Persistent Systems. Institutional Equities. Management Meet Update SELL. Watson IOT Bet Risk/Reward More Muted Than Anticipated

Transcription

1 Management Meet Update Institutional Equities Persistent Systems 22 June 2016 Reuters: PERS.BO; Bloomberg: PSYS IN Watson IOT Bet Risk/Reward More Muted Than Anticipated We had a meeting with Persistent Systems (PSL) recently to understand its Watson IOT deal better. The deal, we believe, is the second large bet (Digital being the first) to de-risk and expand beyond its core ISV-related services which have been under pressure since the past several years. We had questioned its Digital strategy in our report titled Not The Ideal 'Digital' Play; Structural Weakness To Constrain Shareholder Value Creation. The Watson IOT bet, in our view, is slightly more riskier than the Digital bet (as it involves taking over a 500-member team of IBM largely based in developed markets), but not as risky as we had initially anticipated in our report titled Raises Risk Profile; Market Share Critical To Success. However, the profit upside also does not seem to be large. The Watson IOT solution consists of a number of IBM s own old and new products put together to create a full stack out of which Continuous Engineering (CE) is just one piece (in which PSL has invested and gets a small cut from the license fee). It is less risky as unlike in our previous assumption, the product which PSL has taken over is not exactly a new one. It has been around since a long time and has 3,000 clients. Conversely, we do not see any kind of great upside from license sales growth going forward. The upside from the deal will come from implementation and other services (not just for CE, but also for the entire Wa:tson IOT stack) where PSL is a preferred partner, but not the only one. As stated earlier by us, the market share of Watson IOT solution in the coming days and the market share of PSL in implementation services will determine whether the bet will pay off. We continue to retain our Sell rating on PSL with unchanged estimates and target price. We have valued PSL at 10.8x FY18E EPS (25% discount to target P/E multiple of TCS/Infosys). The continuing adverse stance on PSL is based on the view that IT sector s revenue growth and P/E multiple are likely to contract in the base case scenario that we have assumed for the US economy in 2016 and 2017 (Downside Risks Open Up - It Is That Time Of The Cycle! ) which is expected to impact PSL too. Indian mid-sized IT services companies have business models which are weak, volatile and risky. This has been partly because of higher client/vertical/service line concentration. We believe PSL has additional weakness by way of lower service line/vertical capabilities than its mid-sized peers. Why did IBM go for a tie-up with PSL?: One of the things that had intrigued us ever since the deal was struck was the reason for IBM tying up with PSL on a license deal on what seemed like a new product with great potential. For the very large opportunity that is being projected for IOT (some studies indicate it to be in US$trns), we are surprised that IBM was unwilling to foot what seemed like a small bill (US$40mn-US$60mn per annum). Our discussions reveal that the CE piece which PSL addresses is an old one (possibly more than a decade) with 3,000 odd customers. So what seemed to be an investment in a new product is actually not the case, but an extension of its old intellectual property or IP investment strategy involving an old IP and enhancing its life. So why did IBM decide to co-own CE with PSL?. We believe this could be because of lack of management bandwidth to handle an old product, focus on investment dollars into new products, internal politics, etc. The confidence in PSL probably developed because of its decades-long relationship and the fact that PSL took over another product - TNPM successfully and managed it. Watson IOT is about some old and new IPs: What IBM has done is to bring together different products housed under its umbrella and create the Watson IOT brand to go to market with a full solution. Some of these products have been with IBM for many years and individually have customers that run into thousands. Besides CE, some of the other products include Maximo (an enterprise asset management software), Tririga (a workplace and facilities management software), Bluemix (enables organisations to quickly and easily create, deploy, and manage applications on the cloud) and Watson (a platform that uses natural language processing and machine learning to reveal insights from large amounts of unstructured data). Risk-reward ratio more muted than anticipated: While the initial impression we had with Watson IOT deal was that it is a new IP which PSL was taking over, but it is indeed not the case. The CE product deal very much represents a classic IP deal of the past when a mature IP with a lot of customers is taken over and the life of the IP is extended. The only difference here is that unlike in a typical IP deal of the past, this one involves the transfer of a 500-person engineering team (largely based out of the US, UK, Mexico and Israel) which adversely impacts margins in the initial phase. From our discussions, we conclude that the license revenues which PSL will get are not on the entire Watson IOT piece, but just on the CE piece where we believe the scope for expansion is limited. We also believe the big revenue driver is likely to be implementation services and other services that come consequent to implementation. While we did not get the revenue share details, we believe that it is likely in the 5%- 20% range (small, but not too small). Therefore, the annual license revenue run-rate of CE is likely in the range of US$250mn-US$1bn. The IOT opportunity is large and, if successful, it could add substantial revenues for a small company like PSL. However, it does come with its set of challenges. SELL Sector: Information Technology CMP: Rs697 Target price: Rs558 Downside: 20% Girish Pai girish.pai@nirmalbang.com Key Data Current Shares O/S (mn) 80.0 Mkt Cap (Rsbn/US$mn) 55.7/ Wk H / L (Rs) 798/563 Daily Vol. (3M NSE Avg.) 135,107 One -Year Indexed Stock Performance Jun-15 Aug-15 Oct-15 Dec-15 Feb-16 Apr-16 Jun-16 Price Performance (%) 1 M 6 M 1 Yr Persistent Systems (4.0) 5.8 (2.5) Nifty Index (1.6) Source: Bloomberg PERSISTENT SYS Nifty 50

2 Success depends on Watson IOT market share and PSL s own market share in implementation: We believe the IOT space is evolving and there are likely to be competing platforms from other players. Infosys and TCS have both announced collaborations with GE on its Predix IOT platform. We believe that PSL is not likely to be the only preferred partner when it comes to implementation of the platform. Here, we believe, its lack of enterprise reach will come in the way of becoming an effective partner just as it has in the Enterprise Digital Transformation side. While PSL will be wedded to the IBM Watson IOT platform and its success/failure, the other services vendors need not take sides at the moment. If the Watson IOT stack is the most suitable for their customers, the IT services competitors of PSL can approach IBM to sell them the full solution and the implementation work will then go to third-party vendors under the current scheme of things and not to PSL If another IOT platform is more attractive in the coming days, IT services competitors will potentially veer towards it. The selling of Watson IOT as a full stack is in its early stage, in our view, while the underlying parts of it have been sold since the past several years. PSL is yet to start its sell with with the IBM sales team. We believe that it could take a few quarters more. In our discussions, it was indicated that CE (not Watson IOT as a whole) secured a 50% market share in its category. In general, PSL was of the view that for every dollar of license sales, implementation and other services revenues of eight dollars are possible over the long run. Margin pick-up will take time in Watson IOT deal, in our view, and will be volatile: Our discussions with PSL indicate that any material pick-up in margins from this deal are probably about two years away and are dependent on a few things: (1) Pick-up in sales of Watson IOT full stack which will drive CE license sales as well. (2) Implementation revenues that are going to come to PSL as it goes for sell with. (3) Offshoring of CE work in the coming years. Watson IOT revenues will witness seasonality (1QCY being the weakest and 4QCY the strongest) which will lead to significant quarterly fluctuations in margins. Hints dropped at the 4QFY16 result analyst call indicated that margins could come under pressure in 1HFY17 before picking up in 2HFY17. There were also concerns around sustained pressure from Pre-Internet/Cloud era clients in ISV business. With pressure on revenue growth easing because of the Watson IOT deal, PSL is focused on improving margins in its core business by walking away from low-margin contracts. 2 Persistent Systems

3 Exhibit 1: Key metrics 4QFY14 1QFY15 2QFY15 3QFY15 4QFY15 1QFY16 2QFY16 3QFY16 4QFY16 Revenues (US$mn) EBIT (US$mn) PAT (US$mn) P&L (Rsmn) Revenues 4,467 4,350 4,642 4,946 4,975 5,004 5,427 5,921 6,771 EBITDA 1, , ,018 1,110 1,074 PAT Vertical mix (%) Telecom Infrastructure and Systems Life Sciences & Healthcare Financial Services Geographical mix (%) North Americas Europe Asia-Pacific Project type Services IP-driven Revenue mix-onsite Revenue mix-offshore Client concentration (%) Top client Top 5 clients Top 10 clients Number of clients Large > US$ 3mn Medium >US $ 1mn, <US $ 3mn Employees 7,857 7,876 8,067 8,296 8,506 8,454 8,545 8,966 9,264 Attrition rate (%) Persistent Systems

4 Financials Exhibit 2: Income statement Y/E March (Rsmn) FY15 FY16 FY17E FY18E FY19E Average INR/USD Net Sales (US$mn) Growth (%) Net Sales 18,913 23,123 30,657 34,597 36,941 -Growth (%) Cost of Sales & Services 11,317 14,305 19,748 22,250 23,515 % of sales Gross Margin 7,596 8,819 10,909 12,347 13,426 % of sales SG& A 3,690 4,647 5,982 6,470 6,729 % of sales EBITDA 3,906 4,171 4,927 5,878 6,697 % of sales Depreciation EBIT 2,967 3,206 3,826 4,641 5,326 % of sales Other income (net) ,022 PBT 3,900 3,956 4,573 5,513 6,348 -PBT margin (%) Provision for tax ,143 1,378 1,587 Effective tax rate (%) Net profit 2,906 2,974 3,430 4,135 4,761 -Growth (%) Net profit margin (%) Exhibit 4: Balance sheet Y/E March (Rsmn) FY15 FY16 FY17E FY18E FY19E Equity capital Reserves & surplus 13,255 15,593 17,819 20,019 22,552 Net worth 14,055 16,393 18,619 20,819 23,352 Deferred tax liability Other liabilities Total loans Total liabilities 14,084 16,420 18,646 20,846 23,379 Goodwill Net block (incl CWIP) 4,093 4,453 4,751 4,915 4,945 Investments 6,735 6,175 6,175 6,175 6,175 Deferred tax asset Other non-current assets 127 1,721 1,721 1,721 1,721 Other current assets 1,452 2,600 2,447 2,640 2,847 Debtors 3,586 4,275 5,791 6,249 6,737 Cash & bank balance 1,416 1,432 2,491 4,282 6,524 Total current assets 6,454 8,308 10,729 13,171 16,108 Total current liabilities 3,665 4,646 5,138 5,545 5,978 Net current assets 2,790 3,663 5,590 7,626 10,130 Total assets 14,084 16,420 18,646 20,846 23,379 Exhibit 3: Cash flow Y/E March (Rsmn) FY15 FY16 FY17E FY18E FY19E EBIT 2,967 3,206 3,826 4,641 5,326 (Inc.)/dec. in working capital (29) (384) (863) (557) (253) Cash flow from operations 2,939 2,822 2,963 4,084 5,073 Other income ,022 Depreciation & amortisation ,102 1,236 1,371 Tax paid (993) (983) (1,143) (1,378) (1,587) Dividends paid (667) (770) (1,204) (1,935) (2,228) Net cash from operations 3,149 2,785 2,465 2,879 3,650 Capital expenditure 594 1,618 1,400 1,400 1,400 Net cash after capex 2,555 1,167 1,065 1,479 2,250 Inc./(dec.) in debt (7) (Inc.)/dec. in investments (1,841) Equity issue/(buyback) Cash from financial activities (1,448) Others (647) (1,711) (6) 312 (8) Opening cash 957 1,416 1,432 2,491 4,282 Closing cash 1,417 1,433 2,491 4,282 6,524 Change in cash ,059 1,791 2,242 Exhibit 5: Key ratios Y/E March FY15 FY16 FY17E FY18E FY19E Per share (Rs) EPS FDEPS Dividend Per Share Book Value Dividend Payout Ratio Return ratios (%) RoE RoCE RoIC Tunover Ratios Asset Turnover Ratio Debtor Days (incl. unbilled Rev) Working Capital Cycle Days Valuation ratios (x) PER P/BV EV/EBTDA EV/Sales M-cap/Sales Persistent Systems

5 Rating track Date Rating Market price (Rs) Target price (Rs) 21 September 2015 Sell October 2015 Sell December 2015 Sell January 2016 Under Review January 2016 Under Review March 2016 Sell March 2016 Sell April 2016 Sell June 2016 Sell Persistent Systems

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