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Stock Recommendation | PERSISTENT SYSTEMS LTD – BUY – Target Price : 870
Publish date: OCTOBER 23, 2018
IP revenue volatility continues: Persistent Systems indicated better revenue growth and margin improvement in H2FY19 which will partly mitigate the impact of one-offs in Q2FY19. Revenue growth will be supported by good deal wins, project starts in Q2FY19, higher contribution from healthcare business (strong demand on the digital side and higher deal sizes), meaningful jump in IP business and the reseller segment due to seasonally strong Q3FY19. In Q2FY19, it has added net 400 people reflecting strong project pipeline. Margin improvement will be supported by better sales mix (higher offshore mix), better utilization, and efficiency improvement. With strong balance sheet, it is looking for acquisitions of smaller businesses in healthcare, data and machine learning, which can support in geographical expansion.
■ In Q2FY19, the biggest disappointment is the poor growth in Digital segment.
■ Persistent’s Q2FY19 consolidated revenue decreased by 4.3% qoq in US$ terms to US$ 118 mn led by 10% qoq decline in IP revenue (US$ 30mn).
■ Consolidated revenues increased merely by 0.2% qoq to Rs.8.36 bn (+9.8% yoy) supported by 3.7% qoq increase in technology services revenue but revenue from Alliance-IBM declined by 8.3% qoq.
■ Operating profit increased to Rs.1.44 bn (3% qoq and 24% yoy) due to rupee depreciation, lower sales and marketing expenses/ project related travel expenses and lower purchase/royalty expenses. EBITDA margin rose by 40 bps qoq, with rupee depreciation (110 bps benefit) and higher utilization offsetting the wage hike impact.
■ In Aug’18, the company has completed acquisition of Herald Health. It’s a Boston based start-up that transforms healthcare data overload into clear and actionable insights for care providers and patients.
■ Persistent had deposits of Rs.430 mn with Infrastructure Leasing & Financial Services Ltd. (IL&FS) and IL&FS Financial Services Ltd. and the same are due for maturity from Jan’19 to Jun’19. As of Sept’18 end, there have been no defaults in payment of interest. Accordingly, the management believes that there is no immediate need to recognize any impairment.
We have lowered our EPS estimates to reflect H1FY19 performance, higher tax rate guided by company and minor other changes. Accordingly, we now expect Persistent to report an EPS of Rs.47.7/share (earlier Rs.52.2) in FY19E and an EPS of Rs. 61.3/share (earlier Rs.65.1) in FY20E. Margin improvement and decent revenue visibility makes us positive on its growth prospects. We maintain BUY rating on Persistent and a multiple based price target of Rs.870/share (earlier Rs.1025/share). We have valued the stock at 14x PE multiple at a 30% discount to its peers. Additionally, attractive valuations, cash rich balance sheet, strong free cash flow and healthy return ratios (ROE 16+% and ROCE 18+%) also provide high comfort. At CMP, the stock is valued at 5.7x EV/EBITDA and 9.1x P/E on FY20 basis.
■ Revenue in US dollar terms: Persistent’s Q2FY19 consolidated revenue decreased by 4.3% qoq in US$ terms to US$ 118 mn (flat on yoy) led by 10% qoq decline in high-margin IP revenue (US$ 30mn) and 2% qoq decline in services revenue. Services revenue decline due to earlier than expected project completed (US$ 0.8 mn negative impact).
■ In the digital segment, it has again disappointed as revenue dipped for the second successive quarter.
■ Revenue (Rupee terms): Consolidated revenues increased merely by 0.2% qoq to Rs.8.36 bn (+9.8% yoy) supported by 3.7% qoq increase in technology services revenue but revenue from Alliance-IBM declined by 8.3% qoq.
■ The company has highlighted three reasons for sequential decline in revenue 1). Seasonality with one partner in the re-seller business, 2). In digital business, one project got closed unexpectedly in Sep’18 (second half) due to change in product requirement, and 3). Part of the business has moved from US on-site to offshore business which negatively impact revenue growth but improves margin and profitability (better management control, better operating cost, etc.).
■ Staff Cost: Employee cost increased by 6% qoq/yoy to Rs.5.04 bn in Q2FY19 due to wage hike undertaken. Staff cost to revenue (percent) increased 326 bps qoq to 60.3% (-226 bps yoy). Persistent has provided for around 8% hike (average) to off-shore employees, and ~3% hike to non-Indian employees (average).
■ Project related Travel Expenses: Travel expenses as a percent of revenue went down by 60 bps qoq to 1.83%. In absolute terms, travel expenses have decreased by 23% qoq to Rs. 153 mn (30% yoy).
■ Gross Profit: In Q2FY19, gross profit decline marginally by 0.8% qoq to Rs.2.95 bn (12.5% yoy) supported by higher revenues and lower cost of revenue.
■ SG&A expenses: The Company’s SG&A expenses decreased 4% qoq to Rs.1.51 bn (+3.4% yoy). In Q2FY19, SG&A expenses as a percent of revenues decreased by 70 bps qoq to 18.1%.
■ Operating profit (Rs. Mn): The management attributed increase in operating profit to rupee depreciation, lower sales and marketing expenses/ Project related travel expenses and lower purchase/royalty expenses. The management indicated that in H2FY19 sales and marketing expenses will increase. Persistent reported meaningful increase in EBIDTA to Rs.1.44 bn in Q2FY19 (3% qoq and 24% yoy).
■ Operating margin (%): EBITDA margin increased to 17.2% (+40 bps qoq and +200 bps yoy), due to rupee depreciation and lower operating cost.
■ Depreciation charge: Depreciation has decreased 1% qoq. Depreciation as a percentage of revenue stands at 4.8% in Q2FY19 v/s 5.0% in Q2FY18.
■ Other income: In Q2FY19, other income increased 24% (partly base effect) to Rs.231 mn (-31% yoy). Other income consists of interest, forex gain and dividend income.
■ Profit before tax (PBT): Persistent's PBT increased 7% qoq to Rs.1.27 bn in Q2FY19 (+14% yoy), supported by higher operating income, lower depreciation charge, and higher sequential other income.
■ PAT: Persistent's PAT has increased 1% qoq to Rs.881 mn (7% yoy) due to higher PBT. We would like to highlight that quarterly fluctuations are inherent in an IP-based business.
We have lowered our EPS estimates to reflect H1FY19 performance, higher tax rate guided by company and minor other changes. Accordingly, we now expect Persistent to report an EPS of Rs.47.7/share (earlier Rs.52.2) in FY19E and an EPS of Rs. 61.3/share (earlier Rs.65.1) in FY20E. Margin improvement and decent revenue visibility makes us positive on its growth prospects. We maintain BUY rating on Persistent and a multiple based price target of Rs.870/share (earlier Rs.1025/share). We have valued the stock at 14x PE multiple at a 30% discount to its peers. Additionally, attractive valuations, cash rich balance sheet, strong free cash flow and healthy return ratios (ROE 16+% and ROCE 18+%) also provide high comfort. At CMP, the stock is valued at 5.7x EV/EBITDA and 9.1x P/E on FY20 basis.
■ Wide currency fluctuation and INR appreciation will impact earnings. 80%- 90% of Persistent’s foreign currency exposure is in USD.
■ High client concentration – Top 1 client contributes >25% of the revenue.
■ Continuous declining margins.
■ Event-specific risks could impact IT budgets, cut discretionary spend and delay new deals.
■ Higher investment in new products will put pressure on margins.
■ Volatility in revenues sourced through the partners.
Incorporated in 1990, Persistent is founded by Mr. Anand Deshpande. In 2000, it became one of the first companies in Asia to receive an investment from Intel 64 LLC. The Company provides product engineering services, platform based solutions and IP-based software products to its global customers. It designs, develops and maintains software systems and solutions, creates new applications and enhances the functionality of the customer’s existing software products.
Note: Product engineering service can be defined as an engineering consulting activity, which uses various hardware, embedded, software and IT services solution for the designing and development of products.
It delivers services across all stages of the product life–cycle, which enables it to work with a wide–range of customers and allows it to develop, enhance and deploy its customers’ software products. It has been recognized as one of the leading technology companies in the Deloitte Touche Tohmatsu Technology Fast 500 Asia Pacific 2009.
Persistent specializes in software product and technology services and has delivery centers in North America, Europe, and Asia. It has over 9,000 team members worldwide. The company is helping enterprises to transform their business to software-driven business. It has moved from effort-based company (limitations) to value-based company. Further, it has strong foot hold in building software products which offers a distinct advantage and a broader market for growth. It develops best-in-class solutions in key next-generation technology areas including Analytics, Big Data, Cloud Computing, Mobility and Social, for the healthcare and banking & financial services verticals.
Persistent has reorganized its business to four key growth areas which clearly highlights its focus areas. The company has transformed its business from outsourced product development to helping its customers to become software-driven business.
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