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  • Stock Recommendation | Mphasis - SELL - Target price : 900

    Publish date: OCTOBER 22, 2018

    HP/DXC-led growth. Mphasis reported 3% constant currency revenue growth, broadly in line with our estimate. Revenue growth was led by HP/DXC channel that grew 6.4% sequentially. The rest of the portfolio grew at a modest rate. EBIT margin was broadly in line with our estimate but helped by aggressive SG&A cuts. Cut in tax rate assumption leads to a marginal increase in our FY2019-21E EPS estimate. We maintain our SELL rating valuing the company at 14X Sep 2020E earnings. The stock trades at an expensive 17X FY2020E earnings.

    Revenue growth of 3% in constant currency was marginally lower than our estimate as revenues from Digital Risk declined by a sharp 11.5% sequentially. HP/DXC channel was the primary driver with c/c growth of 6.4% sequentially. Non-HP channel revenues posted muted qoq revenue growth of 1.3% in US$ terms. Within the non-HP channel, Direct International revenues grew 0.7% in c/c terms on a qoq basis. Direct Core business comprising 81% of Direct International grew 3.9% in c/c terms sequentially. EBIT margin was lower than our estimates even after a one-off and unsustainable G&A realization boost. EBIT margin stood at 16.4%, down 20 bps qoq and up 200 bps yoy. Net profit increased 4.9% qoq and 37.0% yoy to Rs2.71 bn, beating our estimate by 2.7% aided by a lower than-expected tax rate.

    Mphasis maintained FY2019E EBIT margin guidance of 15-17%. Management expects industry leading growth in both HP/DXC and Direct Core segments, stable run-rate in the US$28-US$30 band for Digital Risk segment and flat/declining revenues for its India business. Net new deal wins of US$210 mn was a record high and grew 37.2% qoq and 70.7% yoy. TCV of deal wins in 1HFY19 was up 18.6% over the corresponding prior period though we do note that deal tenure has increased. This will be a key monitorable going forward. We forecast 13.5% c/c revenue growth in FY2019E and 11.5% in FY2020E

    Our FY2019-21E EPS estimate increases marginally on the back of a lower tax rate. We value the stock at 14X Sep 2020E earnings resulting in a target price of Rs900. At 17X FY2020E earnings, Mphasis trades at par/premium to most Indian IT companies. Valuations are expensive even after acknowledging near-term revenue momentum from the HP channel and Blackstone portfolio of clients. We maintain our cautious stance in view of risks of high client concentration, high legacy portfolio and modest quality of revenue base. Sustainability of growth especially from the fast growing top client is questionable

    Mphasis reported cash flow hedge loss of Rs330 mn resulting from forward contracts as compared to a loss of Rs16 mn in the previous quarter and a gain of Rs397 mn in 2QFY18. Hedging losses led to an EBIT margin impact of 142 bps as compared to 9 bps in 1QFY19 quarter. The company fully hedges four quarters on a rolling basis and partially hedges for the following two quarters. As a result, the company is unlikely to realize any benefit of Rupee depreciation in FY2019. However the P&L will start moving toward the spot rate and above that (premiums on forward contracts) in FY2020, provided the Rupee remains stable in the subsequent year.

    HP/DXC business. HP/DXC channel’s revenues (28% of revenues) grew 6.4% in c/c terms and 5.9% in USD terms sequentially to US$78 mn. Mphasis reported that deals in the channel mainly involved digital transformation rather than traditional IMS and service desk operations. Management reported that seasonality will result in moderation of sequential growth in the near term.
    Direct core. Direct Core revenues (55% of revenues) grew 3.9% in c/c terms sequentially to US$152 mn. Mphasis is confident of sustaining mid-teen growth in its direct core segment. The company has won deals against larger competitors in the segment. Mphasis reported that the Blackstone deal pipeline and conversion were fairly strong.
    Digital Risk. Digital Risk segment remains volatile as it continues to face headwinds in the origination business. Management expects Direct Risk segment’s quarterly revenue run-rate to continue in the US$28-30 mn band. Management reported that its ability to cross sell services to its financial service clients in the segment has increased.
    Onsite revenues. Onsite revenues grew 3.5% qoq, while offshore revenues grew 1.4% sequentially in US$ terms. Mphasis reported that demand growth was mainly from new gen services which require co-location. Management stated that it has managed to cope with headwinds from visa issues.
    Margin walk-through. EBIT margin declined by 20 bps to 16.4% sequentially in the quarter. Margins were impacted by headwinds from (1) higher staffing costs for new projects and (2) hedge losses, offset by, tailwinds from (3) operational efficiencies and (4) one-time savings in G&A costs related to professional charges.
    Margin outlook. Management maintained EBIT margin guidance in the 15-17% range for the full year. Margin tightening through utilization lever is limited. Management was confident of meeting EBIT margin guidance despite wage hikes in 3QFY19 and further investments in TalentNext and NextLabs.
    Deal wins. Mphasis reported highest ever TCV of net new deal wins of US$210 mn in Direct International segment in the quarter. Management reported that deal wins were broad based across verticals, across strategic accounts and across new clients. Management commented that deal sizes are seeing an increasing trend.
    Europe. Deal pipeline in the geography continues to be strong. Management reported visibility of benefits from its investments in the region and would continue to invest in Europe.
    Emerging industries. Emerging industries comprise of transportation, logistics and healthcare verticals. Mphasis plans to leverage reference clients outside of BFSI vertical and its large-client relationships for growth in these verticals. Investments in these verticals will continue.
    Others segment. Others segment contributes 3.7% to overall revenues. It mainly consists of the domestic legacy business. Mphasis expects revenues to remain flat and does not plan on investing in the segment.

    Definitions of ratings

    BUY - We expect this stock to deliver more than 15% returns over the next 12 months.
    ADD - We expect this stock to deliver 5-15% returns over the next 12 months.
    REDUCE - We expect this stock to deliver -5-+5% returns over the next 12 months.
    SELL - We expect this stock to deliver

    Our target prices are also on a 12-month horizon basis.

    Other definitions

    Coverage view. The coverage view represents each analyst's overall fundamental outlook on the Sector. The coverage view will consist of one of the following designations: Attractive, Neutral, Cautious.

    Other ratings/identifiers

    NR = Not Rated. The investment rating and target price, if any, have been suspended temporarily. Such suspension is in compliance with applicable regulation(s) and/or Kotak Securities policies in circumstances when Kotak Securities or its affiliates is acting in an advisory capacity in a merger or strategic transaction involving this company and in certain other circumstances.
    CS = Coverage Suspended. Kotak Securities has suspended coverage of this company.
    NC = Not Covered. Kotak Securities does not cover this company.
    RS = Rating Suspended. Kotak Securities Research has suspended the investment rating and price target, if any, for this stock, because there is not a sufficient fundamental basis for determining an investment rating or target. The previous investment rating and price target, if any, are no longer in effect for this stock and should not be relied upon.
    NA = Not Available or Not Applicable. The information is not available for display or is not applicable.
    NM = Not Meaningful. The information is not meaningful and is therefore excluded.

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