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Global Research

Telecoms, Media & Technology

It Services
Equity – India
MphasiS
Downgrade to N(V): Muted earnings growth due to margin
Neutral (V) headwinds
Target price (INR) 700.00
Share price (INR) 652.05  Volume growth should remain robust as offshore
Potential return (%) 7.4 penetration in HP services is still low
Performance 1M 3M 12M
Absolute (%) 4.7 14.3 2.7  However, higher employee costs, lower hedging gains, and
Relative^ (%) -4.8 0.2 -14.5 likely investments in sales likely to restrict earnings growth
Index^ BOMBAY SE IDX
RIC MBFL.BO  We lower our target price from INR770 to INR700 and
Bloomberg MPHL IN
downgrade our rating from Overweight (V) to Neutral (V)
Market cap (USDm) 3,024
Market cap (INRm) 136,867
Enterprise value (INRm) 120236 Top-line volume growth not a worry: We believe MphasiS has so far only captured 5% of
Free float (%) 78
the addressable share of the HP services division and there is still further scope to increase
Note: (V) = volatile (please see disclosure appendix)
wallet share. MphasiS’s revenue growth from the HP channel is likely to be driven by its share
of the HP’s incremental revenues and wallet share gains in the un-addressable divisions (so
far), such as technology services (which offers maintenance/preventive support services,
warranty support and bespoke solutions). Appointment of HP veterans to the MphasiS board is
likely to accelerate MphasiS’s share of the pie.

Margin concerns have increased. While revenue growth is likely to be robust, we expect
earnings growth will remain muted due to margin dilution expected in FY11. The reasons
for our expectations are: 1) decline in hedging gains, which cushioned FY10 margins by
27 September 2010
c240bps, 2) likely investments in sales and marketing to grow the direct business channel
Yogesh Aggarwal* and 3) employee costs will grow faster than revenues as current pricing, even if assumed
Analyst
HSBC Securities and Capital Markets
stable in FY11, will be 4.5% below the FY11 realisation on a blended basis. Furthermore,
India Private Limited earnings growth will be impacted by an increase in the tax rate in FY11 and FY12 to 18%
+9122 2268 1246 and 25% respectively, from c10% in FY10.
[email protected]
Valuation and forecasts – We cut our FY12 EPS estimates by c5% to factor in the margin
View HSBC Global Research at: concerns outlined in this note and our target PE multiple to 13x on FY12 EPS from 14.5x on
http://www.research.hsbc.com FY11 EPS (similar to what HCLT is trading currently and c38% discount to Infosys). We
*Employed by a non-US affiliate of believe the discount is justified due to MphasiS’ high client concentration risk. The stock is
HSBC Securities (USA) Inc, and is not
registered/qualified pursuant to FINRA currently trading at c12x FY11e EPS and we believe is unlikely to significantly re-rate from
regulations
these levels in the light of our expectations for flat earnings growth in the next two years. We
Issuer of report: HSBC Securities and
Capital Markets
therefore, cut our TP to INR700 (from INR770) earlier, based on 13x FY12e EPS. With
(India) Private Limited 7.4%potential return indicated, we downgrade from Overweight (V) to Neutral (V).
Disclaimer & MphasiS: Key financials (INRm)
Disclosures Revenues EBIT EBIT Margins EPS P/E
This report must be read FY09 42,639 9,252 21.7% 43.3 15.1
with the disclosures and FY10e 50,505 11,134 22.0% 51.6 12.6
the analyst certifications in FY11e
FY12e
61,479
72,452
13,197
14,465
21.5%
20.0%
54.3
53.9
12.0
12.1
the Disclosure appendix, Source: HSBC estimates, Company data
and with the Disclaimer,
which forms part of it
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Financials & valuation

Financial statements Valuation data
Year to 10/2009a 10/2010e 10/2011e 10/2012e Year to 10/2009a 10/2010e 10/2011e 10/2012e
Profit & loss summary (INRm) EV/sales 3.0 2.4 1.9 1.7
EV/EBITDA 11.3 9.4 7.5 7.2
Revenue 42,639 50,505 61,479 72,452 EV/IC 7.9 6.6 5.2 6.8
EBITDA 11,246 12,833 15,165 16,783 PE* 15.1 12.6 12.0 12.1
Depreciation & amortisation -1,994 -1,699 -1,967 -2,318 P/Book value 5.8 4.2 3.2 2.7
Operating profit/EBIT 9,252 11,134 13,197 14,465 FCF yield (%) 7.5 6.3 5.9 7.7
Net interest 28 13 484 533 Dividend yield (%) 0.6 1.1 0.9 0.9
PBT 9,728 12,095 13,942 15,078
HSBC PBT 9,728 12,095 13,942 0 Note: * = Based on HSBC EPS (fully diluted)
Taxation -641 -1,268 -2,556 -3,769
Net profit 9,087 10,827 11,386 11,308
HSBC net profit 9,087 10,827 11,386 11,308 Price relative

Cash flow summary (INRm) 1031 1031

831 831
Cash flow from operations 10,518 11,223 10,807 10,579
Capex -1,500 -2,273 -3,074 -2,170 631 631
Cash flow from investment -9,059 -5,443 -3,074 -2,170
Dividends -486 -1,718 -1,473 -1,718 431 431
Change in net debt -1,240 -4,063 -6,261 3,632
231 231
FCF equity 9,754 7,970 7,473 10,010
Balance sheet summary (INRm) 31 31
2008 2009 2010 2011
Intangible fixed assets 2,945 2,888 2,888 2,945 MphasiS Rel to BOMBAY SE SENSITIVE INDEX
Tangible fixed assets 3,291 4,078 5,184 3,504
Current assets 18,091 23,882 32,488 26,023 Source: HSBC
Cash & others 1,786 5,848 12,109 8,477
Total assets 32,635 42,350 52,063 40,780
Note: price at close of 24 Sep 2010
Operating liabilities 6,448 6,775 6,574 6,323
Gross debt 0 0 0 0
Net debt -1,786 -5,848 -12,109 -8,477
Shareholders funds 23,446 32,768 42,681 31,716
Invested capital 16,093 18,225 21,878 17,672

Ratio, growth and per share analysis

Year to 10/2009a 10/2010e 10/2011e 10/2012e
Y-o-y % change
Revenue 76.0 18.4 21.7 17.8
EBITDA 181.0 14.1 18.2 10.7
Operating profit 231.5 20.3 18.5 9.6
PBT 265.6 24.3 15.3 8.1
HSBC EPS 255.9 19.2 5.2 -0.7
Ratios (%)
Revenue/IC (x) 2.7 2.9 3.1 3.7
ROIC 55.6 58.1 53.8 54.9
ROE 48.1 38.5 30.2 30.4
ROA 34.4 28.9 24.1 24.4
EBITDA margin 26.4 25.4 24.7 23.2
Operating profit margin 21.7 22.0 21.5 20.0
EBITDA/net interest (x)
Net debt/equity -7.6 -17.8 -28.4 -26.7
Net debt/EBITDA (x) -0.2 -0.5 -0.8 -0.5
CF from operations/net debt
Per share data (INR)
EPS reported (fully diluted) 43.31 51.61 54.27 53.90
HSBC EPS (fully diluted) 43.31 51.61 54.27 53.90
DPS 4.00 7.00 6.00 6.00
Book value 111.79 156.21 203.46 243.21

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Volume growth not a concern

Revenue share
___________ HP _____________ ____________________________Mphasis ____________________________
FY10e Revenues Proportion * Revenues Proportion HP revenues, addressable Share of HP
FY10 by MphasiS revenues
ITO 15,824 46% 202 26.9% 7,912 2.6%
Technology Services 9,632 28% 0 0.0% 1,926 0.0%
Application Services 5,848 17% 532 71.0% 2,924 18.2%
BPO 3,096 9% 16 2.1% 1,548 1.0%
TOTAL 34,400 750 14,310 5.2%
Source: Company Reports, HSBC estimates

We believe MphasiS has so far captured only 5% of the addressable share of the HP services division and there
is still further scope to increase wallet share. MphasiS’s revenue growth from the HP channel is likely to be
driven by its share of the HP’s incremental revenues and wallet share gains in the un-addressable divisions (so
far), such as technology services

 Robust wallet share in the incremental revenues of HP services. We forecaste revenue growth of 23%
in FY11 for MphasiS, which translates into USD250m of incremental revenues. Assuming the addressable
divisions of HP (ITO, Application Services and BPO) services grows 3% and offshore c15% of the
incremental revenues to MphasiS, the company will be able to generate half of the required revenues to
achieve our forecasts.

 Appointment of MphasiS board members from HP to target the Technology Services division of
HP. This division offers maintenance/preventive support services, warranty support and bespoke solutions.

Margin concerns have increased

Margin concerns have heightened, led by:

 A decline in hedging gains. In FY10, the company is likely to report INR 1,204m of hedging gains in the
top-line and INR500m of hedging gains below the line. This translates to a c240bps cushion for EBITDA
margins in FY10. This cushion is likely to decline to 150bps cushion in FY11 and nil in FY12 based on
our estimates.

 Employee costs will grow faster than revenues in FY11, as current pricing, even if assumed to be stable
in FY11, will be 4.5% below the FY10 realisation on a blended basis.

 In the analyst call on 25 August 2010, management alluded to its intentions to grow its Direct Channel
business, which will result in a pressure on margins as S&M cost increase. We assume no further pressure
on pricing by HP.

 In addition, earnings growth will be impacted by an increase in the tax rate in FY11 and FY12 to 18% and
25% respectively, from c10% in FY10.

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MphasiS: Financial statements

P&L, INRm FY09 FY10e FY11e FY12e
Revenues 42,639 50,505 61,479 72,452
Gross Profit 13,845 15,360 18,083 20,478
Selling expenses 1,804 2,077 2,336 2,753
G&A 2,782 2,145 2,549 3,260
Operating Profit 9,252 11,134 13,197 14,465
PBT 9,728 12,095 13,942 15,078
Income taxes 641 1,268 2,556 3,769
Net Profit 9,087 10,827 11,386 11,308
EPS Diluted (INR) 43.31 51.6 54.3 53.9

EBITDA Margin 26.4% 25.4% 24.7% 23.2%

Operating Margin 21.7% 22.0% 21.5% 20.0%
Net Margin 21.3% 21.4% 18.5% 15.6%
Balance Sheet (INRm)
Share capital 2,096 2,096 2,096 2,096
Reserves and surplus 21,351 30,672 40,585 48,968
Secured Loans 33 33 33 33
Total funds 23,488 32,809 42,722 51,105
Fixed assets 3,291 4,078 5,184 5,036
Goodwill 2,945 2,888 2,888 2,888
Investments 7,612 10,783 10,783 10,783

Debtors and unbilled revenues 9,064 10,793 13,138 15,483

Cash and bank balances 1,786 5,848 12,109 19,588
Interest receivables 1 1 1 1
Loans and advances 7,240 7,240 7,240 7,240

Current liabilities 6,414 6,740 6,539 7,832

Provisions 2,734 2,801 2,801 2,801
Total funds 23,487 32,809 42,722 51,105
Cash Flow (INRm)
Operating profit before working capital changes 11,543 13,826 15,909 17,396
Debtors and unbilled revenues (52) (1,729) (2,345) (2,345)
Loans and advances (2,300) - - -
Current liabilities and provisions 2,973 394 (201) 1,293
Net cash provided by operating activities 10,518 11,223 10,807 12,574

Purchase of fixed assets (1,500) (2,273) (3,074) (3,623)

Net cash used in investing activities (9,059) (5,443) (3,074) (3,623)

Dividend paid including dividend tax (486) (1,718) (1,473) (1,473)

Net cash provided by financing activities (427) (1,718) (1,473) (1,473)
Cash and cash equivalents at end of the period 1,786 5,848 12,109 19,588
FCF (Operating Cash Flow - CAPEX) 9,018 8,951 7,734 8,952
Source: Company data, HSBC estimates

Valuation and forecasts – We cut our FY12 EPS estimates by c5% to factor in the margin concerns
outlined in this note and our target PE multiple to 13x on FY12 EPS from 14.5x on FY11 EPS (similar to
what HCLT is trading currently and c38% discount to Infosys). We believe the discount is justified due to
MphasiS’ high client concentration risk. The stock is currently trading at c12x FY11e EPS and is unlikely
to significantly re-rate from these levels in the light of a flat earnings growth in the next 2 years. We
therefore, cut our TP to INR700 (from INR770) earlier, valuing the company at 13x FY12e EPS. Our new
target price indicates 7.4% potential return which is within the 1-21% neutral rating band for volatile
Indian stocks. We therefore downgrade our rating from Overweight to Neutral (V).

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Change in estimates
_______Old estimates_____ _____ New estimates ______ _________Change ________
FY10 FY11 FY10 FY11 FY10 FY11
Revenues (INRm) 50,421 61,849 50,505 61,479 0.2% -0.6%
EBIT 10,999 13,040 11,134 13,197 1.2% 1.2%
EBIT Margins 21.8% 21.1% 22.0% 21.5% 0.2% 0.4%
EPS 51.2 52.8 51.6 54.3 0.8% 2.8%
Source: HSBC estimates

Risks:
Upside risks to our Neutral (V) rating includes:

 Significant pick up in the direct channel could result in top-line growth surprises.

 The company might be able to maintain margins due to growth in high value services in the HP channel

 Significant INR appreciation could result in extra ordinary hedging gains.

Downside risks include:

 Higher than expected wage inflation

 Adverse impact from currency fluctuation

 The demand environment may not improve as expected, and volume growth may remain muted.

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Disclosure appendix
Analyst Certification
The following analyst(s), economist(s), and/or strategist(s) who is(are) primarily responsible for this report, certifies(y) that the
opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their
personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific
recommendation(s) or views contained in this research report: Yogesh Aggarwal

Important disclosures
Stock ratings and basis for financial analysis
HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions, which
depend largely on individual circumstances such as the investor's existing holdings, risk tolerance and other considerations.
Given these differences, HSBC has two principal aims in its equity research: 1) to identify long-term investment opportunities
based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon;
and 2) from time to time to identify short-term investment opportunities that are derived from fundamental, quantitative,
technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating.
HSBC has assigned ratings for its long-term investment opportunities as described below.

This report addresses only the long-term investment opportunities of the companies referred to in the report. As and when
HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at
www.hsbcnet.com/research. Details of these short-term investment opportunities can be found under the Reports section of this
website.

HSBC believes an investor's decision to buy or sell a stock should depend on individual circumstances such as the investor's
existing holdings and other considerations. Different securities firms use a variety of ratings terms as well as different rating
systems to describe their recommendations. Investors should carefully read the definitions of the ratings used in each research
report. In addition, because research reports contain more complete information concerning the analysts' views, investors
should carefully read the entire research report and should not infer its contents from the rating. In any case, ratings should not
be used or relied on in isolation as investment advice.

Rating definitions for long-term investment opportunities

Stock ratings
HSBC assigns ratings to its stocks in this sector on the following basis:

For each stock we set a required rate of return calculated from the risk free rate for that stock's domestic, or as appropriate,
regional market and the relevant equity risk premium established by our strategy team. The price target for a stock represents
the value the analyst expects the stock to reach over our performance horizon. The performance horizon is 12 months. For a
stock to be classified as Overweight, the implied return must exceed the required return by at least 5 percentage points over the
next 12 months (or 10 percentage points for a stock classified as Volatile*). For a stock to be classified as Underweight, the
stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10
percentage points for a stock classified as Volatile*). Stocks between these bands are classified as Neutral.

Our ratings are re-calibrated against these bands at the time of any 'material change' (initiation of coverage, change of volatility
status or change in price target). Notwithstanding this, and although ratings are subject to ongoing management review,
expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily
triggering a rating change.

*A stock will be classified as volatile if its historical volatility has exceeded 40%, if the stock has been listed for less than 12
months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility. However,

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stocks which we do not consider volatile may in fact also behave in such a way. Historical volatility is defined as the past
month's average of the daily 365-day moving average volatilities. In order to avoid misleadingly frequent changes in rating,
however, volatility has to move 2.5 percentage points past the 40% benchmark in either direction for a stock's status to change.

Rating distribution for long-term investment opportunities

As of 27 September 2010, the distribution of all ratings published is as follows:
Overweight (Buy) 50% (21% of these provided with Investment Banking Services)
Neutral (Hold) 36% (18% of these provided with Investment Banking Services)
Underweight (Sell) 14% (17% of these provided with Investment Banking Services)

Share price and rating changes for long-term investment opportunities

MphasiS (MBFL.BO) Share Price performance INR Vs HSBC rating history Recommendation & price target history
From To Date
N/A Overweight (V) 05 June 2009
707 Target Price Value Date
607 Price 1 N/A 08 January 2008
507 Price 2 430.00 05 June 2009
407 Price 3 630.00 20 August 2009
307 Price 4 770.00 28 September 2009
207 Source: HSBC

107
Sep-05

Mar-06

Sep-06

Mar-07

Sep-07

Mar-08

Sep-08

Mar-09

Sep-09

Mar-10

Sep-10

Source: HSBC

HSBC & Analyst disclosures

None of the below disclosures applies to any of the stocks featured in this report.
1 HSBC* has managed or co-managed a public offering of securities for this company within the past 12 months.
2 HSBC expects to receive or intends to seek compensation for investment banking services from this company in the next
3 months.
3 At the time of publication of this report, HSBC Securities (USA) Inc. is a Market Maker in securities issued by this
company.
4 As of 31 August 2010 HSBC beneficially owned 1% or more of a class of common equity securities of this company.
5 As of 31 July 2010, this company was a client of HSBC or had during the preceding 12 month period been a client of
and/or paid compensation to HSBC in respect of investment banking services.
6 As of 31 July 2010, this company was a client of HSBC or had during the preceding 12 month period been a client of
and/or paid compensation to HSBC in respect of non-investment banking-securities related services.
7 As of 31 July 2010, this company was a client of HSBC or had during the preceding 12 month period been a client of
and/or paid compensation to HSBC in respect of non-securities services.
8 A covering analyst/s has received compensation from this company in the past 12 months.
9 A covering analyst/s or a member of his/her household has a financial interest in the securities of this company, as
detailed below.
10 A covering analyst/s or a member of his/her household is an officer, director or supervisory board member of this
company, as detailed below.
11 At the time of publication of this report, HSBC is a non-US Market Maker in securities issued by this company and/or in
securities in respect of this company

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Analysts, economists, and strategists are paid in part by reference to the profitability of HSBC which includes investment
banking revenues.

For disclosures in respect of any company mentioned in this report, please see the most recently published report on that
company available at www.hsbcnet.com/research.

* HSBC Legal Entities are listed in the Disclaimer below.

Additional disclosures
1 This report is dated as at 27 September 2010.
2 All market data included in this report are dated as at close 24 September 2010, unless otherwise indicated in the report.
3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business. HSBC's analysts and its other staff who are involved in the preparation and dissemination of Research
operate and have a management reporting line independent of HSBC's Investment Banking business. Information Barrier
procedures are in place between the Investment Banking and Research businesses to ensure that any confidential and/or
price sensitive information is handled in an appropriate manner.

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Disclaimer
* Legal entities as at 31 January 2010 Issuer of report
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Hong Kong; 'TW' HSBC Securities (Taiwan) Corporation Limited; 'CA' HSBC Securities (Canada) Inc, Toronto; HSBC Securities and Capital
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(RR), Moscow; 'IN' HSBC Securities and Capital Markets (India) Private Limited, Mumbai; 'JP' HSBC Securities Registered Office
(Japan) Limited, Tokyo; 'EG' HSBC Securities Egypt S.A.E., Cairo; 'CN' HSBC Investment Bank Asia Limited,
52/60 Mahatma Gandhi Road
Beijing Representative Office; The Hongkong and Shanghai Banking Corporation Limited, Singapore branch; The
Hongkong and Shanghai Banking Corporation Limited, Seoul Securities Branch; The Hongkong and Shanghai Fort, Mumbai 400 001, India
Banking Corporation Limited, Seoul Branch; HSBC Securities (South Africa) (Pty) Ltd, Johannesburg; 'GR' HSBC Telephone: +91 22 2267 4921
Pantelakis Securities S.A., Athens; HSBC Bank plc, London, Madrid, Milan, Stockholm, Tel Aviv, 'US' HSBC
Securities (USA) Inc, New York; HSBC Yatirim Menkul Degerler A.S., Istanbul; HSBC México, S.A., Institución de
Fax: +91 22 2263 1983
Banca Múltiple, Grupo Financiero HSBC, HSBC Bank Brasil S.A. - Banco Múltiplo, HSBC Bank Australia Limited, Website: www.research.hsbc.com
HSBC Bank Argentina S.A., HSBC Saudi Arabia Limited.
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