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i-flex: Top up, bottom down!
Oct 28, 2005

Performance summary
i-flex solutions (i-flex) reported its consolidated financial results for the second quarter and half-year ended September 2005. The topline witnessed a strong growth on a yearly basis, driven by the strong performances of both the products as well as services businesses. However, due to considerably higher marketing and employee expenses, margins were adversely impacted.

Consolidated financial performance: A snapshot
(Rs m) 2QFY05 2QFY06 Change 1HFY05 1HFY06 Change
Net sales 2,558 3,497 36.7% 4,800 6,237 29.9%
Expenditure 1,995 2,968 48.8% 3,722 5,462 46.7%
Operating profit (EBDITA) 563 529 -6.0% 1,078 775 -28.1%
Operating profit margin (%) 22.0% 15.1%   22.4% 12.4%  
Other income 48 105 118.3% 135 154 14.2%
Depreciation 74 102 37.5% 130 205 58.1%
Profit before tax 538 533 -0.8% 1,083 724 -33.1%
Tax 121 151 24.8% 268 190 -28.9%
Extraordinary items - (1)   (17) 39  
Profit after tax/(loss) 417 383 -8.1% 832 495 -40.5%
Net profit margin (%) 16.3% 11.0%   17.3% 7.9%  
No. of shares (m) 77.0 77.1   77.0 77.0  
Diluted earnings per share (Rs)* 21.7 19.9   21.6 12.9  
P/E ratio (x)         68.2  
(* 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 (50% 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 (49% 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 1% 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. In recent times, i-flex has ventured into other related areas of the BFSI space, like risk management (ORTOS) and general insurance (Castek).

What has driven performance in 2QFY06?
Products and services strong: In this quarter, both businesses have witnessed a good performance. While the products business grew at 35% YoY, the services business grew at 34% YoY. The services business was driven mainly by non-Citi clients. The operating metrics have improved for this business on a YoY basis, with Citi contributing to 54% of total revenues, compared to 64% a year ago. Even then, Citi revenues increased at 13% YoY. Non-Citi clients grew at a scorching pace of 72% YoY. Offshore revenues as a percentage of the total increased to 38%, from 33% last quarter and 36% in 2QFY05. The offshore revenues grew by 42% YoY, thus reflecting a movement offshore.

On the other hand, the company’s products business, as mentioned above, showed a 35% YoY growth in revenues. License fees as a percentage of total revenues increased from 27% in 1QFY06 to 31% this quarter. Deferred revenues stood at Rs 1.1 bn, out of which most was from the product business.

The company’s knowledge process outsourcing (KPO) company, Equinox, accounted for nearly 2% of consolidated revenues this quarter and declined at a sequential rate of 2%. Equinox recorded an operating loss of Rs 45 m during the quarter. i-flex continues to invest in this business for future growth.

Client metrics improved for the company this quarter, with Citi contributing 36% of revenues, compared to 41% in 2QFY05 and 38% last quarter. The top client (non-Citi) contributed to 4% of revenues. Total clients added were 16, including 8 in the products business. The tank size was at an all-time high of US$ 61 m, compared to US$ 60 m last quarter and US$ 50 m at the end of FY05. This shows good visibility on the products side. i-flex continues to win more deals across geographies, as core banking packaged software gains increasing acceptance. The Oracle deal also gives the company greater credibility and a huge customer base, particularly in the North American market. The company is also seeing good order wins in its other products, like risk management (Reveleus and ORTOS). It continues to invest in R&D on its products, more so with respect to improving their functionality, scalability and modularity, as opposed to developing new products.

Segment-wise performance*…
(Rs m) 2QFY05 % of total 2QFY06 % of total Change
Products
Revenue 1,277 49.9% 1,730 49.5% 35.4%
OP 498 69.4% 542 71.7% 8.9%
OPM 39.0%   31.4%    
Services          
Revenue 1,279 50.0% 1,717 49.1% 34.2%
OP 220 30.7% 258 34.1% 17.0%
OPM 17.2%   15.0%    
KPO Services          
Revenue - 0.0% 47 1.4% -
OP - 0.0% (45) -5.9% -
OPM 0.0%   -94.3%    
Joint ventures          
Revenue 1 0.1% 3 0.1% 132.5%
OP (0) -0.1% 0 0.0% -160.2%
OPM -37.6%   9.7%    
Total          
Revenue 2,558   3,497   36.7%
OP 718   756   5.3%
OPM 28.1%   21.6%    
* including inter-segment adjustments

Margin blues again: As was the case in the previous quarter, i-flex faced considerable margin pressure during the quarter. The company hired a gross of 1,047 employees during 2QFY06 and a net of 700 people, among the highest additions in recent times. This has resulted in increased cost of revenues and has impacted margins quite significantly. On a segmental basis, margins in the products business have declined by 720 basis points, while in the services business, the figure has been 220 basis points. The total margin fall was 690 basis points. The products business was seemingly impacted due to considerably higher sales and marketing (S&M) costs, as, being a product company, maximum expenses in this business are required for S&M. In this quarter, both the businesses have faced margin pressure, while in 1QFY06, it was mainly the products business that saw margin erosion. At the end of 2QFY06, i-flex had 6,200 employees on its rolls.

Lower margins and higher taxes reduce net profit: Due in part, to the crash in margins as well as a considerably higher effective tax rate, net profit has fallen by 8% YoY. This was despite considerably higher other income, due to forex gains of Rs 41 m. For the half-year, the picture is bleak, with the bottomline down by 41% YoY, due on account of lower margins and higher depreciation.

Performance in the recent past
  3QFY05 4QFY05 1QFY06 2QFY06
Sales growth (%, YoY) 44.0 71.3 22.2 36.7
Operating margins (%) 21.9 35.4 9.0 15.1
Profits growth (%, YoY) 27.4 89.8 (73.0) (8.1)
Products (YoY, %) 27.8 24.7 (8.1) 35.4
Services (YoY, %) 67.9 73.3 56.7 34.2
Products tank size (US$ m) 43.7 50.0 60.0 61.0

What to expect?
At the current price of Rs 877, i-flex’s stock is trading at a price to earnings multiple of 15.7 times our estimated FY08 earnings. This is expensive from a long-term basis. While we believe that the Oracle takeover will prove to be beneficial for i-flex in the long run, we believe that most of it has already been factored into the stock price. Also, issues such as the traditional reluctance of American tier-1 banks and financial institutions to go in for packaged software could make it difficult for the company to effectively tap the US market, something that the company should find easier, given Oracle’s strong brand name, reach and storng clientele. While visibility remains strong for the company, quarterly fluctuations will continue plague the overall performance. However, the strong pipeline will ensure a good topline growth.

Going forward, we expect pressure on margins, due to the higher expenses on sales and marketing (S&M) required. The management has said in the conference call that the company could see longer sales cycles and longer implementation time, going forward. Given the poor bottomline performance till the first half of this year, we might have to re-visit our projections downwards.

We shall soon update our research report on the company.

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