EDS’ MphasiS offer: Our view - Views on News from Equitymaster

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EDS’ MphasiS offer: Our view

Apr 4, 2006

EDS, one of the global ‘Big Six’ IT firms, has announced an open offer to the shareholders of MphasiS BFL, a mid-sized Indian software company, for the acquisition of a majority stake in the company. At Equitymaster, we have always maintained that we expect the top-tier software companies to be the key beneficiaries of the offshoring story, due in part to their significantly higher scalability. The mid-sized firms, in order to gain scale, will have to either acquire other mid-sized companies, or get acquired themselves. In this write-up, we reason as to whether the offer by EDS is fair to MphasiS’ shareholders to tender their shares. The deal…

EDS has made an open offer to MphasiS BFL’s shareholders to acquire approximately 52% stake in the company for a total consideration of approximately US$ 380 m, which, if it goes through, will be the second-largest acquisition by an overseas IT company in the domestic software sector, after Oracle’s acquisition of i-flex. As of now, Barings India Investments Ltd. holds 34.9% in the company, while MphasiS Holdings holds 4.6% and Jerry Rao, Chairman of MphasiS, holds 3.9%.

The price per share of MphasiS BFL works out to Rs 204.5, which is at a 30% premium to the 26-week average price of the company on the stock exchanges. However, it must be noted that EDS will accept shares contingent upon a minimum of 83 m shares being tendered in the open offer. If less than 83 m shares are tendered, then EDS will not accept any shares tendered. The transaction, if it goes through, is expected to be completed by 2QFY07.

What do the valuations say?

At Rs 204.5, the offer price is at 12.8 times our estimated FY08 EPS, and, even giving a conservative 20% growth for FY09 (35% CAGR in net profits in the last 5 years), the valuation comes to 10.7 times estimated FY09 EPS. This is an attractive price for long-term shareholders to hold on to the stock, rather than sell it.

Another factor to consider here is that shareholders, who decide to remain invested in the company, will seemingly be able to participate in the future growth of the company, since EDS has not given any indications that it will de-list MphasiS BFL in the near future.

We can take two scenarios here. The first scenario could be that EDS gets at least 83 m shares in the open offer. This will give the company a controlling stake in MphasiS BFL. Now, we need to consider the benefits that MphasiS will derive on being acquired by EDS. While having built a decent track record over the years, the company has had its share of disappointing performances. In terms of consistency of performance, the company has lagged behind its top-tier peers like Infosys. If EDS does manage to acquire MphasiS BFL, it will be a positive for the company (MphasiS), since it will get access to EDS’ global network of over 50 countries, apart from a strong list of customers who could offshore more work to the company, going forward. EDS itself has been struggling to establish a decent offshore presence. Its peers like Accenture and IBM have already built up significant scale in terms of offshore presence, while EDS has lagged. Thus, if this acquisition goes through, it will enable EDS to get a strong offshore presence through MphasiS BFL.

The second scenario that can be imagined is that EDS does not get 83 m shares tendered and the offer does not go through. In such an event, MphasiS will continue to be held by Barings and it will be ‘business as usual’.

We have always maintained that stocks must be bought with a long-term view. Our initial estimates for FY09 (which we will soon incorporate in our research models) indicate that MphasiS trades at a price-to-earnings (P/E) multiple of 10.7 times, which would put the stock at the lower end of our valuation band. Given the resurgence in its IT services business, good order traction in the BPO business (the Bharti deal) and initiatives like platform-based BPO, the company seems on track to improve scalability and get greater consistency in its growth, going forward.

Therefore, on the balance, we would say that shareholders with a long-term view of MphasiS BFL (two to three years) would be better off holding on to the stock at these levels.

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