Mphasis - HP trouble remain a drag - BRICS

- Weak revenue expected in Q4FY12 with stable margins, due to further decline in HP channel, stagnant Direct Channel (DC) and FX headwind.

- Sharper decline in volume of HP business in FY13, while overall margins to suffer from investments in DC.

- Dividend payout ratio could increase to 50%. Few acquisitions under consideration. Maintain Reduce with target price of Rs360.

We recently met Mphasis' (MPHL) management to understand the growth drivers for Q4FY13 and FY13. Key takeaways:

Revenue to suffer in Q4FY12 due to HP weakness: MPHL's revenue could decline 4.2% qoq in Q4FY12, due to a fall of 5-6% qoq in volume of HP channel and zero growth in DC, on account of temporary weakness. Operating margin to remain stable, as headcount could decline further.

Growth divergence between HP and DC to widen over FY13: The DC business is expected to grow by 15-20%, while HP channel volume is likely to decline by 15% in FY13 (due to troubles at parent HP). MPHL and HP have signed a new master service agreement (MSA) with stable pricing, which will be valid until October 2013.

Investments in DC to result in margin erosion: MPHL will invest US$20-30mn in the DC business over FY13 to improve its delivery capability and sales effort. The headcount reduction in FY13 could be limited due to a strong growth in the DC business on a higher base. These factors are likely to lead to a margin erosion of 260bps in FY13.

Strong cash balance; Dividend payout could increase: MPHL is likely to end FY12 with a cash balance ofUS$0.5bn and quarterly cash generation of US$30-40mn. MPHL will deploy the cash for acquisitions and increasing its dividend payout ratio to 50% (currently 40%).

Outlook and valuation: MPHL trades at a P/E of 10.7x FY12 and 12x FY13 earnings. We are raising our target P/E multiple to 10x (earlier 9x) to account for the company's higher dividend payout and huge cash balance. We are lowering our FY13 earnings estimate by 20.6%, due to a sharper decline in volume of HP channel and expected margin erosion in FY13. We are lowering our target price to Rs360 (from Rs375) based on 10x average FY13-14 earnings. Maintain REDUCE.

Q4FY12 preview: The HP channel is likely to witness a decline of 5-6% qoq in volume, while DC could record a zero qoq growth in revenue (or possibly a slight decline), thus resulting in a decline of 4.2% qoq in MPHL's overall revenue, as pricing is likely to remain stable. The EBITDA margin is likely to be around 19.3%, as the impact of a continued decline in headcount, currency headwind and wage hike on he company's margins has already played out in Q2. Our estimates are based on an exchange rate Rs53/US$, up 3.6% from the rate taken for Q3FY12.

Revising estimates to factor sharper decline in HP channel and FX headwind: We have rebased our estimated exchange rate for FY12-13 to Rs53/US$ (from Rs55/US$ earlier). DC volume is likely to grow by 15-20% in FY13 (with stable pricing), while the HP-channel could remain a drag, with volume down 15% (as against earlier expectation of 2-3%). These factors (Rupee appreciation, weak HP channel and DC performance) are likely to result in a decline of 1.5% yoy in revenue for FY13. Also, the company's margins for FY13 are likely to witness erosion and contract by 260bps, due to a lower revenue growth and investment of US$20-30mn in the DC business.

Source : Equity Bulls

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