i-flex Solutions - margins improve, but concerns persist; result update Q3FY08; maintain Accumulate

-flex Solutions (IFLEX IN, INR 1,111, maintain Accumulate)

i-flex Solutions’ (i-flex) Q3FY08 results were below expectations. Revenues, at INR 6.2 bn, were up 7.6% Q-o-Q and 11.2% Y-o-Y, while net profits, at INR 1.07 bn, were up 22.1% Q-o-Q and down 4.1% Y-o-Y. The products business, at INR 3.6 bn, grew 10% Q-o-Q, in line with expectations, with major contribution (75%) from implementation and AMC fees; license fees accounted for only 24% of product revenues, showing a moderate growth trend. The lower proportion of high margin license fee contribution resulted in significantly lower net profits for the quarter than our expectation. The license fees tank is about USD 81.2 mn, almost flattish from USD 80 mn in the previous quarter. The services business has underperformed in Q3FY08 with revenues from this segment growing a modest 6% Q-o-Q. While EBITDA
margins improved by 490bps to 21.5% vis-à-vis 16.6% in the previous quarter, they still lag 22.6% posted in the corresponding quarter of the previous year.

i-flex’s services business is an under performer with margins being a concern and volatile. Though Q3FY08 EBITDA margins have improved, we believe consistency coupled with more sustainable growth across business lines is still missing, while KPO business, with negative EBITDA, is yet to bear fruits.

The company saw superior growth in FY07 on the back of products catering to regulations such as Sarbens Oxley (SOX), Basel II, and Anti-Money Laundering. We believe growth has moderated as most of the big financial institutions and banks are in a matured phase of implementing these solutions. Added to this, sub-prime and credit related issues in the BFS segment in the
US throw an uncertainty dimension in terms of new license sales.

Adjusting for the much weaker-than-expected product sales on back of U.S subprime concerns and EBITDA volatility, we have revised our EPS estimates marginally for FY08E and FY09E downwards ~3% to INR 45.05 and 5% % to INR 50.9, respectively based on Indian GAAP.

i-flex’s cost management has been unimpressive; S,G&A costs still remain high at >25% of revenues and EBITDA margins are volatile even on an expanding revenue base. The topline growth has not translated into a sustainable bottom line growth, as the latter grew at just half the rate of 36% CAGR during 2004-07.

At CMP of INR 1,095, the stock is trading at P/E of 24x and 21.5x on our FY08E and FY09E earnings, respectively. We are maintaining our ‘ACCUMULATE’ recommendation on the stock for the above given reasons. The only positive trigger we see at current levels for the stock is open purchase offer by Oracle.