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[mehak1]

Mphasis BFL’s (Mphasis’) Q4FY08 results were lower than expectations, both at the revenue and net profit levels. The company reported a sequential increase of 4% in its revenues to Rs6.57bn; net profits increased 7.7% QoQ to Rs714mn on the back of forex gains, MAT credit entitlement and deferred tax asset. In line with its peers in the IT services space, Mphasis is expected to record back-ended growth during FY09E due to elongated sales cycles. The company has not had any project cancellations from any of its clients; it,
however, is experiencing deferment of projects by some of them.

We are reducing our EPS estimates for FY09E and FY10E by 11% and 10% respectively, to take into account
(a) the challenging business environment
(b) higher investments in delivery capacity and
(c) expected increase in the sales and marketing expenditure as the company explores new services and verticals.
We expect Mphasis to post an EPS of Rs 14.7 and Rs 18.6 in FY09E and FY10E respectively, implying a three-year EPS CAGR of 28.8%. Currently, Mphasis is quoting at FY09E and FY10E PER of 15.0x and 11.9x respectively. The stock has underperformed over last three months, growing by only 3% since our last result update in January 2008. At these valuations, the stock offers limited growth opportunity. Therefore, we downgrade our recommendation on the stock from a ‘Buy’ to an ‘Accumulate’.

Key highlights of Q4FY08:

Muted revenue growth of 4% QoQ:  Mphasis reported a 4% sequential growth in revenues, from Rs6.32bn to Rs6.57bn. The company’s application business, which
contributes 63% to the revenues, dropped 20bps to Rs4.16bn; the BPO and ITO businesses, however, reported a growth of 10.4% and 15.1% respectively. The revenue growth was muted primarily due to
(a) pricing pressures, especially from the U.S. market and
(b) lower volume growth in the application business.

Operating margins drop 170bps: Mphasis’ reported a 170bps dip in EBITDA
margins during Q4FY08. The margin dip was on account of-----
(a) lower onsite revenues arising from a drop in onsite utilisation levels due to project delays
(b) higher employee costs as the company is creating a higher bench for the future and
(c) higher sales expenditure due to increase in sales force.

Mphasis has indicated that its sales and marketing costs are likely to increase, as it intensifies its sales efforts. Moreover, as the company is employing more entry-level employees than in the past, its utilisation levels may fall. We believe that higher sales and marketing costs on one end, and lower utilisation levels, on the other, would pressurise Mphasis’ margins during FY09E.

Other income and negative taxation boosts net income: Despite a sequential
drop of 10.2% in Mphasis’ EBIT, its net profit increased 7.7% QoQ. This was on account of other income of Rs42mn and a total tax write-back of Rs5mn; this meant nil tax outgo and an inflow of Rs5mn arising from the write-back. The effective tax rate, however, is expected to be 12-13% during Q4FY09E and FY10E.
This may lower the company’s net profits, going forward. EDS business grows 4% QoQ: The business from EDS channel grew 4% QoQ in Q4FY08. However, as a percentage of revenues, it remained flat at 54%. EDS business predominantly comprises infrastructure management and BPO operations, both annuity-based segments vis-à-vis application development.
Since the revenue generated from these segments is non-discretionary, we anticipate a higher growth in the EDS business in the event of a slowdown in the U.S.

Financials:  We are reducing our EPS estimates for FY09E and FY10E by 11% and
10% respectively to take into account---
(a) the challenging business environment,
(b) higher investments in delivery capacity and
(c) expected increase in the sales
and marketing expenditure as the company explores new services and verticals.
We expect Mphasis to post an EPS of Rs14.7 and Rs18.6 in FY09E and FY10E
respectively, implying a three-year EPS CAGR of 28.8%.

Valuations:
Currently, Mphasis is quoting at FY09E and FY10E PER of 15.0x and 11.9x respectively. The stock has underperformed over last three months, growing by only 3% since our last result update in January 2008. At these valuations, the stock is fully priced and offers limited growth opportunity. Therefore, we downgrade our recommendation on the stock from a ‘Buy’ to an
‘Accumulate’.

Report card:

PE ratio      22.92    13/05/08
EPS (Rs)     10.58       Mar, 08
Sales (Rs crore) 484.19     Mar, 08
Face Value (Rs)     10   
Net profit margin (%) 11.89   Mar, 07
Last bonus         1:1          11/04/05
Last dividend (%)    33        02/05/08
Return on average equity 16.61   Mar, 07