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Margins Likely To Improve

A buoyant spending environment with improving billing rates are positives for Infotech Enterprises…

Hyderabad-based Infotech Enterprises has grown its revenues at a compounded annual growth rate (CAGR) of 30 per cent over the last five years, a growth rate that many companies would kill for. In garnering this growth rate, Infotech has not taken on huge amounts of debt: in fact, it is still debt free. And to top it all, this mid-cap IT player is available at an attractive valuation.

Strengths and Opportunities
Strong revenue growth: Riding on both organic and inorganic growth, Infotech Enterprises managed to notch up a revenue of Rs313.82 crore in Q3FY11. This amounted to a robust growth rate of 31.3 per cent year-on-year (y-o-y) and 6.2 per cent quarter-on-quarter (q-o-q).
The company has two main verticals: Engineering, Manufacturing and Industrial Products (EMI) which brings in 67.5 per cent of revenues, and Network Communication Engineering (NCE) which brings in 32.6 per cent. Both these verticals are doing well.
EMI reported revenue growth of 3.2 per cent q-o-q at Rs211.9 crore. NCE grew 13.3 per cent q-o-q to Rs102.1 crore. EMI reported volume growth of 5.2 per cent q-o-q while that of NCE came in at a higher 14.1 per cent (this high number was made possible by Wellsco’s consolidation). Excluding the Wellsco effect, the NCE division reported a more sedate organic volume growth of 6.5 per cent.
Improved margins expected ahead: With macro-economic conditions improving, Infotech has managed to secure a 3-5 per cent hike in billing rates from its top three clients (who account for an estimated one-third of its revenues). This comes into effect from January 2011. Analysts expect this hike to impact EBITDA margins by around 100-120 basis points positively over the next two-three quarters. Other factors like improved utilisation, pickup in margins of Wellsco (OPM of 3 per cent) and Daxcon (6 per cent) as more work is shifted offshore are expected to push margins from the current 15.3 per cent to above 17 per cent.
Dependence on top 10 clients diminishing: As a result of its acquisitions, Infotech’s reliance on its top 10 clients has reduced from 59.8 per cent of revenue last year to 55.8 per cent currently. According to the management, with spending in the manufacturing sector picking up, budgets for hi-tech, heavy engineering and aerospace verticals are expected to rise more than others. If these sectors do pick up, it will lead to further broad basing of its revenues. Further the company added 15 new clients last quarter — seven in NCE and eight in EMI — which will keep both verticals buoyant.
Geographically diversified: Infotech’s revenues are well spread out geographically. North America accounts for 55.8 per cent of its revenues, Europe 36 per cent, and rest of the world, 8.2 per cent.
Increased utilization: Infotech has steadily managed to increase utilisation in both its verticals. In the NCE division utilisation level now stands at 81 per cent as compared to 75 per cent in Q2, while in EMI division it stands at 75 per cent as compared to 73 per cent (Q2). The company has indicated it wants to push utilisation levels further up to 85 per cent in NCE and 80 per cent in EMI.
The company added 261 employees in the latest quarter, taking its headcount to 8,384 employees.
Future acquisitions: Infotech acquired two US-based companies — Daxcon Engineeering and Wellsco — last year and is still hungry for more. Bhanu Cherukuri, chief strategy officer, pointed out in a recent quarterly conference call that the company is evaluating three opportunities. At least one of these is in the due diligence stage and could close within the next three-four months.
The company had Rs380 crore (as on December 2010) in cash holdings which could be utilised for financing possible acquisitions.
Debt free and strong cash position: As said, Infotech is debt free and has cash and equivalents totalling Rs380.8 crore (as on December 2010). This amounts to Rs34 per share or about 21 per cent of the current market value. Such a high liquidity position provides comfort when compared to other mid-cap IT stocks.

Weaknesses and Threats
Onshore-offshore mix: For IT companies, greater the ratio of offshore to onshore business, greater is the profitability. Infotech hasn’t managed to achieve the right mix yet. Its ratio of offshore to onshore remains skewed toward onshore, which has, in fact, increased.
The ratio of onsite to offshore for NCE in the latest quarter (December 2010) now stands at 49.3 per cent compared to only 30.8 per cent during the same quarter of the previous year. For EMI the ratio stood at 54.7 per cent onsite as compared to 51.5 per cent last year.
Foreign exchange headwinds: Like other IT companies, Infotech is also susceptible to currency fluctuations. The company lost Rs3.6 crore due to forex fluctuation in the December 2010 quarter, which impacted its margins by around 120 basis points. In future, too, this risk will remain for Infotech, as it will for all IT companies.
Risk of margins not rising: B.V.R. Mohan Reddy, the company’s chairman and managing director, in a recent con-call with analysts stated that the company is targeting a margin of 18 per cent. This was after the company saw a 500 basis points contraction in margins y-o-y. Reddy attributed this to a favourable exchange-rate environment a year ago and to the absence of salary hikes in the previous year (FY09).
Other factors negatively impacting margins include slower-than-anticipated off-shoring of Daxcon and Wellsco. Reddy said it may take another quarter before Wellsco starts off-shoring work to India.
But margins look set to improve with price increases and better utilisation levels.

Valuation and Outlook
As for valuations, Infotech’s median P/E over the last five years (12-month trailing) is 18.4. With a current P/E of 15.03, Infotech is trading at a discount to its median. It is also at a significantly lower level than its peak P/E of 33.5 times in the heydays of the bull run (April 2006). In terms of PEG ratio (based on five-year EPS), the stock now trades at a comfortable 0.43.
In spite of the above risk, Infotech is expected to do well in future. What’s helping is the buoyant IT spending environment that is starting to show in higher billing rates. With its US acquisitions expected to move more business offshore, margins are expected to rise. According to Kapil Sangoi of Edelweiss Securities, “We expect the current scenario to improve with pricing hikes from top customers and the strong revenue trajectory continuing. We maintain a buy recommendation and sector outperformer rating on the stock.”
Given the above-mentioned positive changes expected around the company and the reasonable valuation that it commands, one can look at investing in the stock with a long-term perspective.