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Mphasis: Undone by taxes and forex losses - Views on News from Equitymaster

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Mphasis: Undone by taxes and forex losses

May 3, 2007

Mphasis announced mixed results for the fourth quarter and full year ended March 2007. For FY07, the company has reported a 27% YoY growth in its topline but the bottom-line has declined by 20% YoY largely due to contraction in operating margins, higher foreign exchange losses, and higher depreciation and tax expenses. Operating margins contracted by 400 basis points (4%) during the fiscal, largely driven by increase in cost of revenues and selling expenses (both as percentage of sales). The board has recommended a final dividend of Rs 3 per share (dividend yield 0.9%).

Consolidated financial performance: A snapshot…
(Rs m) 3QFY07 4QFY07 Change FY06 FY07 Change
Sales 3,060 3,373 10.2% 9,401 11,958 27.2%
Expenditure 2,677 2,744 2.5% 7,495 10,005 33.5%
Operating Profit 383 629 64.1% 1,906 1,953 2.5%
Operating Profit margin (%) 12.5% 18.6%   20.3% 16.3%  
Other income 11 (6) -153.1% 94 (69)  
Depreciation 16 145 807.6% 443 550 24.1%
Profit before tax 378 478 26.3% 1,557 1,335 -14.3%
Tax 20 22 9.7% 58 136 133.4%
Profit after tax/(loss) 358 456 27.3% 1,499 1,199 -20.0%
Net profit margin (%) 11.7% 13.5%   15.9% 10.0%  
No. of shares (m)         165.1  
Diluted earnings per share (Rs)         7.3  
P/E ratio (x)         44.2  
* On a trailing 12-month basis

What is 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 30% 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). FY06 was a relatively subdued year for the company and FY07 has not been a good year either.

What has driven performance in FY07?
Volume growth drives business: Mphasis’ consolidated revenues grew by 27% YoY during FY07, aided by higher volumes of business from existing clients and service offerings to new clients. Revenues from IT services grew by 30% YoY during the fiscal with a healthy growth in the financial services business, while BPO services revenue grew by 21% YoY with an increase primarily contributed by telecom clients in India. In IT service line, the financial services vertical was the star performer with the company deriving 58% of its IT services revenue from it (55% in FY06). In case of the BPO segment, revenues from BFSI have taken a major hit while technology and telecom sector have contributed 26% of overall segment revenues (14% in FY06). As regards to revenue by service type, there has been a marked shift in IT services from application development to application maintenance and support although development still forms 53% of the company’s IT services revenues.

Segmental Information FY06 FY07 Change
IT Services revenues 6,427 8,361 30.1%
% of total revenues 68.36 69.92  
PBIT margin (%) 34.32 31.23  
BPO revenues 2,974 3,597 20.9%
% of total revenues 31.64 30.08  
PBIT margin (%) 23.87 23.41  

During the fourth quarter, Mphasis, added 7 new clients, 6 in application services and 1 in BPO. For FY07 the company added 2 clients in IT services segment and one client in the BPO segment contributing more than US$ 10 m. The company added 1,604 employees in FY07 in the BPO segment to take the BPO head count to 9,485 while the IT services segment added 1,661 employees and the total head count of the company stood at 14,679.

Higher costs dent operating margins: Mphasis’ cost of revenues expanded by 2% during FY07 as compared to FY06, inflicting damage to the company’s operating margins, which fell by 4%. The cost of revenues represented 71% and 69% of total revenues for FY07 and FY06 respectively. Although the increase in the cost of revenues is in line with the increase in the volume of business, salary increments during FY07 took its toll on the operating profits. The gross margins in IT services decreased to 31% in FY07 (34% in FY06). Margins in BPO services saw a marginal contraction of 50 basis points primarily on account of increase in manpower cost and drop in utilisation.

Selling expenses rose 57% in FY07 over FY06. This increase was mainly on account of salary increments, incentives and increase in sales force. General and administrative expenses rose 31% YoY during the fiscal. This increase was also due to increase in support manpower, salary increments and incentives.

Exchange losses, higher taxes hit bottomline: Mphasis recorded a spike in depreciation expenses during 4QFY07, though the affect was not really seen in the full year. The real dent to the bottomline was attributable to the substantial rise on the tax front, as the effective rate of income tax increased from 3.7% in FY06 to 10.2% in FY07. The increase was on account of reversal of deferred tax assets as the business have turned profitable and on account of higher interest income. Another hard-hitting factor in this year’s performance was the foreign exchange loss of Rs 125 m as against a gain of Rs 85 m in FY06. The loss was primarily on account of losses booked on forward contracts committed earlier and restatement of US dollar denominated current assets arising out of appreciation of rupee against the dollar.

Performance over the past quarters 2QFY06 3QFY06 4QFY06 1QFY07 2QFY07 3QFY07 4QFY07
Sales growth (%, QoQ) 3.5 6.6 3.3 4.1 12.0 4.8 10.2
Cost of sales (% of sales)* 67.9 67.9 69.5 76.2 67.6 69.4 68.9
Selling expenses (% of sales)* 6 5.6 6.4 7.6 8.1 7.1 7.9
G&A expenses (% of sales)* 9.7 8.8 9.3 9.7 9.5 9.4 8.8
EBDIT margins (%) 21.8 23.2 20.5 12.1 9.5 12.5 19.0
Profits growth (%, QoQ) 19.2 1.7 -13.9 -56.9 35.0 53.0 27.3
Employees (Nos.) 9,512 10,871 11,414 11,234 12535 12719 14679

What to expect?
At the current price of Rs 321, the stock is trading at a multiple of 44.2 times its FY07 earnings. During FY07, Mphasis recorded a 3% growth in its onsite billing rates and 5% growth in its offshore billing rates in case of IT services whereas there was a 11% YoY drop in rates in case of BPO services 11%. The management, however, expects the pricing environment to be relatively stable during this fiscal. We have a cautious view on the stock, especially considering its volatile performance history and stretched valuations.

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