A case of overvaluation

Volatility in i-flex earnings doesn't justify its premium valuation

Product revenues account for over 60 per cent of i-flex's revenues, because of which the trend in earnings growth for the company is non-linear.

For instance, after an impressive 71 per cent jump in net profit in FY03, the company has reported a 15 per cent drop in net profit in the nine months till December 2003.

True, this year's results include some one-off expenses but even after adjusting for that there is a drop in net profit. Thanks to a dilution in the equity base, the impact on earnings per share is worse.

So it's no wonder the stock corrected sharply by almost 9 per cent on Friday to Rs 613 on the NSE, and there's been a sharp correction of over 30 per cent in the past month. But even at current levels, the stock trades at around 27 times estimated FY04 earnings, the same valuation as Infosys.

Future growth projections are bullish. The reasoning is that banks and financial institutions are expected to gradually replace old legacy systems, not only because they may not be able to handle the increase in transaction volumes, but more because of a need to cut expenses significantly.

Currently, the market for replacing legacy systems accounts for only 10-15 per cent of the $80 billion banks spend on technology annually. But i-flex expects this segment to grow at a relatively faster rate going forward.

The prospect of winning such big deals has led the company to invest higher amounts in sales and marketing - S&M expenses increased 225 basis points to almost 16 per cent of sales, which is almost double what the industry spends.

Further, the company has acquired SuperSolutions Corporation, which, being a specialised consumer lending solutions provider and having an established customer base, strengthens the company's portfolio.

Then there was the strategic pact with IBM, which will market 'FLEXCUBE' (on the DB/2 platform) through its global sales team. Needless to say, this increases the company's reach.

Even now, revenues have been growing at a decent rate - in the nine-month period, product revenues grew 20 per cent and services revenues jumped 33 per cent.

But earnings were lower because the proportion of license fees in product revenues fell from 57 per cent last year to just 36 per cent this year. In the services business, margins fell 140 basis points, mostly because of higher salary expenses and an increased use of onsite consultants.

Going forward, although the outlook is positive, it's tough to take a call on earnings growth going by the historic volatility in earnings. It seems strange, therefore, that the company enjoys the same premium valuations as Infy.

ITC's good show

ITC's performance in the December quarter has been far better compared with the first half of the year - sales grew at 10.6 per cent last quarter against a mere 3 per cent in the first half.

Gross revenues of the cigarettes business increased 6.8 per cent, well above the 3.7 per cent growth in the first half. This clearly indicates that volumes have picked up strongly, because there have been no price increases after April.

What's more, EBIT margins of the division improved 50 basis points year-on-year, thanks to the price increases taken earlier in the year. With rural incomes having picked up after the good monsoons, potential consumers (currently bidi users) are expected to turn to cigarettes.

The company's new businesses have been doing well - the Branded Garments, Greeting Cards, Stationery & Gifts, and Packaged Foods businesses put together grew revenues by 139 per cent last quarter and accounted for a fourth of incremental revenues.

What's important is that the division's losses have been pruned to 42 per cent of sales, compared to 84 per cent of sales same time last year.

Since the initial product development and brand building expenses have, more or less, been absorbed, losses are expected to drop further going forward.

The hotels business has benefited from the upturn in tourist arrival - revenues grew 31 per cent and EBIT margins jumped 540 basis points, leading to a 98.4 per cent jump in the segment's earnings.

The performance of the agri-business segment was impacted because of last year's high base, while the paper business suffered because of inventory correction by end users and a plant shutdown for maintenance & repairs.

However, last quarter's acquisition of a paperboard manufacturing facility will result in a 32.5 per cent expansion in the current capacity, which is expected to result in higher growth going forward.

The ITC stock now trades at 16 times FY04 earnings, still at a discount to peers in the FMCG sector. One trigger for a rerating would be a favourable hearing in the dispute relating to luxury taxes, for which the company has made a provision of Rs 1260 crore.

A favourable hearing would not only result in a huge write-back, but also cause the company to increase its dividend payout considerably.

With contributions by Mobis Philipose