Buy iGATE Global Sol; target Rs 416: Edelweiss

Edelweiss Research report on iGATE Global Solutions:

iGATE’s net profits for the current quarter were ahead of expectations on the back of improvement in productivity, better cost management, hedging gains, and lower tax outflow. Revenues were reported at Rs 2.0 billion, up 0.7% Q-o-Q, and net profits increased 60% Q-o-Q. During the quarter, EBITDA margins increased 260bps at 15.8%, clocking the highest since FY02. We believe the company is still struggling to attain revenue momentum and is lagging behind peers in terms of top-line growth. While we were concerned about iGATE’s exposure to the mortgage segment (which led to revenue decline), we believe that this exposure has reduced (5.5% of total revenues) and stabilised at the current levels. Further, the revenue visibility has increased with iGATE winning two iTOPs deals and a large ERP implementation deal from its existing clients. Moreover, the management is confident of achieving a 5% sequential growth in revenues, going forward, sustaining profitability simultaneously.

iGATE’s pace of client addition has remained subdued with just three additions over the last two quarters. With the induction of Hari Murthy (former President of North Amercia at Hexaware Technologies) as iGATE’ head of Sales and Marketing, we however, expect the pace of client addition to accelerate and sales traction to increase. The company has also commented that it intends to add about 800 people over the next two quarters.

We have increased our EPS estimate for FY08E by 14% to Rs 24, while maintaining the FY09E EPS of Rs 30. At CMP of Rs 340, the stock trades at a P/E of 14.1x and 11.5x our FY08E and FY09E earnings, respectively. The company has also announced its plan to de-list itself from the Indian markets, which we believe, will keep the investors interested in the near term. Our DCF based valuation suggests a fair equity value of Rs 416 per share, which also approximates a target PE multiple of 14x on FY09 EPS. We continue with our positive outlook on the company and maintain our ‘BUY’ recommendation.

Key highlights

Revenues, at Rs 2 billion, grew modestly at 0.7% Q-o-Q and declined 0.9% Y-o-Y, primarily due to reduced mortgage exposure, and partly on account of rupee appreciation. The mortgage exposure now stands at 5.5% of total revenues and the company expects it to stabilise at the current level going forward.

IT services revenues were flat Q-o-Q, while BPO revenues from the iTOPs grew 5.6% Q-o-Q after declining for three quarters consecutively.

Gross margins improved 120bps Q-o-Q at 32.7% and 340bps Y-o-Y due to improvement in billing rates and higher utilisation.

EBITDA margin increased 260bps Q-o-Q, to 15.8%, recording the highest since FY02 on account of increase in gross margins and reduced SG&A expenses. The company has effected re-engineering on few projects and has controlled transportation costs to reduce its SG&A spend.

Higher hedging income (Rs 16.2 million) and lower effective tax rate (3.5% of PBT) boosted net profits for the quarter. Net profits stood at Rs 229 million, up 60% Q-o-Q and 126% Y-o-Y.

The average onsite billing rates improved 0.9% Q-o-Q and 6.2% Y-o-Y. The offshore rate remained constant Q-o-Q, but was up 4.1% Y-o-Y.

Client addition remained low with just three clients added during the quarter. The number of million dollar clients stood at 29 as against 30 in the previous quarter.

Both offshore and onsite utilisation improved 1.0% Q-o-Q, to 93.0% and 72.0%, respectively.

Net headcount of the company increased by 112 people, with the total employee count currently at 5,977. The company has commented that it expects to add another 800 people over the next two quarters.

Continued traction from the top 2-5 customers

iGATE’s revenues have been mainly driven by its top 2-5 customers that collectively contribute 38% to its total revenues. The revenues from these accounts have grown at a CAGR of 6.4% over the last four quarters as against 5.4% (de-growth) in top 6-10 accounts. We believe this has been on account on company’s strategy to focus on few major customers, leading to dilution of its focus on the top 6-10 clients. However, our discussions with the management suggest that during the current quarter the company has won few deals from other than its top five clients, and expects to ramp it up in the forthcoming quarters.

Consistent improvement in billing rates support growth in EBITDA margins

Pricing, the most important margin driver for the IT services company, has been consistently increasing for iGATE. This has been as a result of higher revenues from the clients acquired over the last 24 months. Improvement in the company’s offshore and onsite billing rates is commendable with impressive Y-o-Y growth over the last four quarters. The onsite billing rates stand at the highest level ever for iGATE, crossing the USD 65 mark, while offshore billing rates remain high at USD 20.1.

EBITDA margin expansion sustainable

Going forward, we estimate iGate’s EBITDA margins to sustain at the current levels of 16%. At the same time, we note that the company’s reduced SG&A spend is non-sustainable and higher investments would be required to fuel revenue growth. The spend (as a proportion of revenues) is however expected to remain at the current level, though the S&M expenses are likely to increase in absolute terms. We also note that the reduction in the SG&A expense is on account of re-engineering of few projects and controlled transportation costs (without compromising on the selling efforts). We expect the company to end FY08E and FY09E with EBITDA margins of 15.2% and 16.3% respectively.

Valuations

We have increased our EPS estimate for FY08E by 14% to Rs 24, while maintaining the FY09E EPS of Rs 30. At CMP of Rs 340, the stock trades at a P/E of 14.1x and 11.5x our FY08E and FY09E earnings, respectively. On an EV/revenue basis, the stock is still attractive at 1.1x FY08E revenues. The company has also announced its plan to de-list itself from the Indian markets, which we believe, will keep the investors interested in the near term. Our DCF based valuation suggests a fair equity value of Rs 416 per share, which also approximates a target PE multiple of 14x on FY09 EPS. We continue with our positive outlook on the company and maintain our ‘BUY’ recommendation.