MphasiS: Acquisitions-led growth! - Views on News from Equitymaster

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MphasiS: Acquisitions-led growth!

Apr 12, 2005

Performance Summary
MphasiS-BFL has announced decent results for the quarter and year ended March 2005. For FY05, while the topline growth has been commensurate with what the management had earlier projected, the growth in profits has seen a significant underperformance. What's more, the operating margins of the company have declined by 150 basis points on account of a disproportionate rise on the expenditure front. But for the tax write-back, the profit growth would have been lower.

Financial performance (Consolidated): A snapshot…
(Rs m) 3QFY05 4QFY05 Change FY04 FY05 Change
Sales 1,918 2,051 6.9% 5,806 7,657 31.9%
Expenditure 1,591 1,676 5.4% 4,650 6,245 34.3%
Operating profit (EBDIT)** 328 375 14.4% 1,156 1,412 22.2%
Operating profit margin (%) 17.1% 18.3%   19.9% 18.4%  
Other income 4 30 560.2% 185 113 -39.2%
Depreciation 103 110 7.2% 287 396 38.1%
Profit before tax 229 294 28.4% 1,055 1,129 7.1%
Tax   (40) (16) 69   (117)  
Profit after tax/(loss) 269 310 15.3% 986 1,246 26.4%
Net profit margin (%) 14.0% 15.1%   17.0% 16.3%  
No. of shares 78.0 78.6   35.5 78.6  
Diluted earnings per share* (Rs) 13.7 15.8   12.5 15.9  
P/E ratio (x)         16.4  
* annualised            
** includes 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 FY05 revenues). The company has a special focus in the BPO segment and derives almost 37% of its revenues from the segment. At the end of FY05, MphasiS had 8,375 employees on its rolls, including 5,634 in the BPO segment.

What has driven performance in FY05?
Acquisitions aid IT services growth: While MphasiS' organic IT services have performed poorly in the past three quarters, the segment has still managed to grow revenues by over 22% for the full year FY05. This seems mainly on account of the fact that the company has acquired three IT companies in the year, including two in the final quarter (Princeton Consulting and Eldorado Computing). The added revenues from these acquisitions is reflected in the total revenues of the IT services segment for FY05. This is vindicated by the fact that, after a 4% QoQ decline in revenues in the third quarter, IT services revenues have growth sequentially by over 11% in 4QFY05. The effect of acquisitions has also seemingly impacted MphasiS' IT services onsite billing rates in the quarter, which have grown QoQ by over 8%, thus aiding the growth in revenues. However, if one were to consider FY05 numbers, onsite rates have declined by almost 2% YoY. The segment has also benefited from the surge in onsite utilisation (86%, from 82% in FY04) while offshore utilisation has dropped marginally.

On the BPO front, while FY05 revenues have grown YoY by a strong 52%, the segment has seen a sequential decline of 0.3% for 4QFY05. What is more discouraging is to note that the segment's performance has been deteriorating every quarter. This is a cause of concern as MphasiS is focusing a lot of its energies in growing the BPO business that is gradually increasing its share in total revenues of the Group. However, one must note the fact that the sequential decline in revenues from the segment is also the doing of an appreciation of the rupee in the fourth quarter. The segment reported a marginal increase in employees and utilisation and stable billing rates. Without the effect of the rupee appreciation, thus, the revenues would have seen a marginal increase on a sequential basis. The segment added just 33 employees in the quarter, one of the slowest additions in recent times. The company has recently commenced its fourth BPO facility at Mangalore and plans to add around 3,000 employees here over the next few years.

Overall, despite the management's conscious strategy, we believe that relying too much on BPO for overall growth is a risky proposition. Compared to revenue per employee of Rs 1.8 m for IT services, that for the BPO business stands at just Rs 0.5 m. Thus, the increase in share of revenues from the latter will just mean reduced productivity levels and a declining quality of growth (as BPO generally commands lower margins than IT services).

Higher SG&A costs dent margins: Higher selling, general and administration (SG&A) expenses have dented margins in FY05. While selling expenses (as % of total sales) have increased from 6.3% in FY04 to 7.4% in FY05, G&A expenses have increased from 8.9% to 10.2%. Incidentally, the 120 basis points expansion in margins during 4QFY05 has been a result of the sequential decline (as % of sales) in the SG&A costs. Based on segments, for FY05, while PBIT margins for IT services have declined by 160 basis points to 32%, those for the BPO business have improved by 550 basis points to around 29%.

Lower margins and other income impacts profits: The contraction in FY05 margins and a decline on the other income front has led to the growth in net profits of MphasiS underperforming that of the revenues. However, but for the tax-write-back (on account of tax credit in respect of past losses), the growth in net profits would have been even lower.

Performance in the recent past…
1QFY05 2QFY05 3QFY05 4QFY05
Sales growth (%, QoQ) 10.7 9.8 (0.6) 6.9
Cost of sales (% of sales) 69.1 66.8 70.0 70.4
Selling expenses (% of sales) 7.1 7.6 7.5 7.3
G&A expenses (% of sales) 10.5 10.3 10.8 9.4
EBDIT margins (%) 18.2 20.2 17.1 18.3
Profits growth (%, QoQ) 40.4 (10.7) (14.9) 15.3
Employees (Nos.) 7,040 7,268 8,089 8,375

What to expect?
At the current price of Rs 260, the stock is trading at a price to earnings multiple of 16.4 times FY05 earnings. The board of the company has recommended a final dividend of 30% (Rs 3 per share, or a dividend yield of 1.3%). The board has also recommended a bonus issue of 1:1, i.e., a share for every share held in the company. This is probably the reason the stock has run up strongly on the bourses today.

The management of the company has projected revenues and profits to grow by 25% and 30% respectively in FY06. Noticeably, this is a sharp cut-down from what the management had projected for FY05 and is in line with what has been actually achieved in the fiscal. While we are cautiously optimistic about the growth of the company's IT services business, the fact that a higher proportion of BPO revenues has led to the PBIT margins declining further is a cause for concern. Moreover, while the recent acquisitions have helped the company shore up its revenue growth in this quarter, what lies in the future remains to be seen.

We will update our research report on the company after a conference call with the management.

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