Warning: Parts of this post are boring as I would be discussing about Hedge accounting, reserve adjustments etc. However if you are invested in IT stocks, I would recommend you to get a good understanding of these concepts as they are now critical to understand how the company is doing.
The company had an average performance for the year 2007-08. The ROE was maintained at 30% level. The sales growth was lower at around 6% (reduced partly by the rupee appreciation) and the net profit growth was around 3%. The net profit margins were maintained at 14.3%. The operating margins also held steady at 19%.
The key segments of BFSI, Insurance and travel now contribute to more than 80% of the revenue. Europe continues to the major geographic segment with the contribution to revenue at 50%. The other performance parameters such as % revenue from top customers, no. of new customers etc showed decent improvement.
The company completed the accquisition of ROOM solutions during the year. This business was not profitable during the year as it is in the investment mode as per the management. In addition the company made another small accquisition of Softec in the airline IT solution space. Thus the company is pursuing a strategy of both organic and inorganic growth in the focus verticals, especially in Insurance and transportation.
The company did not perform as well as the tier I vendors. However the company is now pursuing a strategy of focusing on key verticals. It is growing through accquisitions in these verticals and accquiring the required IP and customers via these accquisitions. This strategy makes sense for mid size companies such as NIIT tech, which cannot compete with the Tier I companies on scale alone.
The company maintained its margins and ROE inspite of the slowing markets and currency fluctuations. The company performed as expected and as the valuations are currently discounting a terrible performance, the stock price did not suffer.
The cash and equivalents for the company now stand at 220 Crs which is almost 30% of the mcap. The company continues to sell at around 2.5 times earnings (or slightly higher than book value), which means the market expects the company to be out of business pretty soon.
The volume growth for the company was poor for the year 2007. The company is definitely not performing as well as some of the Top tier companies.
The accquisition for ROOM solutions was done at 100 Crs. The company is currently making losses. NIIT tech Management has paid quite a bit for the company and must have seen a lot of value. I hope they are right. Although subsequent poor performance of ROOM may not hurt the company a lot, it would definitely put the capital allocation skills of the management into question. I would personally rethink my entire thesis about the company if the accquisition turns out to be a dud
The performance of the accquisition is more critical than it seems on the face of it as the company has a large cash holding. This cash holding would grow further in the future and the management would be looking at new accquisitions with this cash. A poor track record would hurt the performance in the long run.
The company accounted a forex loss of around 6.7 Crs in the P&L account with net impact of +.8 crs ( still trying to figure how they arrived at this number).
Now for the dry part,
The company maintains effective and non-effective hedges. The effective hedges are used to hedge the revenue and recievables. The company booked a loss of around 15.5 crs against reserves in the year 2008. These reserves have increased to around 65 Crs in Q12009. So if the rupee remains at the current levels, the company will close the hedges (which cover 27 months of revenue) over the next 27 months and take a loss of 65 Crs on the P&L account.
So the question is – Has the company already incurrend a loss of 65 Crs ? Yes and No. If the company were to close the contracts then it will have to account for the losses. However NIIT tech is not in the business of derivatives. These derivatives and contracts are used to hedge forex revenues. It is possible that the exchange rate could go in the opposite direction and the losses could worsen or they could go in the intended direction and the company could make profit and come out smelling roses.
The valuation impact
How should one account for forex gains/ losses? I think it would stupid to consider these losses as an ongoing one and capitalize it.
For ex: 2008 net proft was 137 Crs. So would you net the above loss of 15 Crs and say the Net profit is 122 crs and use this number for the final valuation ?
I would rather do the following
Say we take the appropriate PE as 15. The value of the company is 137*15= 2055. I would net off 15 crs from this value to arrive at the final value of 2040 Crs. I would apply the same logic if the company made a profit.
Over the long term, I think the forex gains or losses should be a wash (net impact should be minimal). Unless the treasury department is foolish (which doesn’t look likely) or very smart, the hedges should end up serving their purpose of reducing the impact of exhange losses or gains.
Ofcourse I am assuming the company will not start looking at Forex hedges and derivatives as a source of profit. That is a different ballgame completely. If the company gets in exchange speculation (and some companies have tried that stunt), I will take a very dim view of it.
The employee benefit (AS15) impact is not too high for the year and hence I would not concern myself too much about it.
I am currently reading AS30 standard to get a better understanding of the new accouting standard for mark to market accounting. It is quite a dry read. However if you are interested in understanding the accounting and results of IT companies, then it is important to understand these standards. I would say, that if you are into fundamental analysis, the understanding all the AS standards is crucial.
Ofcourse reading AS standard is as entertaining as getting your dental work done. But investing is not always fun ..is it ? :)
I have still not changed my mind about the company. The market expects a far worse performance and as long as the company can do better than what is expected, the returns for an investor should be good.
The analysis for NIIT tech is uploaded here. Earlier posts on NIIT tech here, here and here