MphasiS BFL: Buy on declines, accumulate over time

Recommendation: Buy on declines, accumulate over time

Suresh Krishnamurthy

THE smallest indication of a turnaround is usually enough for a stock to move up.

A recent example is MphasiS-BFL. The stock's impressive financial performance over the last two quarters has led to the firming up of its stock prices. However, just as one swallow does not a summer make, two quarters of strong growth does not probably indicate a complete turnaround. Especially, in the case of a technology company and, even more so, when the financial performance does not provide a complete and consolidated picture of its operations. That exactly has been the case with BFL Software, whose performance, when taken with that of its subsidiary, Mphasis Corporation, US, indicates that it has not exactly turnaround, yet. It is still doing it.

Click here for Chart

BFL Software stock, now ruling at Rs 539, trades at a price-to-earnings multiple of about 68 times its estimated consolidated earnings for financial year 2001. In terms of peer valuations, taking FY 2001 earnings as the basis, the stock appears over-valued. However, it is very likely that net margins will improve sharply from the estimated 4 per cent for FY 2001 to those of its industry peers. This suggests that on the basis of FY 2002 earnings, the stock trades at a discount compared to its peers.

In this backdrop, shareholders can hold on to the stock. Fresh investments can be contemplated on a staggered basis. If the company is able to manage a turnaround of its net margins, the impact on the stock price is likely to be significant. The valuation difference, compared to its peers, would then be bridged. In such a situation, the stock is likely to deliver above-industry returns. As such, the stock can be accumulated at declines in small doses after carefully considering its progress at the end of every quarter vis-a-vis the performance of the wholly-owned US subsidiary, MphasiS Corporation.

An investment in the technology sector is generally riskier than the market average. Investments in mid-sized software companies, such as MphasiS-BFL, are riskier than that in frontline software companies. Risks in the form of client concentration, skewed off-shore/on-site mix, over-dependence on a few service platforms and, now, issues stemming from acquisitions make mid-sized companies riskier than their big brothers.

In the case of MphasiS-BFL, factors unique to the company -- the need for timely integration of the overseas operations, improvement in its capacity utilisation levels and its ability to raise this -- further enhance the risk profile of an investment. Moderating these risks is the favourable progress made by the company on these parameters. Also, given the possibility of above-normal returns, the BFL Software stock can be added to the portfolio of technology stocks.

Mphasis-BFL Software is a software service provider with a technical staff strength of around 1,300 persons. The company is positioned as solution provider for enabling e-businesses involving integration of business channels of clients, customer relationship management, transaction processing, systems and communications. The company is focussed in the areas of logistics and technology.

After the merger of Mphasis Corporation with BFL Software, the largest stakeholders in the company are the promoters of the erstwhile Mphasis Corporation, who now hold 41 per cent in the merged entity. Barings International, which was the largest stakeholder before the merger, now holds 38 per cent.

Robust performance: Mphasis-BFL's performance on critical parameters was impressive the last two quarters. While the company was not able to make any substantial progress in rapidly increasing its capacity utilisation rates in the Indian operations, which still rule at a little below 70 per cent, it has made headway in increasing the rates charged to customers, augmenting the contribution of e-commerce-related services and reducing client concentration.

According to the company's chairman, Mr Jaitirth Rao, the billing rates of the top five customers were increased by 15-20 per cent. In terms of client concentration, three clients accounted for 73 per cent of the company's revenues in the financial year-ended March 2000. According to Mr Rao, the ratio stands at 65 per cent for the top five customers. Also, e-commerce-related transactions now account for 51 per cent of the revenues.

Considerable progress has also been made in increasing the gross margins of its American operations. For the half year-ended September 2000, the company reported profits before interest, tax and non-cash charges of $0.5 million compared to the earlier losses. Considering the performance of the Indian operations, the gross margins for the consolidated operations have increased noticeably.

However, on a consolidated basis, the company continues to make losses. For the quarter-ended September 2000, consolidated revenues rose to around $14 million while losses were high at $9 million. The losses include some one-time charges such as legal fees incurred for the merger formalities, and restructuring and re-training charges. These, however, have not been indicated. Nevertheless, the company appears to be on track to meet its projections, given the steady improvement in operating margins. The management has projected revenues of $64 million and a profit before tax margin of 4 per cent for the financial year 2001.

More than meeting its target for the next year, a sustained improvement in the consolidated net margins in 2002, perhaps, holds the key for its stock market prospects. In this backdrop, critical issues would be increasing the capacity utilisation of its Indian operations and maintaining a robust sales growth in its US operations. Without rising sales growth in its American operations, transferring work offshore, which is essential for improving profitability, may not be possible.

The unreasonably long wait for a turnaround in profitability for Mphasis-BFL appears to be mainly a factor of the extraordinarily costly acquisition of Mphasis Corporation. This acquisition was made in a deal valued at over Rs 700 crore at the then prevailing BFL Software stock price.

Even at the present stock price levels, the acquisition would be valued at around Rs 350 crore, for a company whose turnover for the present financial year would be a little less than Rs 100 crore. The higher price, perhaps, represents that paid to the promoters of Mphasis Corporation for bailing out the then BFL Software. Now, however, the Indian operations appears to have gravitated to a more firm foundation. A similar progress in the case of the US operations is essential to alter significantly the stock market fortunes.