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MphasiS: IT services show the way, yet again! - Views on News from Equitymaster
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MphasiS: IT services show the way, yet again!
Oct 13, 2005

Performance summary
MphasiS-BFL has announced its results for the second quarter and half-year ended September 2005. A good performance in the IT services division has once again been the main driver of the marginal growth in topline. Margins rose substantially during 2QFY06, driven by lower expenditure, mainly due to savings in communication and selling costs. Consequently, the higher margins translated into a strong double-digit profit growth for the quarter, despite lower other income and no tax credits earned. For the half-year period, the performance was decent, though muted as compared to the top tier companies that have announced their results.

Financial performance (Consolidated): A snapshot…
(Rs m) 1QFY06 1QFY06 Change 1HFY05 1HFY06 Change
Sales 2,197 2,274 3.5% 3,688 4,472 21.3%
Expenditure 1,806 1,779 -1.5% 2,978 3,585 20.4%
Operating profit (EBDIT)** 391 495 26.7% 710 886 24.9%
Operating profit margin (%) 17.8% 21.8%   19.2% 19.8%  
Other income 58 30 -48.2% 79 88 12.2%
Depreciation 118 123 4.5% 182 240 31.8%
Profit before tax 332 403 21.4% 606 734 21.1%
Tax (5) 1   (62) (4)  
Profit after tax/(loss) 337 402 19.2% 668 739 10.6%
Net profit margin (%) 15.3% 17.7%   18.1% 16.5%  
No. of shares 79.0 80.7   75.4 80.5  
Diluted earnings per share* (Rs) 16.7 19.9   17.7 18.3  
P/E ratio (x)         14.2  
* 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 31% of the total revenues. Recently, however, the BPO segment has shown subdued performances, declining for 3 quarters in a row. 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 FY05, MphasiS’ revenues and net profits have grown at compounded rates of 29% and 35% respectively.

What has driven performance in 2QFY06?
IT services drive growth yet again: This has been the third successive quarter in which the IT services segment has been the major driver of topline growth. This segment grew on a sequential basis by 6%, helped by volume growth and increased breadth of services, aided by the recent acquisition of Princeton Consulting. Volumes grew by about 8% QoQ onsite and 9% QoQ offshore. However, the billing rate environment was clearly negative, with onsite rates dropping by nearly 5% sequentially, while offshore rates were flat. This is clearly out of line with what Infosys and TCS have witnessed, where the billing rate environment has been stable-to-positive, with largely no downward pressure. Utilisation rates rose to 77% from 76% in 1QFY06. This could have been partly due to the lower hiring carried out by the company in this segment. MphasiS recruited 117 employees in the IT services segment. Total headcount in the IT services segment now stands at 2,971.

On the BPO side, revenues were flat, falling by 1% and pricing pressure continued. Even though the company saw about 9% sequential increase in volumes during 2QFY06 in the BPO business, billing rates dropped by as much as 9%. For the first half, while IT services grew by 30% YoY, BPO grew by 6% YoY.

However, this period appears to be one of consolidation for the BPO business, as MphasiS recruited 1,222 people in this segment, giving an indication that the deal pipeline is strong. Total headcount in the BPO segment now stands at 6,541, giving the company a total headcount of 9,512. MphasiS added 15 clients during the quarter, 12 in IT services and 3 in BPO.

Lower costs send margins soaring: Operating margins in 2QFY06 rose by as much as 400 basis points. This was mainly due to significant savings in communication and selling costs. As a percentage of revenues, selling expenses reduced from 7.0% in 1QFY06 to 6.0% this quarter, which has been the lowest in the last five quarters. This was possible due to a reduction in the sales force and better management of overheads. Total cost of sales reduced from 71.4% in 1QFY06 to 67.9% this quarter, resulting in the strong upward margin movement.

Higher margins help profits: Due to the higher margins, net profits recorded a strong 19% sequential growth. This was despite lower other income, mainly a result of lower foreign exchange gains due to the depreciation of the rupee against the dollar. Even though there was no tax write-back this quarter, net profit growth was robust. The impact of the fringe benefits tax (FBT) was Rs 6.5 m in 2QFY06 and Rs 14.4 m for 1HFY06.

Performance in the recent past…
  3QFY05 4QFY05 1QFY06 2QFY06
Sales growth (%, QoQ) (0.6) 6.9 7.1 3.5
Cost of sales (% of sales) 70.0 69.1 71.4 67.9
Selling expenses (% of sales) 7.5 7.3 7.0 6.0
G&A expenses (% of sales) 10.8 9.4 8.9 9.7
EBDIT margins (%) 17.1 18.3 17.8 21.8
Profits growth (%, QoQ) (14.9) 15.3 8.8 19.2
Employees (Nos.) 8,089 8,375 8,173 9,512

What to expect?
At the current price of Rs 260, the stock is trading at a price to earnings multiple of 14.0 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 comes to 8.2 times our estimated FY08 EPS, which is attractive.

Barings, one of the principal shareholders of MphasiS BFL, had recently called off its stake sale in the company due to pricing issues with the potential bidders. This has resulted in subdued sentiment for the stock in the recent past. However, this phase appears to be one of consolidation and the strong hiring in the BPO business this quarter seems to be an indication that the company has a healthy strong order pipeline in hand. The company had recently embarked upon a strategy to differentiate itself from other players and this included focusing on platform-based BPO (Eldorado), consulting (Princeton), BPO and application development and maintenance (ADM) in terms of service lines and financial services, retail, transport and high-tech industries in terms of verticals. How this strategy plays out in an industry that is consolidating and becoming increasingly unkind to mid-sized players will be the major factor for MphasiS if it wants to remain a strong contender over the longer term.

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. We believe that this is a high risk-high return tier-2 play in the software sector and investors with an appetite for high risk can consider holding on to the stock.

  • We will update our research report on MphasiS BFL shortly.

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