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Right Business Mix

With a diversified business in four strategic units, CMC Ltd makes for an attractive long-term pick…

CMC Ltd. was earlier a public sector undertaking. In 2001, the Tata group acquired a controlling stake in the company. It has four strategic business units (SBUs): customer services (which is responsible for equipment supply), IT-enabled services, systems integration, and education and training. Both its domestic and international business contribute about 50 per cent each to its total revenue. Currently it earns about 88 per cent of its revenue from solutions and services, and only 12 per cent from the equipment supply business. At the end of Q1FY12, the company’s staff strength stood at 7,809.

Strengths
PSU lineage. Before TCS bought a majority stake in CMC, the latter was a government entity. Even now the fact that it was earlier a PSU and has executed a large number of government projects gives it an edge in winning large government contracts.
The TCS advantage. CMC and its parent TCS bid jointly for several projects. Thus CMC leverages TCS’s brand, sales capability, and IT expertise to win projects. This strategy has been quite successful. The joint entity has been able to win projects such as Passport-Seva and CBEC (Central Board of Excise and Customs).
Scale. CMC has the ability to undertake large-scale systems integration projects.
Improving margins. Earlier, hardware and equipment supply was a major business of the company. But since this was a low-margin business, the company consciously decided to move away from it and towards high-margin value-added businesses. Now the hardware and equipment business participates mainly in those projects where the company has to offer hardware as part of a large project that it has bagged. The decision to shift towards high-margin businesses has enabled the company to improve its operating margin from 6 per cent in FY04 to around 20 per cent in FY11.

Opportunities
Robust outlook. According to management, the company’s business outlook remains robust. It added 16 clients during Q1FY12 — 14 domestic and two international.

Opportunities in domestic business
Rich prospects in e-governance projects. The government has budgeted Rs 2,300 crore for the national e-governance plan. Of 27 mission mode projects, CMC has executed two along with TCS. Currently it is executing the Passport-Seva project. A majority of the 78 sites under this project are yet to be rolled out. All these projects are expected to generate a lot of revenue for the company over the next seven years.
Domestic revenue is also expected to come from a variety of other projects:
UID. India’s landmark unique identification project holds a lot of scope for CMC. During the enrolment phase, CMC will work on capturing data, digitising it, and then providing the card. The company is already doing this type of work.
In the second phase, the company will be called upon to set up data centres, and manage infrastructure and facilities at these centres. Both state governments and private or semi-private entities will set up these data centres. The third type of opportunity will arise in the field of education and training. The government has mandated that all those who work on the UID initiative must be certified. CMC will have the opportunity to create certified workers who can enrol people, digitise data, and issue cards.
Finally, once a lot of UID cards have been issued, a large number of organisations, including private ones, will have to upgrade their systems in order to be able to make effective use of the UID number. Here CMC will be able to offer system integration and software solutions.
R-APDRP: A lot of IT implementation will be required under the Accelerated Power Development and Reform Programme. CMC and TCS are together expected to bag a number of these projects from state governments.
State wide area networks (SWANs). CMC has already implemented a project in Chhattisgarh that allows citizens to make online applications to the state government. It has a good chance of winning similar projects in other states.
Ports and cargo. The company is developing a solution for the logistics industry that holds a lot of promise.
Education and training. Due to the rising needs of companies, the opportunities in the field of custom-designed on-the-job training at companies will grow. It is expected that non-engineering graduates will increasingly have to be inducted for jobs that were earlier done by engineering graduates, and these graduates will need more training. All these developments spell opportunities for CMC’s education and training SBU.
Entering new areas. In the domestic market the company plans to enter new verticals such as agriculture and healthcare.

Opportunities in the international business
CMC’s international business has been growing faster than its domestic business. The company has a subsidiary in the US called CMC Americas. During Q1FY12, this business (the largest abroad) grew 19 per cent quarter-on-quarter and 34 per cent year-on-year. Most of the growth in the international business came from services that required on-site presence (margins in on-site work are lower than in off-site work). But this is because projects were in the initial stage. As the projects advance more work is done off-site. The company is also investing in developing its offshore infrastructure in order to capitalise on the opportunities to do work off-site.
Embedded Systems is the key driver of growth in international markets. The company does a lot of work in this domain in the office and the industrial electronics space. It is also working on developing drivers for a variety of office equipment such as fax machines and printers. The international business also gets a lot of work from automotive and railroad companies.
The company also has branch offices in UK and Dubai.
On the whole, analysts at Almondz Securities expect FY13 to be a strong year for CMC.

Risks and concerns
Risks of government projects. In the domestic business, the company depends on government projects that often get delayed. Collecting dues from the government can also at times become a time-taking exercise, resulting in high receivables.
Currency risk. Almost 50 per cent of its revenue comes from abroad and a large portion of it from the US. If the rupee appreciates against the dollar, that would affect the company’s rupee earnings.
Tax impact. In Q1FY12 CMC’s effective tax rate went up because the tax concessions that software technology parks were entitled to got phased out (from March 31, 2011). As a result, its effective tax rate rose from 15.2 per cent in Q4FY11 to 29.6 per cent in Q1FY12.
To offset this, CMC started operations at its Hyderabad SEZ from April 2011. This will enable it to lower its tax liability in the coming quarters. According to the company’s management, its effective tax rate for the whole of FY12 should amount to 25 per cent.
High level of attrition. This is a problem that affects all players within the IT industry. CMC is no exception. Demand for specific IT skills outpaces supply, and this leads to high attrition rates. Rising salaries of employees erode margins. To retain employees, CMC offers training programmes and differential salaries to all its outperformers.
Legislation against outsourcing. With economic growth in the developed world slowing down, popular sentiment has turned against outsourcing. Hence, there is always the risk that countries such as the US and UK could pass legislation that imposes restrictions on work being outsourced to Indian companies such as CMC.
High working capital requirement. The company requires a higher level of working capital as it is involved in large-scale, long duration, government projects where the recovery time is higher.

Financials
Cash rich. At the end of Q1FY12, the company’s cash and cash equivalents stood at Rs 56.53 crore.
Margins. The company aims to have an operating margin between 16-18 per cent. In FY11 its EBITDA margin stood at 20.59 per cent. According to management, this may drop slightly this year on account of the company going through a phase of growth and investment.

Valuation
The stock is currently trading at a 12-month trailing P/E ratio of 17.33. Currently it is trading more than its five-year median PE of 15.52. Over the last five years, the company’s EPS (earnings per share) has grown at a CAGR of 28.69 per cent. This gives it a price-earnings to growth (PEG) ratio of 0.60.Buy share on dips.