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i-flex: The specialist

Jun 1, 2002

i-flex’s IPO that opens on the 5th of June has generated a lot of interest. And rightly so, it is a software company with a difference. Sounds clichéd? Let us take a deeper look. What makes the company very different from others is that it is one of the very few Indian companies that has managed to create a very successful product, FLEXCUBE. Product companies are at the highest end of the value chain. While others are talking about moving up the value chain, i-flex is already there.

The company, formerly known as CITIL, was formed 10 years ago by a group of professionals that includes Mr. Rajesh Hukku, the current chairman and managing director, and Mr. Deepak Ghaisas, now CEO India Operations. While others were busy writing codes, the company set out to do something different. It focused on a particular vertical, banking, and was busy creating a product that was embedded with strong domain knowledge.

FLEXCUBE supports core banking back office operations. What makes that achievement so commendable is that the product is not an add-on but is at the very heart of banking technology solutions. It is a mission critical product without which, the bank using it will stop functioning.

Products business does bring back memories of companies like VisualSoft, which at one point of time earned almost half of their revenues from the products business. As a result, they had very high operating margins. But then disaster struck and product revenues currently contribute to only 2% of revenues. However, there is a difference between VisualSoft’s products and I-flex. VisualSoft’s products are general in nature and do not require very high technology or domain know-how (these are coding intensive and not domain knowledge intensive unlike FLEXCUBE). Consequently, the entry barrier is low and the companies like VisualSoft face tough competition and threat of new entrants.

Although the market size for most of its offerings look lucrative, the fact remains that its products are not mission critical for organisations. Again, areas like PSA (personal services automation) where VisualSoft has product offerings like productivity enhancement tools, are not so essential for day-to-day operations of organisations. Add-ons are the first area that take a cut in spending when times turn bad.

The point we are trying to make is that i-flex has done just the opposite. The company has created a mission critical product with a very high barrier to entry as not many people have a combination of domain and technical skills. Also, systems that keep a bank or a company up and running have a very low risk of seeing a cut back in spending.

In 1995, the company started with a product called MicroBanker and HDFC Bank was its first client. Gradually with increasing exposure to its client’s requirements, I-flex kept extending its product to cater to other areas. In 1997, a more comprehensive product FLEXCUBE was launched and since then till 2001 the product had sold more than 100 licenses. This is a testimony of the product’s success. Today i-flex can boast of clients like DBS Bank in Singapore, RABO Bank, UBS Warburg and Shensei Bank in Japan. These banks have implemented the product for integrating banking operations across various countries.

The company’s major source of revenues is the licensing for its products. While the license fees is one time, the company also earns additionally though annual maintenance contracts related to the product. Also, the license is for a number of branches and when a client adds more branches, the bank has to purchase additional licenses. Revenues from additional licenses add straight to the bottomline.

A big positive is the fact that FLEXCUBE is not the only source of its revenue. Products contribute to only 60% of its revenues, with the remaining 40% coming from services. The services offered are in the area of financial services. Thus, the company has a revenue mix that to a certain extent dilutes the concentration revenues coming from a single product.

The numbers
The company’s revenues have grown at a CAGR of 52% between FY98 to FY02. Not much inference can be drawn from the growth in different revenues streams other than the fact the product sales tend to be volatile. In FY00, product sales grew by only 30% as compared to an 80% growth in the previous year. The compounded annual growth rate (CAGR) for products works out to be 59%, while the figure for services is lower at 43%. The company’s topline growth for FY02 at 35% bettered industry average of 22% and is inline with numbers posted by the best in the industry.

Growth FY99 FY00 FY01 FY02 CAGR
Products 92.2% 31.3% 70.0% 48.9% 59.0%
Services 65.4% 54.1% 38.7% 19.2% 43.3%
Total 78.7% 41.9% 54.1% 35.3% 51.7%

The operating margins at around 40% are once again way above the industry average and are comparable to the best. However, considering the fact that the company earns a significant portion of its revenues from products, the margins could be higher than others that derive only a small portion of their revenues from products. Infosys earns only 2% of its revenues from products and yet has margins comparable to that of i-flex. The margins fluctuate in line with the growth in the product business. Higher contribution of product sales results in higher margins.

% contribution FY98 FY99 FY00 FY01 FY02
Products 49.6% 53.3% 49.3% 54.4% 59.9%
Services 50.4% 46.7% 50.7% 45.6% 40.1%
Operating margins 38.0% 40.4% 39.6% 38.5% 40.0%

i-flex’s major cost heads are its employee and other costs. These costs have traditionally accounted for 50% to 60% of the revenues. The company’s margins have remained range bound due to the fact that while employee costs have grown at a swifter pace as compared to the revenues, the lower growth in other costs has offset the increase.

(Rs m) FY98 FY99 FY00 FY01 FY02 CAGR
Sales 777 1,389 1,971 3,039 4,113 51.7%
Other Income 49 56 91 173 140 30.2%
Expenditure 482 828 1,190 1,869 2,687 53.7%
Operating Profit (EBDIT) 295 560 781 1,169 1,426 48.2%
Operating Profit Margin (%) 38.0% 40.4% 39.6% 38.5% 34.7%  
Interest 2 0 - 2 3 8.4%
Depreciation 25 81 122 145 145 54.5%
Profit before Tax 317 535 750 1,194 1,418 45.5%
Tax 9 30 58 94 150 103.8%
Adjustments Income/(expenses) 21 (15) 129 40 (64)  
Profit after Tax/(Loss) 329 489 822 1,140 1,204 38.3%
Net profit margin (%) 42.3% 35.2% 41.7% 37.5% 29.3%  
Diluted number of shares 37.3 37.3 37.3 37.3 37.3  
Diluted Earnings per share* 8.8 13.1 22.0 30.6 32.3  
*(annualised)            
Floor price         530  
P/E (x)         16.4  

Thus, at the floor price of Rs 530, the P/E multiple works out to be 16x FY02 earnings post adjustments. The price seems to be fair. A P/E multiple of 16x implies a growth of 16% in bottomline going forward and considering its past performance and domain expertise, clocking 16% growth rates should not be a uphill task for i-flex. Infact, Infosys has indicated of an 18% growth in net profits for FY03. Considering a similar growth, the price could work to be as high as Rs 700.

Concerns
i-flex suffers from the ‘rich man’s disease’ i.e., too much of cash. Almost all the top rung software companies have seen return on RONW (return on net worth) falling as they hold a significant cash that does not generate returns, as high as that of the software business. The company had Rs 2,214 m in cash as on 31st March 2002. The IPO will generate even more cash and the company will have to figure out a way to effectively deploy the cash. Also debtor days for i-flex at 174 days are very high. Infact, the number has steadily increased from 117 days in FY00 Companies like Infosys have brought down their debtor days to 47 days. The company claims forex regulations and the nature of its business is responsible for the high debtor days.

Also, the company has a presence in about 84 countries around the world. This is due to its marketing structure that involves a significant number of partners. This is not new in the software industry. Companies like Checkpoint have adopted a similar methodology. However, there is a risk of relations turning sour and therefore, a problem in reaching out to clients is always there.

The most important concern is that the management’s credibility is yet to be established. However, for that the company will have to be in the public eye for quite a number of years. Considering the vision and performance to date, the management has delivered and investors could adopt ‘innocent till proven guilty’ policy. However, one must keep mind honesty to minority shareholders is not a function of business acumen or technical know how.

Future growth
The company expects future growth by penetrating newer markets. Due to certain legal restrictions the company has started marketing only recently in the US. Consequently, it has a vast market to address. Its revenues are very well diversified across US (32%), Asia Pacific (25%), Europe (21%), Europe (21%) Latin America and Caribbean (1%). Product sales in America account for only 9% of total product revenues. This could be an area of potential growth.

Existing customers growing and taking additional licenses is another area for potential growth. Also, many clients are still on the company’s previous product MicroBanker and may upgrade to FLEXCUBE.

In terms of competition, i-flex faces local competition in almost every country. However, where the company scores over local competition is that it brings in best business practices. With global economies integrating many banks are increasing adopting products that are global in nature so as to be ready for the future.

Conclusion
While the business model and profitability of the company going forward seem sound, the key question is that what valuations should investors accord. A P/E greater than 20x warrants caution.

Please note that the i-flex opens on June 5, 2002 and closes on June 11, 2002. The IPO is an issue of 3.9 m equity shares of face value Rs 5, aggregating around 10% of the company total equity capital. The IPO is through 100% book building route with a floor price of Rs 530 per share. We will put a detailed IPO note on the company soon.

Interview with Mr. Ghaisas, CEO, I-flex


  

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