the performance of the consolidated entity (inclusive of MsourcE), the operating margins have borne the brunt over the past year. From 19.1% at the end of 3QFY03, these have dropped to 15.4% during 3QFY04. And the most important reason for the same is the pressure that has been due to continuous investments in MsourcE. For instance, in anticipation of higher demand for ITES going forward, MsourcE has ramped up its human resource base by 1,000 over the past nine months. At present, while the count stands at 3,100 employees for MsourcE, the company plans to take this to over 4,000 in a short time. However, while this entity has posted positive margins over the past couple of quarters, we believe that this would sustain only if the company is able to garner volumes. The company is making a concerted effort to move up the ITES value chain (like accounts and insurance claims processing), which could bear fruit over a period of years.

Now, as far as the performance of the software services business is concerned, the company has been able to grow revenues only at a CAGR of 12% over the past three years. This is an underperformance to the domestic software industry that has grown at a CAGR of over 30% during the same period. Further, MphasiS' client concentration is on the higher side, which increases the volatility in earnings, unless there is a strong pipeline.

At the current price of Rs 544, the stock is trading at a P/E multiple of 14.3x our FY05 earnings estimates. While we believe that the company has carved a niche for itself in the ITES space, staid growth of the relatively high-value software services business is a cause of concern over the long-term. However, if the company is able to integrate its software services business with the ITES initiative (thus simultaneously providing both services to a client), this would help it to grow faster.