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i-flex: Lumpy performance again!

Aug 1, 2005

Performance Summary
i-flex solutions (i-flex) has reported its consolidated financial results for 1QFY06. The topline has grown at a decent pace and services business has again been the major driver of the revenue growth, while products have witnessed a YoY decline. Margins took a big hit during the quarter, due in part to the salary increases as well as expenses relating to certain order wins being booked during the quarter. The bottomline performance was thus affected by the big fall in margins, and also considerably lower other income and higher depreciation expenses.

Consolidated financial performance: A snapshot
(Rs m) 1QFY05 1QFY06 Change
Net sales 2,242 2,740 22.2%
Expenditure 1,727 2,494 44.4%
Operating profit (EBDITA) 514 246 -52.2%
Operating profit margin (%) 22.9% 9.0%  
Other income 103 49  
Depreciation 56 103 85.3%
Profit before tax 562 191 -66.0%
Tax 147 40 -73.0%
Extraordinary items - 40  
Profit after tax/(loss) 415 112 -73.0%
Net profit margin (%) 18.5% 4.1%  
No. of shares (m) 77.1 77.2  
Diluted earnings per share (Rs)* 21.5 5.8  
P/E ratio (x)   135.4  
(* annualised)      

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 (43% 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 (56% 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.

What has driven performance in 1QFY06?
Services scorcher: i-flex's services segment has yet again been the major driver in the company's topline. In fact, this has been the case over the past few quarters now. The services business grew by a scorching 57% YoY (48% QoQ). On the other hand, the company's products business showed an 8% YoY decline in revenues. An increase in volumes has again been the major contributor to the strong topline growth in services revenues. Billing rates were, by and large, flat and in fact, declined for offshore services. Utilisation fell to 69% from around 75%, due in part to the aggressive hiring carried out during the quarter. Citigroup continues to be the major revenue contributor to this business and accounted for 45% of services revenues in 1QFY06. The company also consolidated revenues of its knowledge process outsourcing (KPO) company, Equinox, which accounted for nearly 2% of consolidated revenues. Equinox recorded an operating loss of Rs 39 m during the quarter. The rupee appreciation against the US Dollar, Singapore Dollar and the Euro has had an adverse impact of 0.5% on revenues.

However, it should also be noted that i-flex did not book revenues from certain order wins during the quarter, as per their accounting policy, which will be recognised over the next couple of quarters. This is clearly reflected in the fact that the proportion of license fees as a percentage of product revenues has declined significantly, from 38% for the full year FY05 to just 27% in 1QFY06. Deferred revenues of the product business stood at US$ 7 m (approx Rs 304 m) for the quarter, which could have been accounted for without adding to the expenses figure. This again shows the 'lumpiness' of the products business, where milestone payments and license fees received and recognised as revenue during one quarter may not be recognised during the next quarter.

But, going forward, depending upon the milestone implementations completed, size of the project and stage of completion, these revenues will be duly recognised and i-flex could see greater traction on the products side. In fact, despite the YoY decline in product revenues, visibility remains strong. The company's tank size has, for the first time ever, hit US$ 60 m (US$ 50 m at the end of FY05), a strong 20% QoQ jump and an impressive 70% YoY jump from the 1QFY05 figure of US$ 35 m. i-flex continues to win major deals across the world for its flagship Flexcube core banking product, as can be seen from the numerous order wins in diverse geographies, such as Brazil, Europe, the Nordic region and North America. i-flex also went live with 3 more countries in the Citigroup Flexcube deal. As of now, around 55 countries have gone live, around half and this deal is scheduled to go on for the next two to three years.

Segment-wise performance…
(Rs m) 1QFY05 % of total 1QFY06 % of total Change
Revenue 1,269 56.6% 1,167 42.6% -8.1%
OP 489 76.0% 147 31.7% -69.9%
OPM 38.5%  12.6%   
Revenue 971 43.3% 1,523 55.6% 56.7%
OP 154 24.0% 356 76.7% 131.2%
OPM 15.9%   23.4%    
KPO Services
Revenue - 0.0% 48 1.8% -
OP - 0.0% (39) -8.3% -
OPM 0.0%   -80.1%    
Joint Ventures
Revenue 1 0.1% 2 0.1% 49.9%
OP 0 0.1% 0 0.0% -77.2%
OPM 26.7%   4.1%    
Revenue 2,242   2,740   22.2%
OP 643   465   -27.7%
OPM 28.7%   17.0%    
* including inter-segment adjustments

Margin blues: i-flex added a net of 753 employees in 1QFY06, among the fastest additions during a quarter. The company also raised salaries of its Indian staff by 15%, while raising them by 2% to 5% for its staff in other locations. This resulted in employee costs as a percentage of sales rising considerably, from 46.2% in 1QFY05 to 54.5% in 1QFY06. This has shaved 8.3% off the company's margins, which fell overall on a YoY basis by as much as 13.9%. Also, i-flex has booked expenses relating to certain order wins during the quarter, while not booking corresponding revenues, based on its accounting policy. This has also resulted in a big hit on the margins. The company's traveling expenses also increased as a percentage of revenues to over 18% from 13% in 1QFY05. Margins of the services business continue to improve and were at 23.4% during the quarter, up from 15.9% in 1QFY05. However, margins of the products business crashed to just 12.6%, from 38.5% in 1QFY05. i-flex also incurred Rs 80 m of higher visa costs, due to the increase in the cost of a visa. At the end of 1QFY06, i-flex had 5,500 employees on its rolls.

Lower margins and lower other income hammer net profit:  Due in part, to the crash in margins as well as considerably lower other income, net profit crashed by a massive 73% YoY. Considerably higher depreciation costs further compounded the problem.

Performance in the recent past
  2QFY05 3QFY05 4QFY05 1QFY06
Sales growth (%, YoY) 36.8 44.0 71.3 22.2
Operating margins (%) 22.0 21.9 35.4 9.0
Profits growth (%, YoY) (16.3) 27.4 89.8 (73.0)
Products (YoY, %) 13.5 27.8 24.7 (8.1)
Services (YoY, %) 72.0 67.9 73.3 56.7
Products tank size (US$ m) 40.5 43.7 50.0 60.0

What to expect?
At the current price of Rs 785, i-flex's stock is trading at a price to earnings multiple of 17.0 times our estimated FY07 earnings, which makes it fairly valued from a medium term perspective. As has been seen, the company has recorded another quarter of lumpy growth in its product business, a complete contrast from the previous quarter, where the company recorded a scorching performance in both its businesses. Services continue to do well, reflecting the linearity of this business. The services business has actually overtaken the products business in terms of percentage of revenues. Given the scorching pace of growth maintained, this is expected to continue. However, as we have mentioned above, going forward, as the company recognises revenues from products over the next couple of quarters, this business is expected to bounce back, as can be seen from the improving visibility, reflected by the all-time high tank size of US$ 60 m.

The profit performance may be poor, but we believe that one quarter is not reflective of the true picture of any company, including i-flex. Management has indicated in the conference call that the type and number of financial institutions (FIs) looking at core banking is looking stronger than ever before, reflected in the tank size. Therefore, the company expects an increase in S&M expenses, going forward. The larger FIs, which typically tend to go for in-house software rather than packaged vendor solutions, are now opening up to this idea. Therefore, there is no let-up in the market momentum. We continue to remain positive on the company's future prospects.

We shall soon update our research report on the company.

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