September 2, 2008

Analysis: NIIT tech Annual results

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.

Results summary
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 positives
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 negatives
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 accounting
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.

Reading up

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 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


Kannan said...

Do you have the electronic copy of AS30 ? If so, can you upload in the group folder?


rajesh said...

Hi Rohit,

I am reading your blog for last few months. Learnt lot of information about capital markets and value investors.

I need your views on something. Recently I read a lot about the healthcare sector as next booming sector in next decade. Some articles also say that there will be shortage of good doctors.

Recent one -

What are your veiws about this sector and also how you view it from individual doctor perspective?

I am doctor by profession and just trying to understand the future of healthcare industry in india. Can you foresee any boom in this sector as we have all seen in IT sector? Currently a decent doctor earns between 30-40k after his MD and 45-50k after doing SRShip. So after 10+ years of work hard he earns only 40-50k. And what is this about venture capital investment in this industry? Is it really possible to get some funding for setting your own hospital if you have viable business model?


Rohit Chauhan said...

you can find the document on the icai website


Rohit Chauhan said...

Hi rajesh
I can speak only as an investor. I think health care should do well in india. With rising populations and income levels, medical tourism health care should do well.
currently there is a shortage of quality healthcare in india.

either there is high quality and expensive health care available or poor quality cheap healthcare. So it is quite likely that the good quality affordable healthcare solutions may do well.

however i really do not have insight into how it will work for doctors. as far as i know, there is a net shortage of doctors ..but even if shortage increases, i think it will never work in the same manner as IT.

IT industry is now a globalised industry. The demand is now global in nature due to the offshoring. The supply has been limited. The indian IT industry arbitraged the indian costs and achieved this advantage. however as per basic economics, this arbitrage is bound to reduce and hence the improvement in salary.

I am not sure if the medical profession works the same way. There are far more barriers in countries such as US due to which the health care cannot be outsourced. parts of it maybe, but not a whole lot.

I really am not aware of funding options for new ventures too


VISHNU said...

Hi Rohit,

Sorry If I am asking stupid questions. (I am not that much good at Accounting)

I had a look at NIIT's notes(Given below) it just says 884 million. i.e 88.4 Cr.

How it became 65Crs (it should be 88.4 cr?) in Q1 2009 ?
what is Non effective hedging ?

If I am not wrong , they changed their accounting policy from Amrotizing Profit/Loss to "Mark to Market" ?

Anyway good article .. I am enjoying your posts related to strategies , valuations and reverse engineering...Keep posting such good articles.


"3. The company had during the last quarter of the previous year changed its accounting policy related to foreign currency derivative instruments taken against the highly probable forecast transactions. The change in policy has resulted in reduction of Reserves & Surplus to the extent of Rs 884.40 million in Hedging Reserve and additional creation of liability of Rs 341.80 million in the current quarter with corresponding impact on profit before tax for the quarter."

Rohit Chauhan said...

Hi vishnu

effective hedge is basically a derivative transaction which will hedge a probable future transaction such a loan, recievable etc.

AS standard state that for an effective hedge, mark to market accounting losses or profit can be adjusted against reserves till such transactions are closed.

I have yet to find the exact definition of non - effective hedge . my guess is that it means a derivative transaction which is not hedging a probable transaction. any loss or gain for such a hedge has to pass through P&L.

the 65 cr no. i got from the management call. frankly i am still trying to reconcile all these numbers in the AR.

so 88 crs (or 65) is for their effective hedge and adjusted against reserves.

they have moved to mark to market in the current year. the earlier accounting was more conservative as it impacted the P&L directly. the new standard gives more leeway to the management to work with numbers.

IT company results are getting complex. i think we should not take the reported numbers at face value for IT companies


Anirban said...

hi Rohit
Can you kindly explain what you mean by ""the market expects the company to be out of business pretty soon.""..Does that mean that the company is on the verge of closing down?? or is it something else..I am a bit confused since you mentioned it under the positives...It will be of great help if you can kindly explain it to me about how you think the company to shape up in future..(Please pardon me if I sound stupid as I am not good at stocks but is a bit concerned about how the company shapes up in future..Thanks in advance)
with regards