ambit- technology-err group- the underbelly of indian it

8/12/2019 Ambit- Technology-eRr Group- the Underbelly of Indian IT

1/28


2/28

Technology

March 24, 2014 Ambit CapitalPvt. Ltd. Page 2

ONTENTSThe underbelly of Indian IT the ugly, the bad and the not so good...4

THE UGLY. 6

Geodesic 7

Educomp.9

Financial Technologies (FTech)11

THE BAD. 13

Rolta..14

MCX.. 16

THE NOT SO GOOD 18

Tech Mahindra 19

Infosys...22

KPIT Technologies.. 24


3/28

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital

may have a conflict of interest that cou ld affect the objectivity of this report. Investors should not consider this report a s the only factor in making their investment decision.

The underbelly of Indian ITThe Indian IT sector is oft praised for its good corporate governance andaccounting excellence. However, our history of covering the sector overthe last four years indicates that this blanket assumption is misleading.We present case studies of companies (classified as ugly, bad and notso good) that underperform on accounting and corporate governancestandards. Whilst some of these companies (such as FTech, Educomp andGeodesic) are already understood by the market for what they are,others (such as Rolta, MCX, Infosys, Tech Mahindra and KPIT) are yet tobe discounted appropriately by investors.

Misconceptions about the quality of Indian IT sector

Five years since the Satyam fraud, the IT Index is up over 300%, implying thatthe Indian IT sector is still assumed to be a safe haven of relatively cleanerpromoters, strong and neat accounts, and sound corporate governancepractices. However, our analysis and experience of the sector suggests this isprobably the easiest sector to fudge accounts, particularly given its largelyservices-led nature and given that it relies on B2B transactions that do not lendthemselves to the sanity checks that one can do in industrial sectors.

Range of tricks to window-dress accounts

Indian IT firms have used a variety of tricks to window dress their accounts,ranging from recognising cashless revenues (Geodesic), recognising seeminglynon-existent revenues (Geodesic, Rolta and MCX), accelerated revenue

recognition (Educomp), margin management (Geodesic, Rolta and KPITTechnologies), inflated balance sheet (Rolta) to cash flow management (Roltaand Geodesic). Furthermore, we also highlight how choice of accountingpolicies can sugar-coat the accounts (Tech Mahindra and KPIT).

Not the cleanest on corporate governance either

Significant related party transactions at MCX (not appearing to be arms length),the NSEL fiasco at FTech, questionably low independent director involvement atTechM and Satyam when the merger ratio was finalised, relatively highpromoter Board representation and peculiar guidance pattern creating stockprice volatility at Infosys are some examples of corporate governanceloopholes. Furthermore, less-than-adequate disclosures at Tech Mahindra,

Educomp and seemingly weak risk management at MCX are also concerns.

Traces of suspicion in MCX and Rolta

Whilst cases such as Satyam (with its artificially inflated bank balances) can bedifficult to detect in advance, other cases such as Geodesic, Educomp and FTechhad similar financial characteristics, which could have been spotted by investorswho were willing to dig deep into their accounts. We find somewhat similarissues in the annual reports of MCX and Rolta India.

On the other hand, Tech Mahindra, Infosys and KPIT present less than desirablestandards of accounting and corporate governance. For firms rated as richly asthese three, this should weigh on their valuation multiples.

We reiterate our SELL stance on Infosys and Tech Mahindra. We do notcover the other IT companies mentioned in this note.

Technology

THEMATIC March 24, 2014

Case studies in this note

The ugly

Geodesic Revenue and cash flowmanipulation; corporategovernance concerns

EducompSolutions

Accounts window dressing

FinancialTechnologies

Suspicious subsidiary accounts;corporate governanceconcerns

The bad

Rolta India Tricky accounting practices

MCXSuspicious related party dealsand seemingly artificial

volumes

The not sogood

TechMahindra/Satyam

Weaker disclosure norms;accounting not up tointernational standards; flagson governance

InfosysLetting down its owngovernance standards?

KPIT

TechnologiesMagnified margins

Source: Ambit Capital research

Key Recommendations

HCL Tech BUY

Target Price:1,614 Upside :13%

TCS BUY

Target Price:2,351 Upside : 11%

Tech Mahindra SELL

Target Price:1,471 Downside : 19%

Infosys SELL

Target Price: 2,945 Downside : 11%

Analyst Details

Ankur Rudra, CFA+91 22 3043 3211

[email protected] Jain+91 22 3043 3291

[email protected]


4/28

Technology

March 24, 2014 Ambit Capital Pvt. Ltd. Page 4

The underbelly of Indian ITFive years on from the Satyam fraud, the Indian IT sector is still assumed to be a safehaven of relatively clean promoters, strong accounting and sound corporategovernance practices. This has been historically reflected in the lower discount ratesapplied to the sector, leading to higher P/E multiples.

However, our analysis and experience of the sector suggests this is probably one ofthe easiest sectors to fudge accounts for three reasons: (1) its largely services-lednature (i.e. there is no tangible output that can be observed), (2) it is centred aroundB2B transactions that do not lend themselves to typical sanity checks that one can doin industrial sectors (limited capability to do ground level surveys), and (3) there is adeclining linear relationship in this sector between revenues and headcount. (Giventhat employee cost is the single-largest input cost, a declining correlation withrevenues offers greater scope for manipulation.)

Based on our observations over the past four years, we present case studies of eightIT companies, highlighting their accounting and corporate governance issues andchallenging the notion that Indian IT firms have high-quality accounts and strongcorporate governance. This is not an exhaustive study and is based on the

standout cases we have come across. Other firms may have similar or evengreater issues. We classify the accounting and governance issues in this sector intosix broad categories:

1. Revenue manipulation:This can be done by either booking cashless revenues(with a corresponding increase in receivables), fictitious revenue booking (throughclassification of other income as revenues) or accelerated revenue bookingthrough creative accounting methods. We find evidences of revenue manipulationby firms such as Geodesic, Rolta, Educomp and MCX.

2. Margin management: This can be done through capitalising expenditures,lower provisioning for doubtful debts or through creative accounting (such as notaccounting for client re-imbursements in revenues and costs). Geodesic, Rolta

and KPITseem to follow such practices.3. Accounting method/system not comparable to peers: The mostapt example

is Tech Mahindra. It uses Indian GAAP, whilst most of its peers have alreadymigrated to US GAAP/IFRS many years ago. Use of Indian GAAP allowed it toadopt the Pooling of interest method (that records all balance sheet items atbook value) for merger accounting of Satyam. The use of Indian GAAP hashelped it maintain high RoEs. Had the transaction been recorded underinternationally accepted Purchase method, the RoEs would have beensignificantly lower. Our back-of-the-envelope calculations suggest that FY13/FY14E RoE could have been 14.8%/18.4% under the purchase method (withGoodwill recognition) vs the RoEs of 36.3%/33.3% under the currently followedPooling of interest method(see pages 19-20).

4. Balance sheet and cash flow management: This can be done by removingthe borrowings from the balance-sheet through a separate Special Purpose

Vehicle (SPV) and accelerating cash flow receipts through factoring using this SPV(example Educomp) or through the use of creative accounting (Rolta revaluation of land to offset additional depreciation charges).

5. Corporate misgovernance:This can be done through under-representation ofindependent directors (Tech Mahindra and Satyam), higher promoterdominance (Infosys), related party transactions which do not appear to be atarms length prices (MCX and FTech), less-than-adequate risk control measures(MCX) and a peculiar pattern of representing the future outlook to investors(Infosys).

6. Weaker disclosure norms: Relatively weak financial and event disclosures leadto investor decision-making based on inadequate information. Educomp, FTechand Tech Mahindraappear to fall in this category.

Tech Mahindras RoE sensitivity toIFRS accounting

mn

Current(Pooling of

interestmethod)

Purchasemethod

(estimated)

FY13 FY14E FY13 FY14E

Adjusted netincome

21,157 27,674 13,694 20,211

Adjusted Equity 68,530 97,484 99,168 120,659

Adjusted RoE 36.3% 33.3% 14.8% 18.4%

Source: Ambit Capital research


5/28

Technology


We present case studies on the following companies:

The Ugly

1. Geodesic:Are the revenues real?2. Educomp Solutions:The accounts appear to be window dressed3. Financial Technologies (FTech):Suspicious subsidiary accounts; corporategovernance concerns

The bad

4. Rolta India:Tricky accounting practices5. MCX:Suspicious related party deals and seemingly artificial volumes

The not so good

6. Tech Mahindra/Satyam: Weaker disclosure norms; accounting not up tointernational standards; flags on corporate governance

7. Infosys:Letting down its own governance standards?8. KPIT Technologies:Magnified margins


6/28

Technology


Part 1: The Ugly

Geodesic

Are the revenues real?

Geodesics receivable days have increased to 300 days in FY12 (from 120 days in

FY12), whilst the doubtful debt provisioning has increased to 11.9% of debtors (9.8%of revenues in FY12). Cash yields remain at astonishingly low levels. All these raiseconcerns whether the earlier years revenues were indeed real. Cash conversionthough improved over the last three years, the increase in current liabilities has beena significant factor pushing up the cash conversion.

Educomp Solutions

Accounts window dressing

Educomps creation of a special purpose vehicle to transfer its receivables and thensecuritise it was an attempt to improve its cash conversion and make its balance

sheet look lighter. Its change in revenue recognition policy was also intriguing. Thesecoupled with instances of poor disclosures make it an interesting case study.

Financial Technologies (FTech)

Suspicious subsidiary accounts; corporate governance concerns

From a stockmarket darling, riding on success in MCX and similar expectations fromthe other exchange ventures, Financial Technologies is now struggling to retainownership of these exchanges on the back of the NSEL fiasco, bringing downexpectations from its other exchange ventures. Besides the corporate governanceissues (for not curbing the illegitimate activities at NSEL), our analysis also indicates

suspicious manipulation of subsidiary accounts to present a better picture atstandalone business. FTech does not publish consolidated quarterly results (despite~40% revenues from subsidiaries), and hence, presenting good-looking standalonenumbers makes sense.


7/28

Technology


Geodesic

Are the revenues real?

Geodesic offers an interesting case study that shows several signs of revenue andcash conversion manipulations. With a glorious historical track record (104% FY04-09revenue CAGR and ~55% EBITDA margins), Geodesic was viewed as an internet andmobile software company with exciting B2C products in instant messaging, cheaperSMS, VoIP calling, mobile TV and several products in a fast-growing market. Althoughits products were exciting, most of them failed to get commercial scale before theycommoditised. The quality of revenue growth was always under question givensignificantly higher receivable days and low yield on investments (indicatingpossibilities of fictitious revenue booking).

Whilst this remained unnoticed till the time the company was growing in triple digits,the problems intensified FY10 onwards, when the companys revenues declined forthe first time in FY10, with a consequent decline in margins. Geodesics receivabledays have increased to 300 days in FY12 (from 120 days in FY12), whilst the doubtfuldebt provisioning has increased to 11.9% of debtors (9.8% of revenues in FY12).

Cash yields remain at astonishingly low levels. All these raise concerns whether theearlier years revenues were indeed real. Cash conversion, though improved over thelast three years, increase in current liabilities has been a significant factor pushing upthe cash conversion.

Geodesic unsurprisingly finds itself in a greater mess now, with its auditor (Borkarand Muzumdar) raising qualifications on revenue and expense accounting, default onFCCBs, and forex hedging losses. The company has not yet published theconsolidated FY13 accounts, is yet to pay the final dividend for FY12 and isfunctioning with just three directors all executive (all of the independent directorshave resigned). This reflects in the market capitalisation which is down from `6.9bnat the beginning of 2009 to `284mn.

Cashless revenues

We find at least three evidences raising concerns on Geodesics revenue recognition:

1. High receivable days and increasing doubtful debt provisions: Althoughrevenue growth recovered in FY11 and FY12, it came on the back of significantincrease in receivable days (see Exhibit 1 below). Receivable days increased from120 days in FY10 to 174 in FY11 and further to 300 in FY12. This, coupled withhigh bad debt provisioning in FY12, raises concerns on the quality of revenuesbooked in earlier years.

Exhibit 1:Suspicious revenue accountingmn FY08 FY09 FY10 FY11 FY12

Revenues 3,164 6,530 6,374 8,732 11,627

Revenue growth 92% 106% -2% 37% 33%Receivable days 120 168 120 174 300

Bad debts (P&L) as % of debtors 0.2% 1.8% 0.2% 0.8% 11.9%

Bad debts (P&L) as % of revenues 0.1% 0.8% 0.1% 0.4% 9.8%

Source: Company, Ambit Capital research

2. Low yield on cash and cash equivalents: The average yield on cash andinvestments was moderate 1.5% during FY10-12, which also raises concerns overfictitious revenue booking (see Exhibit 2). The proportion of cash in the currentaccounts was not material enough to result in such low yields.

Exhibit 2:Fictitious revenue booking?mn FY08 FY09 FY10 FY11 FY12

Interest and dividend income 118 206 75 183 212Average Cash and investments 3,898 6,862 7,991 10,878 12,163

Yield on average cash and investments 3.0% 3.0% 0.9% 1.7% 1.7%


Five-year share priceperformance

Source: Bloomberg

Financials

mn FY11 FY12 FY13*

Revenues 8,732 11,627 NA

PAT 2,737 2,600 NA

FCF 4,707 1,363 NA

Source: Company, Ambit Capital researchNote: * FY13 annual report is not yet

published

0

50

100

150

10,000

15,000

20,000

25,000

Mar-09

Jun-10

Aug-11

Nov-12

Jan-14

Sensex Geodesic


8/28

Technology


3. Revenue reversals and auditor qualifications:Furthermore, as disclosed bythe company in its filing to the BSE, auditors raised qualifications on inability to

verify the correctness of write-off of `2,778mn on licence sales. This also raisessuspicion on the quality of revenues booked in earlier years. The auditors alsoraised qualifications on lower doubtful debt provisioning to the extent of`3,675mn.

Playing with current liabilities to shield cash conversion?Whilst Geodesic reported better cash conversion in FY10, thanks to a 48 day YoYdecline in receivable days, FY11 and FY12 were marked by an unusually highcontribution from the current liabilities to offset the impact of the increase inreceivable days.

Exhibit 3:Cash conversion improved but was driven by current liabilitiesmn FY08 FY09 FY10 FY11 FY12

CFO/EBITDA 57% 31% 125% 134% 92%

CFO 1,172 1,122 4,188 5,413 3,893

CFO before working capital changes 1,978 3,601 3,531 4,294 4,115

Increase in debtors -413 -1,959 905 -2,074 -5,396

Change in loans and advances -584 -663 -727 1,344 -2,230

Change in current liabilities 264 290 563 1,956 9,696

Others -74 -149 -84 -107 -2,292


Underestimation of expenses

Besides lower provisioning of expenses, as discussed above, auditors also raisedconcerns over correctness of write-back of `4,370mn in respect of software licencereturned to the supplier. Furthermore, auditors also qualified on non-provisioningfor depletion of the companys investment in Geodesic Technologies Solutions Limited(GTSL) amounting to `616mn.

Corporate governance concerns

1. Lack of Board independence: Whilst Geodesic had more than 50%independent directors on the board as on March 2012, all these independentdirectors have resigned since then and the Board now comprises just threedirectors, all of them executive. Departure of all the independent directors andinability of the company to bring in new independent directors to replace themfurther accentuates our concerns.

2. Non-payment of dividends:Furthermore, despite the cash crunch arising fromFCCB maturity in FY13, Geodesic proposed a dividend of `2/share in 2012,

which still remains unpaid.


9/28

Technology


Educomp Solutions

Accounts window-dressing

Educomps creation of a special purpose vehicle to transfer its receivables and thensecuritise it was an attempt to improve its cash conversion and make its balancesheet look lighter. Its revenue change in revenue recognition policy was alsointriguing. These coupled with instances of poor disclosures make it an interestingcase study.

SPV structure allowed accelerated revenues, better CFO and lower leverage

In FY10, Educomp changed its revenue recognition policy for the Smart_Classbusiness. It created an SPV (named Edu Smart) for this purpose. It created a modelwhereby the Smart_Class receivables were securitised through Edu Smart. Ratherthan following the earlier BOOT (Build, Own, Operate and Transfer) model, Educompsold the hardware and content as a package to Edu Smart (whom it called a thirdparty vendor), which then securitised the receivables with banks. This securitisationprocess helped Educomp to window dress its accounts in three ways:

1.Accelerated revenue recognition: In the earlier BOOT model, Educomprecognised contract revenues over a five-year period (i.e. only 20% of TCV wasrecognised in any quarter). However, under the new securitisation model,Educomp booked 75% of revenues for the total signed classrooms during thequarter in two tranches, whilst 25% was passed on to the vendor (Edu Smart).Out of the 75% revenues, 52.5% was recognised upfront during the particularquarter whilst 22.5% was booked in the successive year same quarter. SinceEducomp had an economic obligation to provide content updates, Educompdecided to recognise the content revenues over a two-year period. Thisaccelerated the revenue recognition as well as profitability.

2. Cash flow from securitisation boosted Educomps cash flows: Whilst theproceeds from securitisation are ideally in the nature of borrowing, the SPV

structure allowed Educomp to account it as cash flow from operations. Thisartificially improved Educomps cash conversion ratio.

3. Off balance sheet liabilities:The structure allowed recognition of liabilities onthe SPVs balance sheet. However, Educomp had given corporate guarantees forEdu Smarts securitisation arrangement. (Given that Edu Smart was a new entity,it would have been difficult for it to raise funds on its own.) This made it liable tobanks in the event of default by Edu Smart or any breach in the securitisationcovenants. However, the SPV structure allowed Educomp to keep its balancesheet light, so that it can raise funds for its evolving K-12 business.

In FY10, Educomp disclosed Corporate guarantee to banks for secured loansto third party of 6,650mn in the notes to accounts of the Annual Report. Across check with Edu Smarts return filing at the Ministry of Corporate Affairs(MCA) confirms that this was the guarantee given by Educomp to Edu Smart.Through the SPV structure, Educomp managed to under-report the leverage(Debt/Equity) by 39%. The actual reported leverage was 0.64x, whilst thereal leverage accounting for the liabilities on SPVs balance sheet wouldhave been 1.04x. The extent of contingent liabilities and true leverage keptrising significantly till this SPV was made redundant in FY13.

However, in the 3QFY13 results, the management announced the move back to theBOOT model, feeling pressure from the institutional shareholders.


Source: Bloomberg

Financials

mn FY11 FY12 FY13

Revenues 13,509 14,913 12,109

PAT 3,354 1,355 -1,328FCF -5,267 -2,281 -3,585


0200400

600800

1000

5,000

10,00015,000

20,000

25,000

Mar-09

Jun-10

Aug-11

Nov-12

Jan-14

Sensex Educomp


10/28

Technology


Less-than-ideal disclosures

We also observed some disclosure lapses by Educomp, worth highlighting:

1. Promoter allotted warrants: Educomp increased the stake in EducompInfrastructure and School Management Ltd (EISML) from 69.4% to 78.2% at`4.89bn in 2009. This gave EISML an implied valuation of `16.42bn. However,the promoter (MD of Educomp) was awarded 800K warrants at the same

valuation as Educomp, over six months after Educomps equity infusion accordingto filings to the Ministry of Corporate Affairs. We find the lack of disclosure on thisfront unsettling although we recognise that the law might not require Educomp tomake such a disclosure.

2. Undisclosed JV with an existing school: Educomp established a JV with anexisting school called the Ambika Modern School in Jalandhar that has beenrebranded as Millennium Jalandhar. We find it intriguing that the managementdid not disclose this explicitly.


11/28

Technology


Financial Technologies (FTech)

Suspicious subsidiary accounts; corporate governanceconcerns

From a stockmarket darling, riding on the success in MCX and similar expectations

from the other exchange ventures, Financial Technologies is now struggling to retainownership of these exchanges on the back of the NSEL fiasco, bringing downexpectations from its other exchange ventures. Besides the corporate governanceissues (for not curbing the illegitimate activities at NSEL), our analysis also indicatessuspicious manipulation of subsidiary accounts to present a better picture at thestandalone business. FTech does not publish consolidated quarterly results (despite~40% revenues from subsidiaries), and hence presenting good-looking standalonenumbers makes sense.

Significant related party transactions standalone numbers appearartificially attractive

FTech derives more that 40% of its revenue from subsidiaries (its investments inseveral exchanges and related businesses), which make them an important part ofthe overall financials. We have observed that FTech has allocated a higher proportionof its expenses to subsidiaries. For example, it allocates all the advertisement andpromotion expenses and more than half of its other expenses to subsidiaries. Giventhat FTech reports only standalone results in its quarterly filing (despite subsidiariesaccounting for >40% of revenue), charging of significantly higher expenses tosubsidiaries raise concerns on accounting manipulations in company financials,making the standalone financials look better.

Exhibit 4:Consolidated vs standalonemn FY10 FY11 FY12 FY13

Revenue

Consolidated (a) 3,292 4,079 5,012 7,519

Standalone (b) 3,286 3,577 4,255 4,509a - b 6 502 757 3,010

Add: Sales by Standalone to Subsidiaries 1,519 1,434 1,785 1,176

Estimated Subsidiary revenue 1,525 1,936 2,542 4,186

Employee benefit expenses

Consolidated (a) 2,151 2,638 2,469 2,501

Standalone (b) 900 1,154 1,125 1,241

% of Standalone revenue 27% 32% 26% 28%

a - b 1,251 1,484 1,344 1,260

% of Subsidiary revenue 82% 77% 53% 30%

Other expenses

Consolidated (a) 2,430 2,572 2,607 3,053

Standalone (b) 1,004 1,089 1,019 651

% of Standalone revenue 31% 30% 24% 14%a - b 1,425 1,484 1,588 2,402


Advertisement and business promotion expenses

Consolidated (a) 129 204 319 337

Standalone (b) 0 0 0 0

% of Standalone revenue 0% 0% 0% 0%

a - b 129 204 319 337


PAT

Consolidated (a) 1,401 -1,368 2,641 2,274

Standalone (b) 3,444 919 4,780 3,229

a - b -2,043 -2,287 -2,140 -954



Source: Bloomberg

Financials

mn FY11 FY12 FY13

Revenues 4,079 5,012 7,519

PAT -1,368 2,641 2,274

FCF -5,371 2,107 756


0

500

1000

1500

10,000

15,000

20,000

25,000

Mar-09

Jun-10

Aug-11

Nov-12

Jan-14

Sensex FTECH


12/28

Technology


NSEL fiasco Corporate governance issue

National Spot Exchange (100% subsidiary of FTech) was promoted as a deliverybased market place for the purchase and sale of commodities. However, as iteventually turned out, NSEL became an unregulated repo market for agriculturalcommodities as collateral1. Contracts were rolled over without mark to market (MTM)adjustments, there was no physical transfer of commodities (indeed the underlying

commodities and warehouses did not exist in many cases) and there were also shortselling. The pair trades in various commodities were offered in forward contracts ofT+2 to T+25 (sometimes even T + 35) payment terms (bought and sold at the sametime), whilst the maximum allowed settlement period was T+11. Such pair tradesoffered an arbitrage opportunity of about 12-15% return per annum.

The Ministry of Corporate Affairs took exception to this and appointed the ForwardMarket Commission (FMC) to investigate. The Minister for Consumer Affairs, KVThomas, and the FMC sent a circular to NSEL to stop launching new forwardcontracts and make deliveries on existing contracts to curb speculation2. Given thatdelivery never happened in the earlier scheme of things, sudden termination ofcontracts in the absence of collaterals led to defaults by the borrowers.

The company is now looking to sell some of its assets. For example, Financial

Technologies sold its stake in Singapore Mercantile Exchange to the Singapore unit ofIntercontinental Exchange Group for US$150mn in November 2013. It also sold itswarehousing subsidiary (National Bulk Housing Corp) for ~US$40mn3.

Financial Technologies now struggles to maintain ownership of its most profitableventure, MCX and its other Indian exchange holdings such as MCX-SX, givenquestions raised by regulators SEBI (regulating stock exchanges) and FMC(regulating commodity exchanges) over its fit and proper status to be ashareholder in commodity and stock exchanges4 5.

1http://articles.economictimes.indiatimes.com/2013-0802/news/41008403 _1_national -spot exchange -

nsel-contracts

2 http://www.livemint.com/Money/N0hCBdRIbDKuOcD4o4ZW6M/NSEL-suspends-trading-of-all-contracts-except-eSeries.html

3http://www.moneycontrol.com/news/business/ftil-sells-nbhc-for-rs-242-crore_1054257.html

4 http://www.business-standard.com/article/markets/all-eyes-on-sebi-after-fmc-s-decision-on-ft-

113121800892_1.html

5 http://www.moneylife.in/article/sebi-rules-fintech-not-fit-and-proper-to-hold-stake-in-any-stock-exchange/36774.html


13/28

Technology


Part 2: The Bad

Rolta India

Tricky accounting practices

An analysis of the financial statements of Rolta India indicates a couple of grey areas.

Its recent revaluation of land just coinciding with the change in depreciation policy (tobring the depreciation rates to the industry norms) seems to be an accounting trick tomanage the net worth, whilst at the same time not hurting the future profitability (asland is not subject to depreciation). Roltas capital employed turnover has also beenquite low (0.5x on an average over FY11-13). A deeper look indicates that despitemoderate revenue growth (6% USD revenue CAGR over FY10-13), the capitalexpenditure has remained surprisingly high (average 46% of revenues over FY11-13).This creates suspicion on expense manipulation (through capitalisation).

Furthermore, Rolta has an uneven accounting history with the SEBI probe on over-reporting of revenues through booking of inter-divisional transfer of self-assembled/integrated capital equipmentas sales. Though Rolta has abandoned thispractice post the SEBI order in 2004, the other observations raise concerns on the

sanity of accounting practices.

Multi Commodity Exchange (MCX)

Suspicious related party deals and seemingly artificial volumes

Whilst MCX has been a success story and the only publicly listed commodity bourse inIndia with ~77% market share, it does not have a clean accounting and operationaltrack record. The reported volumes seem to be overstated (evident from unnaturallyhigher Average Daily Volume to Open Interest ratio), whilst transactions withpromoter entity do not seem to be at arms length. Lower margin to open interestalso reflect imprudent risk control, presumably in pursuit of higher volumes.


14/28

Technology


Rolta India

Tricky accounting practices

An analysis of the financial statements of Rolta India indicates a couple of grey areas.Its recent revaluation of land just coinciding with the change in depreciation policy (tobring the depreciation rates to the industry norms) seems to be an accounting trick to

manage the net worth, whilst at the same time not hurting the future profitability (asland is not subject to depreciation). Roltas capital employed turnover has also beenquite low (0.5x on an average over FY11-13). A deeper look indicates that despitemoderate revenue growth (6% USD revenue CAGR over FY10-13), the capitalexpenditure has remained surprisingly high (average 46% of revenues over FY11-13).This creates suspicion on expense manipulation (through capitalisation).

Furthermore, Rolta has an uneven accounting history with the SEBI probe on over-reporting of revenues through booking of inter-divisional transfer of self-assembled/integrated capital equipmentas sales. Though Rolta has abandoned thispractice post the SEBI order in 2004, the other observations raise concerns on sanityof accounting practices.

Accounting gimmicks to protect net worthDuring the fourth quarter of FY13, Rolta changed its depreciation policy (by reducingthe estimated useful life of the assets) and at the same time re-valued land on thebalance sheet.

The management highlighted that as a matter of prudence and to align depreciationpolicy with the current replacement cycle taking into consideration various factorssuch as technology up-gradation and industry best practices, the Company hasrevised estimated useful life of all assets. Consequently, Rolta India reduced theestimated useful life of Computer Systems to 2-6 years against 4-10 years earlier,Other Equipment at 10 years against 20 years earlier, Furniture & Fixtures at 10years against 15 years earlier and Vehicles at 5 years against 10 years earlier.

Consequent to the above, it booked an additional charge for depreciation during thequarter, amounting to `11,537mn as an exceptional item. Interestingly, themanagement simultaneously revalued the freehold and leasehold land during thequarter, booking the revaluation gains of `10,571mn directly in the reserves, with aneventual impact of just `966mn on the net worth.

Had the company not revalued land, the depreciation estimate revision could haveeroded the net worth by 57%. Given ~2x Debt/Equity ratio, 57% erosion in net worthcould have a serious implication on Rolta, both in terms of re-financing the existingdebt at the same or better borrowing cost as well as raising additional funds. Moreimportantly, revaluation of land will also not impact the future profits and land is notsubject to depreciation. This clearly seems to be an accounting trick to managethe net worth without hurting the future profitability at the same time.

Low capital employed turnover and high capitalisation raise concerns overexpense manipulation

Roltas asset turnover (sales/average capital employed) has been significantly belowthe peer average over the last three years (0.5x vs tier-2 peer average of 1.6x). Adeeper look into the causes shows that capitalisation as a percentage of revenues hasbeen extraordinarily high (~46% on an average over FY11-13 vs tier-2 peersaverage of 6%). More surprisingly, this comes at a time when Roltas revenues havegrown at a moderate 12.3% CAGR over FY10-13 (6.6% in USD terms).

Given such a moderate growth rate, disproportionately high levels of capexcreate suspicion regarding expense manipulation (through capitalisation).


Source: Bloomberg

Financials

mn FY11 FY12 FY13

Revenues 18,056 18,288 21,788

PAT 3,519 -959 -8,674FCF -1,345 -4,418 -4,696

Capex -8,393 -13,932 -16,069


2070120170220270

10,000

15,000

20,000

25,000

Mar-09

Jun-10

Aug-11

Nov-12

Jan-14

Sensex Rolta


15/28

Technology


Exhibit 5:Low asset turnover coupled with high capitalisation raises concerns on expense manipulationCompany\Metric

Asset turnover(sales/average net capital

employed)

Capitalised R&D (mentioned bycompany) as % of revenue

Intangibles (Ex Goodwill) additionas % of revenue

Overall capex as % of revenues

FY11 FY12 FY13 Average FY11 FY12 FY13 Average FY11 FY12 FY13 Average FY11 FY12 FY13 Average

Rolta 0.6 0.5 0.4 0.5 2.7% 4.0% 5.4% 4.0% 9.7% 8.3% 4.3% 7.4% 18.7% 49.4% 68.9% 45.7%

Tier 2 peers

eClerx 1.6 1.6 1.7 1.6 NA NA NA NA 0.7% 0.3% 0.5% 0.5% 7.0% 5.3% 16.4% 9.6%

Persistent Systems 1.1 1.3 1.3 1.2 0.1% 0.1% 0.0% 0.1% 6.9% 4.1% 2.7% 4.6% 12.5% 15.1% 8.8% 12.1%

Hexaware 1.1 1.5 1.7 1.4 NA NA NA NA 0.2% 0.2% 0.4% 0.3% 3.2% 4.4% 3.8% 3.8%

Infotech Enterprises 1.2 1.4 1.5 1.3 NA NA NA NA 0.4% 1.1% 1.7% 1.1% 9.0% 5.3% 4.9% 6.4%

KPIT 1.6 1.7 1.9 1.7 1.5% NA NA 1.5% 2.5% 1.2% 0.8% 1.5% 4.3% 4.1% 3.1% 3.8%

NIIT Tech 1.8 1.8 1.9 1.8 NA NA NA NA 0.7% 1.1% 1.5% 1.1% 4.1% 5.9% 4.6% 4.9%

Mindtree 2.0 2.1 2.0 2.1 NA NA NA NA 0.4% 0.0% 0.0% 0.1% 5.6% 2.5% 4.5% 4.2%

Polaris 1.7 1.7 1.6 1.7 NA NA NA NA 0.4% 0.3% 0.5% 0.4% 7.1% 7.2% 2.5% 5.6%

Tech Mahindra 1.0 1.0 1.1 1.0 NA NA NA NA 0.0% 0.3% 1.0% 0.4% 3.0% 5.4% 2.6% 3.7%

Tier 2 peersaverage 1.5 1.6 1.6 1.6 0.8% 0.1% 0.0% 0.8% 1.3% 1.0% 1.0% 1.1% 6.2% 6.1% 5.7% 6.0%


Uneven accounting history - Inter-divisional transfers booked as revenues!

Rolta followed a practice of booking the self-assembled/integrated capitalequipment transfer (including the fixed assets and estimated labour and overheadcosts) from its CAD/CAM division to internet and export divisions as revenues from1996-2003. It booked the cost of these assets as expenses and then capitalised theoverall cost of the capital equipment. Whilst this did not impact the bottom-line of thecompany, the revenues were overstated to the extent of these transfers. Furthermore,~50% of these capital equipment costs comprised overheads which were based onmanagement certification rather than an external audit. This left scope for significantrevenue manipulation.

Rolta was following this accounting practice for seven years (since 1996) and hadclaimed that given the accounting treatment is EPS neutral, it should not impactinvestor decision-making. However, post the SEBI order in July 20046, Rolta Indiaabandoned reporting these inter-divisional capital equipment transfers as sales.

6http://www.sebi.gov.in/cmorder/roltaorder.html


16/28

Technology


Multi Commodity Exchange (MCX)

Suspicious related party deals and seemingly artificialvolumes

Whilst MCX has been a success story and the only publicly listed commodity bourse in

India with ~77% market share, it does not have clean accounting and operationaltrack record. The reported volumes seem to be overstated (evident from unnaturallyhigher Average Daily Volume to Open Interest ratio), whilst transactions withpromoter entity do not seem to be at arms length. Lower margin to open interestalso reflect imprudent risk control, presumably in pursuit of higher volumes.

Creating volumes in thin air?

The ratio of Average Daily Volume traded (ADV) to Open Interest (OI or the positionskept open overnight) is often used to measure market depth. Given below is thecomparison of ADV (average daily volume) to OI (Open Interest) for the past threeyears for Futures contracts on MCX as compared to NCDEX, CME and NSE NiftyFutures (see Exhibit 6). This is the best measure of depth and hedging interest in anexchange and separates speculative/artificial volumes from sustainable volumes(lower the better). MCXs ADV/OI has historically been significantly higher that ofNCDEX, NSE and CME.

Exhibit 6:Ratio of ADV to Open Interest2011 2012 2013 Jan-14 Feb-14

MCX 7.48 4.79 4.13 3.65 3.29

NCDEX 3.78 1.49 0.84 0.81 0.64

NSE 1.17 1.56 1.37 1.63 1.47

CME 0.44 0.40 0.39 0.35 NA

CME - Metals and Energy 0.13 0.12 0.13 0.13 NA

Source: Company, Bloomberg, FMC, Ambit Capital research

Besides this, certain media reports7also claim that a special audit report by PwC hasfound the Indian Bullion Markets Association, a firm related to MCX, indulged involume rigging on the commodity exchange. The report claims the value of thetransactions to be `400bn. This corroborates our analysis of significantly higher ADVto OI as compared to other exchanges.

Related party transactions are these at arms length?

FT, the promoter entity of MCX, provides it the software and business supporttechnology. MCXs technology charges (as a percentage of revenues) appear to betoo high relative to the other global bourses, which raises concerns whether thesetechnology service payments are at arms length.

Exhibit 7:Comparison of technology charges

As % of revenues FY10 FY11 FY12 FY13 FY14

MCX 20% 21% 16% 18% NA

CME 5% 4% 4% 5% 5%

SGX 8% 10% 10% 9% NA

ICE 4% 4% 4% 3% NA

Hong Kong Exchange 4% 4% 4% 5% 7%

Bursa Malaysia 5% 5% 7% 8% 8%


7 http://www.moneycontrol.com/news/business/pwc-audit-finds-ibma-rigged-tradesmcx-sources_1046667.html


Source: Bloomberg

Financials

mn FY11 FY12 FY13

Revenues 3,689 5,451 5,240

PAT 1,763 2,867 2,992

FCF 2,387 3,305 68


0500

1000

1500

2000

10,00015,000

20,000

25,000

Mar-12 Dec-12 Oct-13

Sensex MCX


17/28

Technology


Indeed, according to media reports8, interim findings of a special audit by PwC flagseveral related issues regarding related party transactions:

1. No documented policy was in place for buying services from group firms andrelated parties, while certain contracts with the parent company FinancialTechnologies were not discussed and approved in the exchange boardand directors' committee.

2. MCX paid a mark-up of up to 32% on procurement of hardware by FTILand signed contracts with it that had "unprecedented long tenure" of 33-50 years

with a provision of automatic renewal for another 33 years.

3. Several other suspicious transactions have been highlighted in the report. (Clickhere for the news release disclosing these transactions.)

Although these revelations are still preliminary and not publicly available, ouranalysis of astonishingly high technology charges to FT certainly raises concerns.

Declining margins Are the default risks managed well?

MCX collects margins from its members to deal with price volatility. This reduces

systemic risk of defaults in periods of high volatility. The growth in MCX's OpenInterest and Margin Money (as reported on the Balance Sheet) is shown in Exhibit 8below. The percentage of margin money has declined from 12.7% in FY08 to 2.2% inFY13. This indicates either of the below three possibilities:

1. The exchange is collecting lower margins per contract than before that indicatesrising systemic risk from defaults in case of high price volatility.

2. Increasing trades by some members that do not stump up margins.3. Possibility of accepting off balance sheet collateral or assets in lieu of margin such

as liens on FDs or liquid investments. This still may not make such a big shortfall.Moreover, brokers may accept this and this does not seem prudent practice for anexchange.

Exhibit 8:Declining margin of safetyIn mn Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13

Margin money disclosed in current liabilities 3,205 5,449 4,082 5,283 6,096 4,324

Total Open Interest Amount 28,780 50,562 74,017 138,430 155,868 192,935

Margin to OI 12.7% 10.8% 5.5% 3.8% 3.9% 2.2%

Source: Company, FMC, Ambit Capital research

8http://articles.economictimes.indiatimes.com/2014-0224/news/47635734_1_shreekant -javalgekar- year-mcx-ftil-group


18/28

Technology


Part 3: The not so good

Tech Mahindra

Weaker disclosure norms; accounting not up to international standards; flagson governance

Whilst many see Tech Mahindra as the next tier-1 Indian IT service company, itsquality of disclosure lags that of other tier-2 companies such as Mindtree. TechMdoes not publish quarterly cash flow and balance sheet statements and it provides noservice-line break-up.

Secondly, whilst all the tier-1 firms publish IFRS financial statements, along with theIndian GAAP accounts (with the exception of HCL Tech that reports under US GAAP),Tech Mahindra reports financials only under Indian GAAP. This makes comparisonswith peers less meaningful due to differences in accounting methods.

Finally, lack of adequate independent director representation on the Satyam Board atthe time when the swap ratio between Satyam and TechM was finalised raisesconcerns on corporate governance.

Infosys

Letting down its own governance standards?

Ever since its IPO in 1993, Infosys has been regarded as a paradigm of corporategovernance in India. Whilst this image earned Infosys goodwill from investors, clientsand employees, there are signs that these high corporate governance standards arefraying. NRN Murthys entry into Infosys in an executive capacity (even after Infosyswell-articulated policy of executives retiring at the age of 60), bringing with him hisson as executive assistant, higher promoter representation at the Board and peculiarguidance pattern resulting in high volatility in the share price none of this gels with

Infosys imageof a leader when it comes to corporate governance.

KPIT Technologies

Magnified margins

KPIT Technologies margins appear to be overstated given the accounting policiesand estimates that are different from its peers. Its accounting policy of excluding re-imbursements both from income and cost (contrary to accounting policy followed bycompanies such as Infosys, TCS and Persistent Systems) benefits its margins by~50bps according to our calculations. Furthermore, its actuarial assumption of salaryincrease for retirement benefit obligations is significantly below that of peers (5% vs

peer average of 7%).


19/28

Technology


Tech Mahindra

Weaker disclosure norms; accounting not up tointernational standards; flags on governance

Whilst many claim Tech Mahindra is the next tier-1 Indian IT services company, its

quality of disclosure still lags that of several tier-2 companies such as Mindtree.TechM does not publish quarterly cash flow and balance sheet statements and itprovides no service-line break-up. Secondly, whilst all the tier-1 firms publish IFRSfinancial statements, along with the Indian GAAP accounts (with the exception of HCLTech that reports under US GAAP), Tech Mahindra reports financials only underIndian GAAP. This makes the comparison less meaningful due to differences inaccounting methods. Finally, lack of adequate independent director representationon the Satyam Board at the time when the merger swap ratio with TechM wasfinalised raises concerns on corporate governance.

Weaker disclosure norms

Tech Mahindras disclosures (in the quarterly financials) still lag that of tier-1 Indianfirms and even the tier-2 firms such as Mindtree and Persistent Systems. Tech

Mahindra does not report the quarterly balance sheet and cash flow statements.Given cash flow (and working capital intensity) is the most widely tracked metric foran IT service company, this creates information asymmetry. Furthermore, absence ofa service-line breakup makes the analysis of underlying revenue growth driversdifficult.

Cash flow and cash conversion are amongst the most keenly tracked financial metricsfor IT companies. Non-reporting of quarterly balance sheet and cash-flow statementsmakes this analysis very difficult. Our back calculation of cash flow from operationsusing changes in net debt, capex and other expenses indicate that cash conversionhas remained weak for Tech Mahindra in 9MFY14 (even weaker than 57% cashconversion in FY13).

Furthermore, there was no satisfactory explanation for the US$22mn stamp dutypayment for the Tech Mahindra and Satyam merger by the company management. Itwas neither mentioned in the notes to the accounts although we understand that thispayment was made during 3QFY14.

Exhibit 9:Unexplained weakness in cash conversion*mn FY13 1QFY14 2QFY14 3QFY14 9MFY14

Net debt 24993 29,081 29,376 31,177 31,177

Net change in cash 4,088 295 1,801 6,184

Capex 2333 1497 1316 5,146

Adjustment for stamp duty payment (US$22mn) 0 0 1320 1,320

Adjustment for final dividend (incl dividend tax) for FY13

(assumed to be paid in 2QFY14)0 750 0 750

CFO 16382 6,421 2,542 4,437 13,400

EBITDA (Adjusted for BT deferred revenues) 28627 8092 10557 10810 29,459

Revenues (Adjusted for BT deferred revenues) 141315 40479 47162 48432 136,073

CFO/EBITDA 57% 79% 24% 41% 45%

CFO/Revenues 12% 16% 5% 9% 10%

Receivable days 96 97 102 100 100

Source: Company, Ambit Capital research *Our estimates as company does not disclose quarterly cashflow statement

Accounting systems though legitimate, not comparable with tier-1 peers

Whilst all the tier-1 firms publish IFRS financial statements, along with the Indian

GAAP accounts (with the exception of HCL Tech that reports under US GAAP), TechMahindra reports financials only under Indian GAAP. This makes an apple-to-applecomparison difficult, particularly in the areas where Indian GAAP provisions differsignificantly with those of international accounting standards.


Source: Bloomberg

Financials

mn FY11 FY12 FY13

Revenues 102,852 117,024 143,320

PAT 5,965 18,431 19,556

FCF -121 2,474 6,132


200

700

1200

1700

10,000

15,000

20,000

25,000

Mar-09

Jun-10

Aug-11

Nov-12

Jan-14

Sensex Tech Mahindra


20/28

Technology


One such area of difference is merger accounting. Indian GAAP allows the use oftwo methods for merger accounting:

1. Pooling of interest method: In this method no goodwill is recognised and allthe assets and liabilities are accounted at book value. The applicability criteriaare: (a) all assets and liabilities should be transferred, (b) the considerationshould be through share swap, and (c) at least 90% of the shareholders of the

acquired company should become the shareholders of the acquirer.2. Purchase method: If the merger fails the conditions for Pooling of interest

method, Purchase method applies.Here, the assets and liabilities are recordedat fair value and hence goodwill is recognised.

On the other hand, US GAAP and IFRS prohibit the use of Pooling of interestmethod. Hence in the event of a merger, the merged entity needs to account for allthe assets and liabilities at fair value. Consequently, goodwill is recognised inmergers in US GAAP and IFRS.

The method of accounting for merger has a significant bearing on the RoE post-merger.If the assets and liabilities of the acquired company are accounted at fair value(Purchase method - the general internationally accepted norm) and the consideration

is greater than the book value, a goodwill is recognised (which is then amortised overfive years unless a longer period is justified) that inflates the equity base andeventually results in relatively lower RoE for the merged entity. Indeed, in laymanslanguage, the goodwill is effectively written-off against equity in the Poolingof the interest method,whilst it is routed through P&L in Purchase method.

Given the Satyam merger met the Pooling of interest methods criteriaunder IndianGAAP, Tech Mahindra recorded the merger under Pooling of interest method. Theuse of Indian GAAP has helped it maintain high RoEs. Had the transactionbeen recorded under the internationally accepted Purchase method, theRoEs would have been significantly lower. Our back-of-the-envelopecalculations suggest that FY13/FY14E RoE could have been 14.8%/18.4% underthe purchase method (with Goodwill recognition) vs the estimated RoEs of

36.3%/33.3% under the currently followed Pooling of interest method (seeExhibit 10 below).

Exhibit 10:RoEs could be significantly lower under the purchase method of merger accountingIn mn

Pooling of interest method(currently followed by TechM)

Purchase method (estimated)

FY12 FY13 FY14E FY12 FY13 FY14E

Adjusted net income 18,062 21,157 27,674 18,062 21,157 27,674

Goodwill amortization 0 0 0 -11,306 -11,306 -11,306

Tax benefit on above (@33.99%) 0 0 0 3,843 3,843 3,843

Proforma net income 18,062 21,157 27,674 10,599 13,694 20,211

Equity at TechM's share price as on the appointed dated of merger* 48,158 68,530 97,484 86,259 99,168 120,659

RoE 36.3% 33.3% 14.8% 18.4%

Source: Ambit Capital research; Note: * Appointed date of the merger was 1 April 2011

Please reach out to us for greater details on the calculations and underlyingassumptions.

Questionable attendance on Satyams Boardwhilst deciding the merger ratio

From 19 September 2011 to 23 January 2012, the Board comprised less than 50% ofindependent directors. This was the period when Satyams merger ratio was decided(announced in March 2012). Also, the merger ratio was announced shortly after twonew independent directors (Mr Ashok Kacker and M Rajyalakshmi Rao) wereappointed (Jan and Feb 2012) who presumably had limited understanding of the firmto push for a fairer ratio for minority shareholders. The swap ratio seems relativelyunfair to Satyams minority shareholders. Although there have been departures inindependent directors, board meeting attendance has been appalling, particularly in


21/28

Technology


FY11 and FY12, which was also the period when the merger ratio was accepted bythe board.

Exhibit 11:Satyam independent directors poor attendance track-record during thetime merger ratio was finalised

Name/Attendance FY10 FY10 FY11 FY12

Deepak Parekh (Independent) 12/13 5/10

Keeran Karnik (Independent) 13/13 7/10Vineet Nayyar 5/10 6/6 8/8

CP Gurnani 3/10 6/6 7/8

C Achuthan (Independent) 13/13 9/10 4/6 1/8

Tarun Das (Independent) 10/13 5/10

TN Mahoharan (Independent) 11/13 8/10 6/6 6/8

SB Mainak (Independent) 12/13 7/10

M Damodaran (Independent) 1/10 2/6 4/8

Ashok Kacker (Independent) 1/8

M Rajyalakshmi Rao (Independent) 1/8

Sanjay Kalra 5/10 3/6

Gautam S Kaji (Independent) 1/6

Ulhas N Yargop 5/10 6/6 5/8

Ravindra Kulkarni (Independent) NA

Source: Company, Ambit Capital research Note: Independent directors in Grey shade

Similarly, the independent directors participation in the Board meetings was notparticularly strong at the time Tech Mahindra was bidding for Satyam in FY09-10 (seeExhibit 12 below).

Exhibit 12:Tech Mahindra independent directors poor attendance track-record atthe time of bidding for Satyam

Name/Attendance FY09 FY10

Anand G Mahindra 5/6 8/8

Akash Paul (Independent) 4/6 4/8

Al-Noor Ramji 2/6 1/8

Anupam Puri (Independent) 3/6 6/8

Arun Seth 4/6 4/8

Bharat N Doshi 6/6 8/8

B H Wani (Independent) 8/8

Clibe Goodwin 4/6 2/8

CP Gurnani NA

M Damodaran (Independent) 2/6 4/8

Nigel Stagg * NA

Paul Zuckerman (Independent) 4/6 4/8Dr Raj Reddy (Independent) 4/6 4/8

Nigel Stagg 1/8

Ravindra Kulkarni (Independent) 8/8

Richard Cameron* 1/8

Vineet Nayyar 5/6 5/8

Ulhas N Yargop 6/6 8/8

Source: Company, Ambit Capital research Note: Independent directors in Grey shade


22/28

Technology


Infosys

Letting down its own governance standards?

Ever since its IPO in 1993, Infosys has been regarded as a paradigm of corporategovernance in India. Whilst this image has earned Infosys goodwill from investors,clients and employees, there are signs that these high corporate governance

standards are fraying. NRN Murthys entry into Infosys in an executive capacity (evenafter the firmswell-articulated policy of executives retiring at the age of 60), bringingwith him his son as an executive assistant, higher promoter representation at theBoard and peculiar guidance pattern resulting in high volatility in share price noneof this gels wellwith Infosys image of a leader in corporate governance.

Breach of corporate policies

Infosys has historically followed a well-articulated policy of executive retirement at theage of 60, with Mr NRN Murthy himself being a strong proponent of the policy.Similarly, all the founders have time and again mentioned about not letting familymanage the business. More surprising was Rohan Murthys entry into Infosys as MrNRN MurthysExecutive Assistant. Whilst this is a position of power but not of control,

the manner in which Rohan Murthy was brought in raised eyebrows to put it mildly.High promoter representation on the board

The promoters Board representation is significantly higher relative to theirshareholding in the company. Whilst NRN Murthy, S Shibulal and KrisGopalakrishnan collectively hold ~10% stake in the company, they represent 23% ofthe voting rights on the Board. With the highest promoter representation and thelowest proportion of independent directors on the Board, Infosys Boardindependence appears to be the weakest among the tier-1 firms.

Exhibit 13:Infosys ownership structurePromoter representation on the board 23.08%

Promoter ownership 15.94%

Active promoters

NRN Murthy 4.47%

S Shibulal 2.20%

Kris Gopalakrishnan 3.41%

Combined shareholding of active promoters 10.08%

Source: NSE, Ambit Capital research

Exhibit 14:Measuring the board independenceCompany Promoter shareholding

Promoter representationon the Board

Non-independentdirectors on the Board

Infosys 15.9% 23.1% 46.2%

TCS 73.9% 9.1% 45.5%Wipro 73.5% 7.7% 23.1%

HCL Tech 61.8% 20.0% 20.0%

Source: Company, NSE, Ambit Capital research

Peculiar guidance pattern leading to extreme volatility

There has been a pattern in Infosys guidance and outlook over the last three years. Itsets a lower expectation in the fourth quarter of the year and over-delivers in thefollowing quarters, causing extreme volatility in the share price. Indeed, Infosys hasrepeated this pattern yet again by indicating on 12 March 2014 that it will settle atthe lower end of the guidance for FY14 and giving a weaker outlook for 1HFY15.


Source: Bloomberg

Financials

mn FY11 FY12 FY13

Revenues 275,010 337,340 403,520

PAT 68,230 83,210 94,210

FCF 46,070 66,800 86,510


100015002000

2500300035004000

10,000

15,000

20,000

25,000

Mar-09

Jun-10

Aug-11

Nov-12

Jan-14

Sensex Infosys Tech.


23/28

Technology


Exhibit 15:Playing with investorsexpectations?

Source: Company, Bloomberg, Ambit Capital research; Note: Infosys abandoned the quarterly guidance from 1QFY13 * Infosys management announced in anInvestment Banking Conference that it will meet the lower end of the FY14 revenue guidance (11.5-12%)

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

-6%

-4%

-2%

0%

2%

4%

6%

8%

1QFY10

2QFY10

3QFY10

4QFY10

1QFY11

2QFY11

3QFY11

4QFY11

1QFY12

2QFY12

3QFY12

4QFY12

1QFY13

2QFY13

3QFY13

4QFY13

1QFY14

2QFY14

3QFY14

Mar-2014*

Actual vs guidance (mid-point) -LHS

Change in next year guidance(mid-point of guidance) - LHS

Share price performance on theday of results - RHS

Absolute volatility range (RHS)

Setting lower expectationin 4Q


24/28

Technology


KPIT Technologies

Magnified margins

KPIT Technologies margins appear to be overstated given the accounting policiesand estimates that are different from its peers. Its accounting policy of excluding re-imbursements both from income and cost (contrary to accounting policy followed bycompanies such as Infosys, TCS and Persistent Systems) benefits its margins by~50bps according to our calculations. Furthermore, its actuarial assumption of salaryincrease for retirement benefit obligations is significantly below that of peers (5% vspeer average of 7%).

Margin management through change in accounting policy

During FY12, KPIT Technologies changed its policy of booking re-imbursementexpenses. KPIT mentioned in its FY12 annual report that the reimbursement expensebilling has been netted off against the actual expenses whilst previously thereimbursement billing was accounted as income in revenues and as expense in thecosts. The third-party license sale amount now appear in revenues only to the tune ofthe margins on such sale (earlier the full sale amount used to appear as revenue and

the cost of the license as direct cost).

The new policy is not consistent with that followed by Infosys, TCS and Persistent (theother companies do not mention the accounting policy in this regard). Thesecompanies follow the policy of booking the third-party licence sales under revenue aswell as costs (these companies book it under third-party items, Equipment andsoftware cost and Purchase of software license and support services, respectively).

This change in policy makes the operating margins appear artificially better than thehistorical margins and that of competitors, because operating margin is nowcalculated by dividing the operating profit by a lower denominator (revenues).Indeed, our calculations suggest that just because of this change in accountingpolicy, FY11 EBITDA margins were overstated by 50bps.

Exhibit 16:Margin impact from change in re-imbursement accounting policymn Earlier policy New policy

FY11 Revenue 10,230* 9,870**

FY11 EBITDA 1,484 1,484

EBITDA margins 14.5% 15.0%

Source: Company, Ambit Capital research *reported revenue in FY11 annual report ** restated FY11 revenue inFY12 annual report

We have assumed that all the restatement in FY11 revenues is due to change inaccounting policy of excluding the re-imbursement from the revenues and costs.Given this change in accounting policy is margin neutral (reimbursements areremoved from both revenue and costs), we have used re-stated FY11 EBITDA (from

FY12 annual report) for margin calculations.

Lower salary increase estimate for retirement benefit accounting

The retirement benefit obligations of a firm depend to a large extent on theunderlying variables such as discount rate (to calculate present value of futureobligations), long-term salary increase rates, attrition, demographics, return on planassets etc. Manipulation of any of these variables could materially impact theeventually calculated liability.

Whilst KPIT Technologies discount rate estimates are conservative as compared tothe industry average (8.5% vs industry average of ~8%), its salary increase estimateof 5% appears to be too low relative to the industry average of ~7% (see Exhibit 17).Furthermore, KPITs retirement benefit obligations are unfunded (i.e. there are no

plan assets).


Source: Bloomberg

Financials

mn FY11 FY12 FY13

Revenues 1,484 2,166 3,214

PAT 946 1,454 1,990

FCF 221 396 503


20

120

220

320

420

520

10,000

15,000

20,000

25,000

Mar-09

Jun-10

Aug-11

Nov-12

Jan-14

Sensex KPIT


25/28

Technology


Exhibit 17:Retirement benefit actuarial assumptionsCompany

Discount rate Salary increase

FY11 FY12 FY13 FY11 FY12 FY13

KPIT 8.3% 8.5% 8.5% 5.0% 5.0% 5.0%

Tier 2 peers

Mindtree 8.0% 8.5% 8.0% 10-12% 6.0% 6.0%

Hexaware 8.0% 8.6% NA10% for first year and

7.5% thereafter10% for first year and

7.5% thereafterNA

Tech Mahindra 7.7% 8.6%8.6% for funded and8% for non-funded

9% for first year and8% thereafter

11% for first year and9% thereafter

9% for non-fundedand 7.5% for

funded

Infotech Enterprises 8.0% 8.5% 8.0% 7.5% to 10% 7.5% to 10% 6% to 8%

NIIT Tech 8.1% 8.6% NA 9.15% to 9.4% 9.15% to 9.4% NA

eClerx 8.0% 8.5% 8.0% 4.0% 4.0% 5.0%

Persistent Systems 8.5% 8.7% 8.3% 7.0% 7.0% 7.0%

Tier 1 peers

TCS 8.0% 8.25% to 8.5% 8.0% 4% to 12% 4% to 9% 4% to 7%

Infosys 8.0% 8.6% 8.0% 7.3% 7.3% 7.3%

HCL Tech 8.4% 8.1% 7.5% 6% to 10% 7.0% 7.0%Wipro 8.0% 8.4% 7.8% 5.0% 5.0% 5.0%


Poor cash flow generation at subsidiaries

KPIT Technologies cash conversion has been materially weaker than the peers,largely due to poor cash generation at the subsidiaries. As shown in Exhibit 18 below,KPIT has infused significant amounts of cash into the subsidiaries with weak cashgeneration profile.

Exhibit 18:Burning cash at subsidiariesmn FY11 FY12 FY13

CFO 645 1,005 1,203

Capex -422 -609 -701

Investment in equity shares of subsidiaries -463 -2,088 -1,255

Investment in equity shares of associates 0 -98 0

Investment in preference shares of associates 0 -278 0

Cash & Cash Equivalent from acquisition of subsidiaries 37 146 0

FCF 222 396 503

FCF including acquisitions and investments in subsidiariesand associates

-203 -1,922 -753

Cash conversion

KPIT (Consolidated) 43% 46% 37%

KPIT (Standalone) 46% 100% 70%

KPIT (Subsidiaries) 41% 4% 3%


Higher use of subcontractors

KPIT uses subcontractors to a significantly larger extent as compared to its tier-2peers. This artificially inflates the revenue per employee (given sub-contractors arenot included in the reported headcount) and gives a prima facie impression of betteremployee productivity.


26/28

Technology


Exhibit 19:Higher subcontractors use artificially inflates the employee productivityCompany/Metric

Subcontracting cost as % ofRevenue

Subcontracting cost as% of Operating Cost

Subcontracting cost as % ofTotal Cost

Revenue per employee(INR mn)

FY11 FY12 FY13 FY11 FY12 FY13 FY11 FY12 FY13 FY11 FY12 FY13

KPIT (Consolidated) 14.5% 17.2% 17.7% 46.5% 50.5% 52.0% 17.1% 20.1% 20.7% 1.5 1.9 2.7

KPIT Standalone 2.8% 2.2% 3.3% 13.5% 9.6% 12.4% 3.3% 2.7% 4.2% NA NA NA

KPIT (Subsidiaries) 28.0% 27.6% 24.5% 65.1% 66.5% 64.9% 33.8% 31.9% 27.3% NA NA NA

Tier 2 peers

eClerx NA NA NA NA NA NA NA NA NA 0.9 1.1 1.1

Persistent Systems 4.0% 4.2% 4.1% 22.6% 23.6% 19.7% 5.0% 5.4% 5.4% 1.2 1.5 1.9

Hexaware 7.2% 7.7% 8.9% 26.3% 30.3% 36.0% 7.9% 9.4% 11.3% 1.6 1.7 2.1

Infotech Enterprises 2.6% 2.2% 3.9% 11.7% 11.1% 18.8% 3.1% 2.7% 4.8% 1.4 1.7 1.8

NIIT Tech NA NA NA NA NA NA NA NA NA 2.1 2.1 2.5

Mindtree 3.0% 3.5% 3.6% 13.2% 16.7% 17.9% 3.4% 4.1% 4.5% 1.6 1.7 2.0

Polaris 6.5% 5.8% 5.9% 40.6% 37.3% 40.3% 7.5% 6.8% 6.7% 1.5 1.6 1.7

Tech Mahindra 9.6% 10.6% 9.6% 28.7% 52.2% 59.3% 12.0% 12.7% 11.9% 1.3 1.3 1.4

Tier 2 peer average 5.5% 5.7% 6.0% 23.9% 28.5% 32.0% 6.5% 6.8% 7.4% 1.5 1.6 1.8



27/28

Technology


Institutional Equities Team

Saurabh Mukherjea, CFA CEO, Institutional Equities (022) 30433174 [email protected]

Research

Analysts Industry Sectors Desk-Phone E-mail

Aadesh Mehta Banking & Financial Services (022) 30433239 [email protected]

Achint Bhagat Cement / Infrastructure (022) 30433178 [email protected]

Aditya Khemka Healthcare (022) 30433272 [email protected]

Akshay Wadhwa Banking & Financial Services (022) 30433005 [email protected]

Ankur Rudra, CFA Technology / Telecom / Media (022) 30433211 [email protected]

Ashvin Shetty, CFA Automobile (022) 30433285 [email protected]

Bhargav Buddhadev Power / Capital Goods (022) 30433252 [email protected]

Dayanand Mittal, CFA Oil & Gas / Metals & Mining (022) 30433202 [email protected]

Deepesh Agarwal Power / Capital Goods (022) 30433275 [email protected]

Gaurav Mehta, CFA Strategy / Derivatives Research (022) 30433255 [email protected]

Karan Khanna Strategy (022) 30433251 [email protected]

Krishnan ASV Banking & Financial Services (022) 30433205 [email protected]

Nitin Bhasin E&C / Infrastructure / Cement (022) 30433241 [email protected]

Nitin Jain Technology (022) 30433291 [email protected]

Pankaj Agarwal, CFA Banking & Financial Services (022) 30433206 [email protected]

Pratik Singhania Real Estate / Retail (022) 30433264 [email protected]

Parita Ashar Metals & Mining / Oil & Gas (022) 30433223 [email protected]

Rakshit Ranjan, CFA Consumer / Real Estate / Retail (022) 30433201 [email protected]

Ravi Singh Banking & Financial Services (022) 30433181 [email protected]

Ritika Mankar Mukherjee, CFA Economy / Strategy (022) 30433175 [email protected]

Ritu Modi Automobile (022) 30433292 [email protected] Mukhija, CFA E&C / Infrastructure (022) 30433203 [email protected]

Sales

Name Regions Desk-Phone E-mail

Deepak Sawhney India / Asia (022) 30433295 [email protected]

Dharmen Shah India / Asia (022) 30433289 [email protected]

Dipti Mehta India / USA (022) 30433053 [email protected]

Nityam Shah, CFA USA / Europe (022) 30433259 [email protected]

Parees Purohit, CFA UK / USA (022) 30433169 [email protected]

Praveena Pattabiraman India / Asia (022) 30433268 [email protected]

Sarojini Ramachandran UK +44 (0) 20 7614 8374 [email protected]

Production

Sajid Merchant Production (022) 30433247 [email protected]

Sharoz G Hussain Production (022) 30433183 [email protected]

Joel Pereira Editor (022) 30433284 [email protected]

Nikhil Pillai Database (022) 30433265 [email protected]

E&C = Engineering & Construction


28/28

Technology

Explanation of Investment Rating

nvestment Rating Expected return(over 12-month period from date of initial rating)

Buy >5%

Sell

ambit- technology-err group- the underbelly of indian it

Documents