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MphasiS: IT services bloom, BPO gloom! - Views on News from Equitymaster
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MphasiS: IT services bloom, BPO gloom!
Jul 12, 2005

Performance summary
MphasiS-BFL has announced decent results for the first quarter of FY06. Increased offshore utilisation and improvement in billing rates for the IT services segment has led to the sequential growth in company’s topline during the quarter. What is, however, disappointing to note is the sequential decline of 3% in the company’s BPO revenues. Operating margins have declined by 50 basis points, seemingly due to the first quarter revision in salaries.

Financial performance (Consolidated): A snapshot…
(Rs m) 4QFY05 1QFY06 Change
Sales 2,051 2,197 7.1%
Expenditure 1,676 1,806 7.8%
Operating profit (EBDIT)** 375 391 4.3%
Operating profit margin (%) 18.3% 17.8%  
Other income 30 58 96.9%
Depreciation 110 118 6.5%
Profit before tax 294 332 12.9%
Tax (16) (5)  
Profit after tax/(loss) 310 337 8.8%
Net profit margin (%) 15.1% 15.3%  
No. of shares 78.6 79.0  
Diluted earnings per share* (Rs) 15.7 17.1  
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, particularly in the BFSI segment. The company has a special focus in the BPO segment, which contributes to around 33% 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). During the period between FY01 and FY05, MphasiS’ revenues and net profits have grown at compounded rates of 29% and 35% respectively.

What has driven performance in 1QFY06?
IT services drive growth again:  In the recent past, MphasiS struggled to grow revenues in its organic IT services business. As a result, it resorted to inorganic growth, recently acquiring Princeton Consulting. Helped by this, in 1QFY06, the IT services business recorded a strong growth QoQ growth of 13% in revenue terms. This follows the double-digit sequential growth of 11% in 4QFY05. However, it should be noted that in the previous quarter, MphasiS had acquired Princeton Consulting, revenues from which were added to the topline. This quarter, the picture seems to be that of organic growth. In fact, management has indicated in the conference call that the company won 3 major clients who will give it annuity revenues over the next few years. Offshore volumes grew by as much as 17% QoQ, the highest in the company’s history. Onsite volumes grew 4% QoQ. Utilisation rates have also risen to 76% from 72% in 4QFY05.

BPO, on the other hand, actually recorded a dip of 3% on a sequential basis. The major reasons given by the management in the conference call has been a slower-than-expected ramp up by clients, pricing pressure and the salary increases. In fact, the number of employees in the BPO business actually fell. Non-voice component contributed 20% of the BPO business. The goal of the company is to increase this to 25%.

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 salary costs dent margins:  The company revised its salary levels upwards in April, a yearly phenomenon for a number of IT companies. As a result, cost of revenues showed a higher than proportionate increase compared to revenues. Cost of revenues as a percentage of total revenues rose to 71.4% from 69.1% in 4QFY05. This in turn affected the company’s margins, which fell by 50 basis points over the previous quarter.

Lower margins and other income impacts profits:  Considerably higher foreign exchange gains and lower than proportionate depreciation costs helped completely mitigate the impact of the lower margins. Also, other income was nearly double the level from 4QFY05, which aided the bottomline growth. Going forward, the company sees good visibility in the IT services business. The tax write-back is also expected to continue for another 2 quarters. The impact of the fringe benefits tax (FBT) was Rs 6.5 m.

Performance in the recent past…
  2QFY05 3QFY05 4QFY05 1QFY06
Sales growth (%, QoQ) 9.8 (0.6) 6.9 7.1
Cost of sales (% of sales) 66.8 70.0 69.1 71.4
Selling expenses (% of sales) 7.6 7.5 7.3 7.0
G&A expenses (% of sales) 10.3 10.8 9.4 8.9
EBDIT margins (%) 20.2 17.1 18.3 17.8
Profits growth (%, QoQ) (10.7) (14.9) 15.3 8.8
Employees (Nos.) 7,268 8,089 8,375 8,173

What to expect?
At the current price of Rs 280, the stock is trading at a price to earnings multiple of 16.3 times its annualised 1QFY06 earnings and 15.1 times our estimated FY06 earnings. At current levels, the stock appears expensive in the medium term. However, if one were to take a 3-year view on the stock, the price to earnings valuation come to 8.8 times our estimated FY08 EPS, which is attractive. There has been news about the impending stake sale of Barings, the major investor in MphasiS BFL, to a possible financial investor or a foreign IT company. However, we would like to mention that investing on the basis of such news rather than potential growth prospects is a risky proposition. We expect the company to grow revenues and profits at a CAGR of 34% and 26% respectively over the next three years.

We had recommended a ‘Buy’ on MphasiS in February 2005 at Rs 260 with a target price of Rs 360 in the medium to long-term. Buoyed by improving prospects of the IT services business, we maintain our stand on the stock.

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