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Mphasis 1QFY2010 performance highlights and result update

Contributed by Angel Broking

By Angel Broking

For 3QFY2010, Mphasis reported top-line growth of 4.8% qoq to Rs1,279cr. The company reported mixed performance. Volume growth in the application and ITO segments stood robust, but pricing cut by HP stood steep at 9.6% for the application segment. However, the restructuring exercise in the BPO segment, change in business mix and favorable price review in the ITO segment led to 180bp and 470bp expansion in BPO and ITO margins, respectively, limiting the overall gross margin erosion to 110bp.

Robust volume steals the show: Mphasis registered impressive volume growth of 7.6% qoq in the application segment and ~20% qoq growth in the ITO segment (including revenue from Fortify Infrastructure, which was acquired during the quarter). During the quarter, client addition stood high at 22, spanning across the BFS, manufacturing and healthcare verticals. Net employee addition stood at 1,156, with majority of additions on the lateral side highlighting a strong demand landscape. EBITDA margin declined by 110bp because of the new rate card pricing model with HP, which brought down realisations by 9.6% in the application business. Net profit increased to Rs271.3cr despite flat EBIT due to tax write-back with retreatment of profits under Section 10AA related to SEZ.

Outlook and valuation: Mphasis has been consistently outperforming its peers on the back of a strong pipeline from HP-EDS. Going ahead, we expect the company to achieve steady volume growth of 4.5% CQGR over 3QFY2010–4QFY2012E and stable pricing across its business segments. With the new rate card for its application business in place, the gross margin will shift its orbit to the lower side, but strong growth and robust profitability in the ITO segment will provide some cushion. We expect EBIT margin to settle to 22.3% for FY2011E and 21.3% in FY2012E. PAT is expected to register a 12% CAGR over FY2009–12E on the back of in-the-money hedges as well as yield from a strong cash position setting off increased tax rates from 11% (FY2010) to 25% (FY2012E). We value Mphasis at 14.3x FY2012E EPS of Rs60.9 (at 32% discount to Infosys’ target PE of 21x) and maintain our Buy rating on the stock with a Target Price of Rs872.

Volume-led growth continues…

Mphasis recorded 4.8% qoq and 15.7% yoy growth, generating overall revenue of Rs1,279cr in 3QFY2010. This included forex impact of Rs21cr. In USD terms, the company registered revenue of US $275.6mn, up 1.8% qoq (18.9% yoy). Segment wise, the application business witnessed strong volume growth of 7.3%, limiting the impact of steep price cuts of 9.6% under the new rate card pricing model with HP. Also, favorable dollar rate aided revenue growth of 0.6%. Thus, revenue from the application segment declined by 1.7 % qoq. The ITO business grew at whopping 33.8% qoq on the back of strong ~20% volume growth. This was coupled with 12% growth in pricing on account of improved mix with the acquisition of Fortify Infrastructure (which added Rs27cr to the company’s revenue) and because of one-time revenue of Rs10cr booked on account of achievement of certain milestones targeted in the past. The BPO business witnessed a 0.5% qoq (14% yoy) decline despite flat volume, which was mainly on account of a one-time outage in one of the telecom clients’ facility. However, the BPO restructuring is on course and is expected to yield better results in the coming quarters.

Mixed performance in terms of verticals

Growth was driven primarily by the BFS; technology and OEM; and healthcare and pharma verticals. The company’s telecom vertical was affected by some technical issues at the BPO client site, which resulted in breach of Service Level Agreements and loss of revenue. The logistics, airlines and transportation vertical remained flat, whereas the manufacturing and retail vertical posted laggard performance, down 2% qoq.

Higher margins in ITO and BPO arrested overall margin erosion

Mphasis witnessed a 103bp qoq (403bp yoy) contraction in EBITDA margin in 3QFY2010. During the quarter, the company gave re-compensation payout and fixed salary hikes, which resulted in a 160bp qoq (430bp yoy) increase in manpower costs, thereby impacting the company’s margin. Segment wise, the company’s pricing witnessed a steep cut of 9.6% in the application business, pulling down the gross margin for the same by 380bp qoq. Overall, gross margin erosion was limited to 103bp due to a positive effect of restructuring in the BPO segment and cost optimisation witnessed in the ITO segment by switching to rate card pricing from the earlier cost plus pricing with HP. Gross margin for the BPO and ITO segments expanded by 180bp and 470bp qoq, respectively. Thus, EBITDA margin slipped by only 110bp qoq despite higher selling and marketing expenses on account of a one-time write-back in general and administration expenses of Rs15cr, which contained further erosion in margin.

Improved wallet share in HP channel…

During the quarter, Mphasis witnessed 22 new client wins during the quarter, of which the application segment won 20 and the BPO and ITO segments won one each. These wins were witnessed mainly in the BFS, healthcare and manufacturing verticals.

The HP channel is yielding fruits as reflected by higher-end migrations across client pyramid. During the quarter, the company witnessed addition of one client in over US $20mn category; three additions in over US $5mn category; and four additions in over US $1mn category.

The direct channel witnessed migration of one client from over US $5mn category to over US $1mn category in 3QFY2010.

Hiring spree continues to brace strong pipeline…

Mphasis added 524 employees in the application segment, with 302 people onsite indicating impending kick-off in some projects. The ITO segment also added 753 people offshore, envisaging a strong demand pipeline, and 211 people onsite, largely related to absorption of Fortify Infrastructure’s manpower.

Investment arguments

HP business to stabilise, as price uncertainty is now over

During the quarter, Mphasis demonstrated strong volume growth, primarily because of the BFS spending wave. The company’s growth has been phenomenal as it continues to enjoy the benefits of offshoring by HP. The flip side to this Master-level Service Agreement is the kind of pricing cut witnessed by the company in 3QFY2010 in the application business. However, increased pricing in  the ITO segment came in as a surprise for the company in 3QFY2010. The major pricing review overhang is done and dusted and, going forward, management expects a stable pricing arrangement with HP given that the 50% of rate card pricing will remain fixed and 50% will be market driven. In case of the ITO segment, which is primarily HP-driven, the rate card has proved favorable and, with the acquisition of Fortify, will help to manage cost due to its remote infrastructure services. Thus, we believe HP’s strong parentage would continue to support and provide increased business opportunities to Mphasis.

Focus on Non-HP business and M&As vital for growth

Management has appointed Boston Consulting Group for reviewing the overall organisational performance and for enhancing the company’s growth trajectory in the Non-HP business going forward. This initiative coupled with the effective rate card implementation, which has witnessed cost optimisation, would certainly see improved operational performance for Mphasis going ahead. Mphasis has strong cash position of Rs1,487cr as on date, which would help it to go for acquisitions of strategic fit in the size of US $50mn–$100mn annual revenue run rate.

Outlook and valuation

Mphasis has been consistently outperforming its peers on the back of a strong pipeline from HP-EDS. We assume the company’s ITO business to be the major beneficiary of HP’s restructuring exercise. Further, we expect the ITO business to scale up due to the acquisition of Fortify Infrastructure, growing at a scorching pace of 7% CQGR over 3QFY2010–4QFY2012E, followed by the application business, which will likely grow at a 5% CQGR over the same period. Going ahead, we expect the company to achieve steady volume growth of 4.5% CQGR, with stable pricing across its business segments. With the new rate card in place for its application business, gross margin will shift its orbit to the lower side, but strong growth and robust profitability in the ITO segment will provide some cushion. With fixed rate card in place for the ITO segment, cost pressures will play out and EBIT margin will slip. Hence, we expect EBIT margin to settle to 22.3% for FY2011E and FY2012E from 21.3% in FY2010. PAT is expected to increase at a 12% CAGR over FY2009–12E on the back of in-the-money hedges as well as yield from a strong cash position setting off increased tax rates from 11% (FY2010) to 25% (FY2012E). We value the stock at 14.3x FY2012E EPS of Rs60.9 (at 32% discount to Infosys’ target PE of 21x) and maintain our Buy rating on the stock with a Target Price of Rs872.

We have changed our estimates for FY2011E from Rs54.5 to Rs59.0 and for FY2012E from Rs64.5 to Rs61.0 as we expect strong volume growth in the ITO segment and favorable price points to aid margins. In FY2012E, we believe strong hiring with cost inflation and fixed rate card system will cease the cushion benefit given by the ITO segment. Hence, profitability growth in FY2012E will be limited.