3i Infotech: Float under water

3i's valuation is expensive at 24 times trailing earnings

The IPO of 3i Infotech is among the handful that have listed recently below their issue price. The fact that the company reported impressive numbers for the quarter and year ended March 2005 didn't make much to 3i's share price, which continued to languish at around Rs 95, about four per cent lower than its issue price of Rs 100.

The company's operating profit rose by 91.65 per cent in the March quarter, with operating margin inching up to 17.5 per cent, from 16.25 per cent for the nine month period ended December 2004.

The rise in operating profit was more dramatic at 242 per cent for the whole year due to the low base in FY04. Operating margin was just 6.1 per cent in FY04, and has jumped by over 10 percentage points to 16.6 per cent in FY05.

One of the reasons for the jump in profitability was an increase in the proportion of product revenues. Product revenues grew 77.8 per cent in FY05, accounting for 44 per cent of total revenues, compared with just 31 per cent in the previous fiscal.

Also, product revenues had gross margins of 51.3 per cent, much higher than the services division's 37 per cent margin. Even going forward, the company expects the products division to drive growth for the company.

Within product revenues, the share of AMC revenues are expected to rise, which, in turn, will provide some amount to stability to revenues. Yet, as in the case if i-flex, a high proportion of product revenues normally leads to non-linear growth.

As far as valuations go, the stock looks expensive at around 24 times trailing earnings (using the post-issue capital). Yet, based on the company's guidance of a 25-30 per cent growth in revenues, and the fact that net margins would improve by 200-400 basis points to a big jump in earnings in FY06.

Earnings attributable to shareholders would be even higher, since the company would be repaying a large portion of its preference capital. As per the company's projections, the FY06 EPS would be in the region of Rs 9-10, which gives the stock a forward PE of 9.6-10.7 times. Most other mid cap IT stocks trade at 12-14 times FY06 earnings.

Nervous markets

During the last ten days or so, markets across the world tottered on news of two very contradictory reports on the US economy. First, worries about slowing growth in the US affecting corporate earnings growth""-the chief example being IBM-spooked the Dow, and markets throughout the world fell in sympathy.

Then reports showed that inflation was strong in the US, which led to the Dow falling on fears that rising prices will lead to the US Fed tightening rates more rapidly, a fear that also haunted the market a month ago.

Again, global markets fell in tandem with the Dow. All this is very strange, because shouldn't slower growth dampen inflation and remove the reason for faster interest rate increases?

It's not only the data that is confusing""the market can't seem to make up its mind whether the threat comes from slower growth or higher inflation.

That's probably because so far it has had the best of both worlds "" high growth and low inflation""and the market downtrend is a sign of mourning for the passing of that "sweet spot."

For the Indian market, however, slowing US growth leading to a stagnating Dow may not affect funds flows. In fact, the Dow has been range-bound between 10,000 and 11,000 since early 2004, but that didn't affect FII net inflows to the Indian market.

On the other hand, it is the fear of higher US interest rates or an appreciating dollar that has led to sharp drops in FII net inflows to India.

Seen from this perspective, a moderately slowing US economy, which may lead to the US Fed postponing any further tightening of interest rates, may well be a boon for the inflows into Indian equities. The sectors to remain invested in, of course, will be the plays on the domestic economy.

UTI Bank

UTI Bank's fourth quarter net profit was up 33.82 per cent, driven by rising fee income, net interest income and trading income ""in that order. That's an impressive performance, suitably appreciated by the market.

Yet growth has slowed compared to the third quarter. To illustrate, net profit growth was 35.12 per cent in Q3. Net interest income rose by 26 per cent in Q3 and 17.96 per cent in Q4, and even fee income, which grew a sizzling 62.5 per cent in Q4, grew an explosive 135 per cent in the previous quarter.

Only trading income, which was negative in Q3, did much better in Q4. But too much need not be read into these percentages""the fact remains that Q4 has seen higher net interest income, more fee income and more trading income.

UTI Bank's net interest margin has been under pressure, falling from 3.36 per cent in Q4, FY 2004 to 2.90 per cent in Q3, FY 2005 to 2.64 per cent in the last quarter, and the management says that's because of its anxiety to grow the balance sheet. As credit growth picks up and short-term advances are replaced by longer-term ones, the bank hopes that the NIM too will pick up.

Nonetheless, cost of deposits too is rising, and there's little doubt that scale is very important in offsetting the impact of a squeeze in NIM.

That's where UTI Bank scores ""net advances and balance sheet size have grown by 67 per cent and 56 per cent respectively y-o-y. But as our earlier comparison with Q3 growth rates shows, the bank needs to do more to ensure that earnings growth is maintained.

With contribution from Mobis Philipose