Buy Mastek with target of Rs 440: ASK-RJ

Broking house, ASK Raymond James is bullish on Mastek. It has maintained buy rating on the stock with a target price of Rs 440.

The ASK Raymond James report on Mastek:

Government business - Mastek mainstay

“Mastek does business in this segment primarily through BT and Capita (relationship for about 10 years now). In the UK, Mastek has an arrangement with Capita that if it sells to a third party then the price will not be below a certain floor level. The NHS project contributing about 25 million GBP per annum will last till FY08 unless renewed. The company hopes that it will be able to more than make up for the shortfall via new partnerships like Euriware.”

Insurance business - Gaining traction

“The insurance segment contributes about 25% of overall revenues and has 18 customers. Elixir is the dominant contributor in this segment with about 50% of revenues. The competitors that Mastek faces in this segment are from the likes of Accenture and CSC. Currently there are 15-20 Elixir based deals in the pipeline (the company expects 5-6 of these to materialize in 2Q FY07) of which Mastek is pursuing about 75% on its own. Strong growth is seen in this segment because of the business need to either integrate various disparate platforms or to migrate to a completely new platform.”

Expect bounce back in order book

“In 1Q FY07 there was a dip in the order book by 6% QoQ for the first time in the last six quarters to Rs 3.59 billion. However, the management expects to bounce back with a USD 15-20 million addition to its order book in this quarter (2Q FY07) on the back of a strong pipeline. The management would continue to focus on the top 100 players in the insurance space and large system integration deals in the government vertical.”

Two margin levers available

“Mastek has significantly higher proportion of SG&A compared to its Indian peers. G&A at about 10% has little room for reduction but S&M at about 20% is high and the company expects a drop of 4-5% over the next 3-4 years. The management cited building of prototypes for each new project as the reason for high SG&A and expects scale benefits going forward.”

“The company plans to add about 400-500 employees per annum. Historically, only 20% of new hires were freshers but going forward this would be increased to about 40%. We believe that the attrition rates would increase as a result of this, but still the costs per employee should work out cheaper.”

Revenue from top clients remain at uncomfortably high levels

“The management continues its focus on few strategic clients and is working towards deepening the relationship with each of them. Revenues from top five and top ten clients continue to remain at uncomfortably high levels of 73% and 88% respectively. We believe that this will continue to remain a concern for investors and warrant lower PE multiples (12x) for Mastek vis-à-vis players like Patni which get 15x.”

Outlook and valuation

“The management reiterated that the margin guidance of 100-150 bps improvement in FY07 is very much on track. Our earnings estimate for the company is Rs 31.7 in FY07E and Rs 36.7 in FY08E. At the current market price, it trades at 10.8x FY07E and 9.3x FY08E earnings . Our target price is Rs440 (12x FY08E earnings). We maintain our Buy rating on the stock, as we believe that it offers upside potential of about 30% from the current levels.”