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MphasiS: Are IT services out of trough?

Oct 11, 2004

Performance summary
MphasiS-BFL has announced its results for the second quarter and half year ending September 2004. While topline growth has been strong for both 2QFY05 and 1HFY05, a large foreign exchange loss has led to the bottomline witnessing a decline on a sequential basis for the quarter. Lower cost of sales has, however, helped the company report an improvement in margins during the quarter.

Financial performance (Consolidated): A snapshot…
(Rs m) 1QFY05 2QFY05 Change 1HFY04 1HFY05 Change
Sales 1,758 1,930 9.8% 2,732 3,688 35.0%
Other income 88 (9)   82 79 -4.2%
Expenditure 1,525 1,635 7.2% 2,337 3,160 35.2%
Operating profit (EBIT)** 233 295 26.5% 395 527 33.7%
Operating profit margin (%) 13.2% 15.3%   14.4% 14.3%  
Profit before tax 321 286 -10.9% 477 606 27.2%
Tax (32) (29)   27 (62)  
Profit after tax/(loss) 353 315 -10.7% 450 668 48.6%
Net profit margin (%) 20.1% 16.3%   16.5% 18.1%  
No. of shares 35.5 77.4   35.5 77.4  
Diluted earnings per share* (Rs) 18.2 16.3   11.6 17.3  
P/E ratio (x)   18.7     17.7  
* annualised   ** includes depreciation and 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, especially in the BFSI segment (48% of 2QFY05 revenues). The company has a special focus in the BPO segment and, in FY04, merged the business of its BPO subsidiary, MsourcE, with itself. The company has 7,268 employees on its rolls, including 5,010 employees in the BPO segment.

What has driven performance?
  • Sales:  Growth witnessed in MphasiS’ consolidated topline in 2QFY05 is a result of 10.0% QoQ growth in the IT services business (63.3% of revenues) and 9.4% QoQ growth in the BPO business (36.7% of revenues). Stable billing rates and a higher proportion of offshore revenues (37% in 2QFY05 from 34% in 1QFY05) have helped IT services revenues grow at the fastest sequential rate in the last seven quarters. In case of BPO, revenue growth was muted (in comparison to 15% QoQ growth in 1QFY05) and this seems a result of a marginal decline in billing rates, as utilisation levels have remained stable. During the quarter, MphasiS added 17 (11 in 1QFY05) new clients. This included 15 additions in IT services and 2 in BPO.

  • Operating margins:  In a quarter when MphasiS added 228 employees, which is its lowest addition in a quarter in recent times, decline in cost of revenues as a percent of sales (from 69% in 1QFY05 to 67%) helped improve profit margins. Also, as said earlier, an increased revenue contribution from offshore services helped improvement in margins for the quarter. This is because while offshore services command lower billing rates as compared to onsite services, relatively lower expenses in the former (offshore) mean higher margins than the latter (onsite). The company also seems to have reaped advantages of low training costs of BPO employees, as it now hires only trained people for this division. Selling expenses (7.6% of revenues) continued their rise in this quarter as well. However, as MphasiS targets a larger customer base in its bid to grow in size, spending on this account is likely to increase further. While this might dampen margins in the medium term, investors need to understand this as an investment towards future growth.

  • Net profits:  Despite QoQ growth of around 26% in operating margins, net profit declined in 2QFY05, mainly due to a big loss of Rs 16.5 m on the foreign exchange front.

Performance in the recent past…
  3QFY04 4QFY04 1QFY05 2QFY05
Sales growth (%, QoQ) 4.0 6.8 10.7 9.8
Cost of sales (% of sales) 70.4 70.5 69.1 66.8
Selling expenses (% of sales) 5.8 6.2 7.1 7.6
G&A expenses (% of sales) 8.3 7.6 10.5 10.3
EBIT margins (%) 15.4 15.5 13.2 15.3
Profits growth (%, QoQ) 11.9 (11.8) 40.4 (10.7)
Employees (Nos.) 5,229 6,278 7,040 7,268

What to expect?
At the current price of Rs 305, the stock is trading at a P/E multiple of 17.7 times annualised 1HFY05 earnings. The stock has lost over 6% in today’s trade and this seems a result of the sequential decline in profits for the second quarter.

During presentation of its FY04 results, the management of the company had projected revenues and profits to rise by 35%-40% and 40%-45% in FY05. As seen from 1HFY05 revenue growth, while the company seems on course to meet its revenue target, any further losses on the foreign exchange front can have a significant impact on the profit growth for the fiscal. Post its acquisition of Kshema Technologies during 1QFY05, growth in IT services revenues seem to have picked up pace, and this is a good sign. Also, while the BPO business has witnessed a lower rate of growth in the quarter, profitability of this segment is on a rise and this has led to improved margins for the consolidated entity. All in all, while the results seem satisfactory at first glance, the fact that MphasiS has been able to continue with its growth momentum in both its business segments is a positive sign as far as long-term prospects are concerned. However, high forward valuations remain a concern.

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