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3i Infotech: Debt hangover haunts - Views on News from Equitymaster
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3i Infotech: Debt hangover haunts
Dec 15, 2011

The stock of 3i Infotech has seen a 65% decline over the past seven months. This significant price erosion has been a cause of concern for many investors.

The opportunity

We had recommended 3i Infotech Ltd in August, 2009. At that time, the company looked very promising on account of its future growth prospect. Unlike most of other IT companies, 3i had a fair share of revenues coming from both the IT services as well as IT products segments. The company was on an acquisition spree and was looking at smaller companies which were expected to fuel 3i's growth in the future. As the company was using debt to fund these acquisitions, the debt to equity ratio was at an uncomfortable level of 2x. However, the management had concrete plans for balance sheet restructuring. Towards this, they were looking to raise funds through a QIP (qualified institutional placement) issue. After that, the debt to equity level was expected to come down to 1x.

How it panned out

To start with, the funds raised through QIP failed to bring the debt to equity levels. The management utilized the fund towards the pending payments in the Regulus acquisitions. As a result, the company's debt levels continued to remain alarmingly high. This was the main cause which led us to downgrade our view on the stock to a 'Hold' in May, 2011.

Even with the acquisitions, nothing worked out as per the company's plan. 3i went ahead with its buying spree and acquired J&B Software in November 2007, Regulus Group in May 2008 and JP Morgan Chase's retail check processing division in June 2009 amongst others. It looked like a good call as at the time of acquisition, these companies were seeing growth in both business volumes as well as their profitability. These companies were consolidated together to form the Global Billing & Payments unit of the company. But due to economic slowdown in 2008, this business unit got hit and over the next three years, it witnessed negative growth. Even future expectations of growth were hurt due to rapid shifting of the payment processes to the electronic platforms. The company was not in the position of consolidating this business further through anymore acquisitions. It had already stretched its balance sheet to breaking point. Finally, the company decided to hive off this unit at the start of the financial year 2011-2012. Though the management had genuine reasons to sell this business, however it adversely affected the earlier charted growth trajectory of the company.

More bad news

The management had indicated that the proceeds from the sell-off of the Global Billing & Payments unit would be utilized to lower the debt levels. In the June 2011 quarter conference call, the management of the company had mentioned that they had paid off nearly Rs 500 m of debt in the month of July which would be reflected at the end of September quarter. Further, the company sold its 100% stake in HCCA Business Services Pvt. Ltd. for a consideration of Rs. 385 m. Despite all this, the debt levels went up by Rs 1,359 m at the end of the September quarter of financial year 2011-12. At the same time, cash and cash equivalents including investments have also gone down by Rs 844 m. Hence, net debt level (debt minus cash) has gone up by Rs 2,203 m during the quarter. This does not bode well for the company as the management has been trying to control the debt levels for quite some time with no relief.

Recent events

In a recent development, rating agency CRISIL has downgraded its ratings on 3i Infotech Ltd's bank facilities and commercial papers to junk (CRISIL D) from earlier rating of stable (CRISIL A-/Stable/CRISIL A1). This has created problems for the company for refinancing the short term loans. Post the downgrade, the interest burden would go up as well. The management is trying to meet its short term financial obligations. For this they are even looking at getting long term loan facilities.

The different possibilities

  • If somehow the company manages to get loans to fulfill its short term obligations, it will further worsen its already stretched balance sheet. But the chances of the company getting more loan facilities are very slim.

  • The company could raise equity to make its balance sheet look better. The management of the company has already approved a proposal to raise long term funds by way of issuance of further equity shares through rights and/or public Issue or convertible instruments or such other options. It has also formed a committee of directors to decide the manner of raising long term funds. They have also approved a proposal to increase the authorized share capital to accommodate further issue of shares. This may help company to control its rising debt to equity ratio. However, equity dilution at the present valuations would hurt the existing shareholders.

  • If the company does not manage to raise funds, possibility of a default cannot be ruled out.
The management's silence

Despite the negative news, the management has decided to take the evasive route and maintain silence. It even discontinued its post result conference calls that it used to host every quarter. Several attempts to get a meeting with the management of the company also failed. Probably, they do not have any concrete plans to share with the investor community. This definitely puts a big question mark on the management's ability to run the company, if not on integrity. After all, time and again they failed their own plans to lower the debt to equity ratio.

What to expect?

Hence, we advise our investors to cut their losses in 3i Infotech at current levels as further downside cannot be ruled out. Even if the management somehow sails through the current turbulence; the debt burden would continue to hit the net profits of the company. With the continued selling of its past acquisitions, a spectacular growth at the topline level is already ruled out. And if the current uncertain demand environment continues, it would only worsen the situation for the company.

It may be noted that excellent fundamentals combined with able management are the driving factors for stock prices. Currently both these factors seem to be missing for 3i. We thus advise our investors to "SELL" the stock at current levels.

We are well aware that doubts will be raised with respect to our inability to inform our subscribers of the developments in the company before hand. It should be noted that this is a difficult task given the kind of long term investing philosophy we believe in. It is almost impossible to predict beforehand which event would have what kind of an impact on price and how soon a bad event can remedy itself. The only way to avoid this problem perhaps is to invest in highly predictable business and to ensure there is an appropriate margin of safety in the stock price. It isn't that we do not follow these procedures already but will certainly be even more careful about them in the future. Investors on their part can keep the risks to their portfolio restricted by ensuring that no single midcap stock comprises more than 5% of the overall portfolio.

We are firmly of the belief that the losses that subscribers would incur by selling the stock stand better chance of recovery in some of our recent MidcapSelect recommendations like:

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