i-flex: Pressure takes its toll!

Within the highly competitive Indian technology space, where companies are vying to capture the market share and 'mind-share' of global clients, there are a few who have created a niche for themselves and have even emerged successful in their endeavors of increasing their reach in the global marketplace. One such company is i-flex solutions (i-flex), the largest and the most successful in India in the software products space. In this article, we try and bring to notice the key aspects from the latest annual report of the company.

Some good things…

i-flex, with its flagship product, Flexcube (core banking solution) continues to penetrate deeper into the global banking and finance industry. The product, which was launched in 1997, has not only attained a large clientele, but has also outperformed its competitors to emerge as the largest selling core banking solution in the world in 2003, for the second consecutive year. However, the company still has a long way to go. This is indicated by the fact that the addressable market for i-flex in the IT spending by global banking and finance industry is likely to grow from US$ 140 bn in 2002 to around US$ 186 bn by 2006, CAGR of 7.4%. When compared to this, i-flex revenues in FY04 was a miniscule US$ 173 m, or 0.1% of the market size.

However, the company seems to be moving in the right direction of increasing this share as seen by the global strides it has taken over the past few years. For instance, i-flex has rapidly grown its customer base for both products (61% of FY04 revenues) and services (39%) to 497 spread across 108 countries. This gives the company's revenues a hedge against slowdown of a particular region/country, thus helping it derisk its revenues. i-flex has also grown its revenues from the US markets to over 45% in FY04 (40% in FY03). Apart from large US banks, the company is also gradually tapping regional banks in the country that have been using local banking solutions over the past years. While it will still take a long time for i-flex to really penetrate deep in this fast growing segment, it is important to understand that a beginning has been made in this direction.

On the products front (Flexcube and Reveleus), the company continues to witness decent growth (revenues from the segment have grown by 25% YoY). While this pales in comparison to 55% and 52% YoY growth achieved in FY02 and FY03, one must take into account the large base of FY03 that included a one time large size deal from Citibank for Flexcube implementation across 100 countries. The effect of the same is seen in the almost stagnant license fee revenues (see graph below) and marginal increase in tank-size (unbilled license fee) in FY04 as compared to FY03. The tank-size increased by 9.5% YoY to US$40.5 m, from US$ 37.0 m in FY03. This should not be a cause of concern, as the company continues to make significant investments towards capturing a larger market share going forward. As a matter of fact, the tank-size stood at US$ 43.7 bn at the end of 1QFY05.

From the services segment, i-flex witnessed a strong revenue growth of 36% YoY in FY04. i-flex continues in its focus in considering the services business as an incubator for new product technologies. As a result, the company is making large investments in this segment towards adding to employee base, improving sales and marketing infrastructure and setting up development centres. For instance, in FY04, the company completed the construction of its corporate and development centre at Bangalore, which has a capacity for 1,400 employees.

…and some not so good!

Now, the continued initiatives on the expansion front have cost the company on the profitability front. In FY04, while operating margins for the products division declined to 43% (48% in FY03), those for the services division declined to 18% (19% in FY03). Also, the company's debtor days, which had declined from 164 in FY02 to 86 in FY03, climbed up to 113 in FY04. However, this should be seen as one of the costs of increasing initiatives towards expanding the customer base.

Under-performing the benchmark?

The graph below indicates that i-flex has underperformed the Sensex in the past since the beginning of the calender year 2004. And much of the reason lies in the poor quarterly performances that the company has reported since then, i.e., 3QFY04. Over this period, the company has witnessed high volatility in its operating performance as indicated by a sharp drop in its operating margins. These declined from 31% in 2QFY04 to 24% in 3QFY04, then increasing to 30% in 4QFY04 and again declining to 23% in 1QFY05.

At the current price of Rs 600, i-flex is trading at a P/E multiple of 25.1x FY04 EPS. This is at the higher side of the valuation spectrum, and is indicative of the volatility in quarterly earnings over the past year. However, we believe that since the company is making large investments into future growth, investors need to look beyond quarterly numbers that might indicate pressure on profitability and volatility in valuations. Low penetration and a increasing acceptance of third-party core banking solutions promises a high growth potential for the company going forward.