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MphasiS: All fall down! - Views on News from Equitymaster
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MphasiS: All fall down!
Aug 1, 2006

Introduction to results
MphasiS BFL announced its first quarter results for FY07 late yesterday evening. The company has reported a relatively subdued growth in its topline, which was mainly driven by the IT services business, even as BPO revenues remained sluggish. However, considerably higher cost of revenues on account of the salary increase carried out this quarter (an annual event) led to a significant fall in margins. Despite a near-doubling of other income, the lower margins coupled with a higher effective tax rate led to a substantial fall in the bottomline for the quarter.

Financial performance (Consolidated): A snapshot…
(Rs m) 4QFY06 1QFY07 Change
Sales 2,505 2,607 4.1%
Expenditure 1,992 2,292 15.1%
Operating profit (EBDIT) 513 315 -38.7%
Operating profit margin (%) 20.5% 12.1%  
Other income 22 42 95.1%
Depreciation 140 150 6.9%
Profit before tax 394 207 -47.5%
Tax 43 55 29.8%
Profit after tax/(loss) 352 152 -56.9%
Net profit margin (%) 14.0% 5.8%  
No. of shares (m) 160.7 163.7  
Diluted earnings per share (Rs)*   8.0  
P/E ratio (x)*   19.6  
* On a trailing 12-month basis.

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 on the BPO segment, which contributes to nearly 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). During the period between FY01 and FY06, MphasiS’ revenues and net profits have grown at compounded rates of 28% and 32% respectively.

What has driven performance in 1QFY07?
Its ‘IT’ again: In 1QFY07, MphasiS recorded a relatively sluggish 4% QoQ growth in its topline. This is a vast under-performance when compared with its top-tier peers, which have grown their topline at rates between 6% and 15% QoQ. In fact, in dollar terms, revenue growth was less than 2% QoQ. The management has said in the conference call that through most of the quarter, valuable management time was spent on the open offer made by EDS. This resulted in lesser time spent on front-end activities such as client acquisition and sales and marketing.

During the quarter, the IT services business was the major driver for the topline growth. This business has witnessed a reasonable 6% QoQ topline growth, driven mainly by volumes as well as rupee depreciation. As regards delivery-based revenues, onsite revenues increased at a strong pace of 13% sequentially, while offshore revenues were up by a mere 2% QoQ. Growth in offshore revenues seems mainly a result of higher billing rates (up 5% QoQ) plus the favourable exchange rate. This is because the offshore volumes have declined by around 3% QoQ. The total number of employees in the IT services business stood at 3,670 at the end of 1QFY07, as compared to 3,533 at the end of FY06.

As regards the BPO business, it showed marginal de-growth of 0.2% QoQ. Billing rates were flat, indicating that volumes may have fallen sequentially. This business continues to witness sluggish-to-negative growth. The loss of a client in its international BPO business was one factor that could have impacted the topline this quarter. If we take a 2-year view, over the past 8 quarters, the BPO business has shown a meager 2.4% compounded quarterly growth rate, increasing from Rs 647 m in 1QFY05 to Rs 779 m this quarter. Going forward, the management has said that it expects this business to grow at a faster pace. This could be aided in some way by EDS. EDS’ BPO business is significant, at US$ 3 bn, and it is strong in areas like contact centres and HR outsourcing. Thus, MphasiS could benefit from this alliance, although it should be noted that this process could take some time to finally reflect on the topline, due to it being a gradual process. The total number of employees in the BPO business stood at 7,564 at the end of 1QFY07, as compared to 7,881 at the end of FY06. Thus, there was actually a reduction in employee headcount in this quarter.

Salary hikes hammer margins: During 1QFY07, MphasiS’ operating margins crashed by as many as 840 basis points (8.4%). This was primarily due to higher employee costs as a result of the salary hikes carried out during the quarter. MphasiS increased its offshore salaries by between 15% and 20% (10% to 15% in 1QFY06), while onsite salaries were hiked by 6% (3% in 1QFY06). This is a clear indication that wage inflation and higher attrition rates are increasingly beginning to take their toll on margins of the company. This has always been our stance, and it is being vindicated here. For MphasiS, in 1QFY07, attrition rates in its IT services business were as high as 18%, while those in the BPO business were 35%.

Lower margins, higher taxes bleed the bottomline: Due to the considerably lower margins during the quarter, as well as a considerably higher effective tax rate, the net profits of the company fell by as much as 57% QoQ. The company has said that most of the higher taxes are due to the reversal of deferred tax credits seen in previous quarters, and has said that it expects the average tax rate to be between 12.4% and 12.7% of PBT for FY07.

Performance in the recent past…
  2QFY06 3QFY06 4QFY06 1QFY07
Sales growth (%, QoQ) 3.5 6.6 3.3 4.1
Cost of sales (% of sales)* 67.9 67.9 69.5 76.2
Selling expenses (% of sales)* 6.0 5.6 6.4 7.6
G&A expenses (% of sales)* 9.7 8.8 9.3 9.7
EBDIT margins (%) 21.8 23.2 20.5 12.1
Profits growth (%, QoQ) 19.2 1.7 (13.9) (56.9)
Employees (Nos.) 9,512 10,871 11,414 11,234
* Including depreciation.

What to expect?
At the current price of Rs 157, the stock is trading at a price to earnings multiple of 11.4 times our estimated FY08 earnings. With EDS India being merged into MphasiS, there will be an equity dilution to the tune of around 25%. This deal will be complete by end of December 2006, subject to regulatory clearance. We believe that this merger is a positive for MphasiS. However, the full impact on the company’s financials may take some time to reflect. The company expects to end 2006 with an employee base of over 20,000 people (including EDS’ employees). This reflects the strong hiring that it expects to do this year.

The IT services business continues to witness good traction, while the BPO business has remained sluggish. Despite expected improvements over the next few quarters in its performance, there is a likelihood of us revising our projections downwards for the company. If we include EDS India, in FY06, this company had revenues of Rs 3.2 bn and net profits of Rs 422 m. Thus, this will add to the earnings of MphasiS.

However, we would remain cautious on the stock over the medium-term, given uncertainties regarding the performance in future quarters, its greater susceptibility than top-tier software companies to wage inflation and higher attrition rates, the continued inconsistency seen in the BPO business and the fact that the integration of EDS will be a gradual process. We shall soon update subscribers with our view on the stock.

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