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i-flex: Flex(cube)ing its muscles! - Views on News from Equitymaster
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i-flex: Flex(cube)ing its muscles!
May 6, 2006

Introduction to results
i-flex solutions has reported its consolidated financial results for the fourth quarter and full-year ended March 2006. For FY06, the topline has seen impressive growth, driven by good performances in both the products as well as the services businesses. However, margins fell during the year, due to considerably higher cost of revenues, possibly employee costs. The lower margins, as also lower other income and higher depreciation charges, led to the bottomline growing at a subdued pace. However, it should be noted that the growth in profits is mainly a result of the fourth quarter performance, which was highly impressive.

Consolidated financial performance: A snapshot
(Rs m) 4QFY05 4QFY06 Change FY05 FY06 Change
Net sales 3,586 4,705 31.2% 11,386 14,823 30.2%
Expenditure 2,318 3,125 34.8% 8,384 11,564 37.9%
Operating profit (EBDITA) 1,268 1,580 24.6% 3,001 3,259 8.6%
Operating profit margin (%) 35.4% 33.6%   26.4% 22.0%  
Other income 121 115 -5.5% 260 249 -4.1%
Depreciation 99 142 43.4% 309 460 48.8%
Profit before tax 1,290 1,553 20.3% 2,952 3,048 3.3%
Tax 252 153 -39.3% 627 580 -7.4%
Share of profit in associate company - -   (1) 3  
Minority interest - -   - 3  
Extraordinary items - -   - 97  
Profit after tax/(loss) 1,038 1,400 34.8% 2,324 2,377 2.2%
Net profit margin (%) 29.0% 29.7%   20.4% 16.0%  
No. of shares (m) 77.1 77.6   77.1 77.6  
Diluted earnings per share (Rs)       29.9 30.6  
P/E ratio (x)         42.5  

What is the company’s business?
i-flex is India’s premier software products company, focussed on the banking and financial services (BFSI) vertical. The company’s portfolio of offerings comprises products (nearly 52% of revenues) like Flexcube, an end-to-end product suite for retail, corporate and investment banking, asset management and treasury. The company also provides software services (47% of revenues) like application software development and deployment, maintenance and business and IT consulting. During FY05, i-flex acquired a company called Equinox Corporation, which provides BPO services. This contributes to nearly 2% of revenues. For the year 2004, International Banking Systems (IBS) ranked the company’s flagship product, Flexcube, as the number one selling wholesale as well as retail back-office banking solution in the world for the third year running. In fact, Flexcube has been rated among the top-selling banking solutions for the last six years. In recent times, i-flex has ventured into other related areas of the BFSI space, like risk management (ORTOS) and general insurance (Castek).

What has driven performance in FY06?
All-round growth: During FY06, i-flex saw a strong 30% YoY growth in its topline. Segment-wise, the flagship products business grew at nearly 28% YoY, while the services business saw a 30% YoY growth. Thus, both the major businesses of the company saw good traction. The contribution of Citigroup, the largest customer of i-flex, to revenues, has been steadily declining. In FY05, Citigroup contributed to 22% of product revenues, while in FY06, this stood at 17%. The license fee contribution to total product revenues stood at 38% in FY06 (38% in FY05). In fact, the last quarter saw license fees contribute as much as 54% to total product revenues. Going forward, the management has said in the conference call that it expects the contribution from license fees to remain at higher levels going forward.

This year has seen the company witness increased traction in its product business. Flexcube was rated as the number one selling banking solution globally for the fourth year in a row. The company won as many as 9 top-tier customers this year. One of these deal wins was through the Oracle partnership. This relationship continues to evolve, and Oracle has been authorised to sell Reveleus globally through its entire network. Reveleus, in fact, is now used by 3 of the top 5 US banks for the Basel-II requirements. The tank size at the end of FY06 stood at US$ 65 m (US$ 50 m in FY05). Going forward, the company sees good opportunities in replacing older packages. Flexcube has, in fact, replaced a number of vendor’s existing packages already.

As regards the services business, Citigroup continues to contribute the lion’s share of revenues (56% of total services revenues in FY06). Onsite revenues contributed a total of 67% to total services revenues. The company’s knowledge process outsourcing (KPO) company, Equinox, accounted for nearly 2% of consolidated revenues this year. Equinox recorded an operating loss of Rs 146 m during the year, as compared to Rs 26 m last year. This business continues to be in the investment phase.

As regards client metrics, Citigroup contributed to 36% of total consolidated revenues in FY06, compared to 38% in FY05. The top client (non-Citi) contributed to 3% of revenues (7% in FY05). The total number of clients added in FY06 were as many as 98, including 65 in the products business. The US$ 65 m tank size shows good visibility on the products side. i-flex continues to win more deals across geographies, as core banking packaged software gains increasing acceptance. The Oracle deal also gives the company greater credibility and a huge customer base, particularly in the North American market.

Segment-wise performance…
(Rs m) FY05 % of total FY06 % of total Change
Revenue 5,975 52.5% 7,637 51.5% 27.8%
OP 2,454 81.8% 2,838 87.1% 15.7%
OPM 41.1%   37.2%    
Revenue 5,347 47.0% 6,930 46.8% 29.6%
OP 1,222 40.7% 1,347 41.3% 10.2%
OPM 22.8%   19.4%    
KPO Services          
Revenue 48 0.4% 235 1.6% 385.9%
OP (26)   (146)    
OPM -   -    
Joint ventures          
Revenue 15 0.1% 21 0.1% 37.0%
OP 6 0.2% 7 0.2% 7.3%
OPM 41.4%   32.5%    
Revenue 11,386   14,823   30.2%
OP 3,001   3,259   8.6%
OPM 26.4%   22.0%    

Margins fall: i-flex saw a 440 basis points margin fall during FY06. This was mainly due to considerably higher cost of revenues. Cost of revenues as a percentage of sales increased to 52.8% (50.1% in FY05). S&M expenses increased marginally as a percentage of sales from 13.4% in FY05 to 13.5% this fiscal. General and administrative (G&A) expenses, on the other hand, increased to 11.6% of sales, from 10.1% in FY05. We believe that the main reason for the escalation in costs has been employee costs. In both the company’s businesses (products and services), there has been depletion in margins. The company added a net of 2,111 employees during FY06. At the end of FY06, i-flex had 6,858 employees on its rolls. It should be noted that, given the nature of i-flex’s business, which is more IP-intensive, the proportion of freshers to the total recruitment would differ from a pure-play software services company. Thus, as a percentage of new recruits, the proportion of lateral recruits was as high as 75%.

It boils down to the bottomline: Due in part to the lower margins, and also lower other income and higher depreciation charges, the net profit of the company grew at a rate of just over 2% YoY. If we exclude prior period items of Rs 97 m incurred, the profit growth stands at over 6% YoY. However, it must be noted that it was almost entirely the fourth quarter performance that has resulted in i-flex actually being able to record a profit growth, given that at the end of 9mFY06, the bottomline declined by 24% YoY. In fact, the 4QFY06 profits accounted for as much as 59% of FY06 net profits. This was even higher than the figure in FY05, which was 45%. It can be recalled that in FY05 as well, the company registered as strong performance. Thus, the strong growth in 4QFY06 is on a higher base, which is undoubtedly an encouraging sign.

Performance in the recent past…
  1QFY06 2QFY06 3QFY06 4QFY06
Sales growth (%, YoY) 22.2 36.7 29.4 31.2
Operating margins (%) 9.0 15.1 23.3 33.6
Profits growth (%, YoY) (73.0) (8.1) 6.2 34.8
Products tank size (US$ m) 60.0 61.0 72.5 65.0

What to expect?
At the current price of Rs 1,301, i-flex is trading at a price to earnings multiple of 42.5 times its FY06 earnings. While this may appear expensive, we believe that the Oracle relationship has the potential to take the company to newer heights. The evolution of this relationship over the next few years will undoubtedly help i-flex to grow and become even more global than it already is. The company already services as many as 123 countries. The strong pipeline will ensure good topline growth in the future. In fact, the company already services 12 of the top 56 banks in the global Fortune 500, of which 5 were acquired in FY06. This shows the strong traction that the company is gaining. The ever-improving visibility of Flexcube is likely to ensure that the company is in a good position to take advantage of the increasing opening up of the global financial sector and greater acceptance of packaged software. The management has also said in the conference call that it expects margins to be stable with a slight positive bias in the future. We remain positive on the company from a long-term perspective. Given the better-than-expected performance of the company, we will upgrade our numbers.

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