Sonata Software BUY. Laying the Platform for Growth. Institutional Equity Research. December 01, Target Price Rs185.

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1 CMP* (Rs) 157 Market Cap. (Rs bn) 17 Free Float (%) 69 Shares O/S (mn) 15 Sonata Software Laying the Platform for Growth Sonata Software (Sonata) a mid-sized IT firm based in Bangalore caters to Travel, Retail & Distribution and OPD verticals in its IT services business, oering consulting, ADM, ERP, Microsoft Dynamics AX, testing, IMS, cloud, mobility and platform services. We believe platform focus is a key dierentiator that will stand Sonata in good stead, enabling double digit USD revenue growth over FY16-FY18E. No equity dilution since 21 and high dividend payout ratio (5-6%) make Sonata s dividend yield attractive, at 5.7% (trailing DPS), which we believe would provide a cushion to the stock price. We believe current valuation at 8.5x FY18E EPS is reasonable. We initiate coverage on Sonata Software with recommendation and Target Price of Rs185. A Quality Dierentiated Firm at Reasonable Valuation A major focus area for Sonata is software platforms. Platform & new services (36% of rev in 2QFY17) clocked 3.5% USD revenue CQGR over 8 quarters (co avg 3.2%). With 12.5% USD revenue CQGR, Infra Services (IMS) has been a major success story (18% of revenue in 2QFY17 vs 9% in 2QFY15). While platforms have driven digital revenue, IMS has benefited as clients move IT infrastructure to cloud. On the back of high exposure to faster-growing services, we believe Sonata will drive 14% USD revenue in its International IT Services (IITS) business over FY16-FY18E. Share price (%) 1 mth 3 mth 12 mth Absolute performance (2.5) Relative to Nifty (5.9) Shareholding Pattern (%) Jun 16 Sept 16 Promoter Public Year Stock Price Performance High Dividend Yield Provides Cushion to Stock Price Sonata s dividend/share has risen steadily over last 4 years (dividend payout ratio at 5-6% of PAT); we expect high dividend payouts to sustained. Sonata had gross/ net cash equivalents of ~Rs3bn/~Rs1.5bn, respectively at the end of 2QFY17. Based on our FY18E dividend/share estimate (Rs11), dividend yield is 7%, providing good downside protection. Sustained dividend payout record boosts confidence on cash generating ability to fund dividends, capex and strategic acquisitions. 12 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Note: * CMP as on November 3, 216 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 No Equity Dilution, High Interest Coverage Reflect Healthy Cash Flow Sonata has not raised equity since April 21. Gross debt-equity ratio has ranged between.1x-.4x over the past 4 years. Interest coverage ratio has ranged between 7-23x, reflecting comfortable debt servicing capability. This drives further confidence in its ability to generate healthy cash flows and maintain a prudent capital structure. Outlook and Valuation At the CMP, Sonata s stock trades at a PE of 8.5x FY18E EPS, which leaves a lot on the table for investors in light of a dierentiated business model, high dividend yield, high RoE and no equity dilution for last 15 years. We initiate coverage on Sonata Software with recommendation and Target Price of Rs185, which implies a PE of 1x FY18E EPS. Key Financials (Rs mn) FY14 FY15 FY16 FY17E FY18E Net Revenue 15,658 16,821 19,45 24,839 28,414 EBITDA 995 1,676 1,919 2,37 2,578 APAT 778 1,337 1,586 1,57 1,941 Diluted EPS (Rs) P/E (x) EV / EBITDA (x) RoE (%) Research Analyst: Harit Shah Contact: harit.shah@relianceada.com 1

2 Key Investment Arguments Platform Dierentiator to Drive Growth We believe clear business dierentiation is essential for mid and small-sized IT firms like Sonata to drive growth. This becomes more relevant in current global scenario marked with distinct challenges on the macroeconomic front. It is sine qua non especially given that the impact of BREXIT is yet to be factored in and disruptive trends in the IT sector (mainly SMAC) are driving revenue cannibalisation, as newer work on the cloud comes at lower price points. Software platforms both horizontal and vertical continue to be Sonata s major focus areas to drive growth and profitability. We believe that focus on a particular vertical/horizontal is imperative for any mid and small-sized IT firm to develop deep domain expertise in that vertical or horizontal as depth rather than breadth is imperative for these companies. Its key verticals Independent Software Vendors/Outsourced Product Development (ISV/OPD), Retail & Distribution, and Travel collectively contributed 82% to Sonata s total revenue in 2QFY17. In the ISV/OPD vertical (31% of revenue), Sonata provides Product Engineering, Product Support, cloud-based Platform-as-a-Service (PaaS) & Software-as-a-Service (SaaS) and Mobility Services to clients, including a top global SMB ERP company and a leading software company. In the Retail & Distribution vertical (accounting for 23% of revenue), Sonata provides mobility, analytics, omni-channel commerce, supply chain software (IBIS), Hybris & Microsoft Dynamics AX services. It has also developed vertical-specific platforms including a Brick & Click retailing platform and RETINA (retail analytics platform). In Travel vertical (accounting for 28% of revenue), Sonata provides mobility, analytics, social, a retail travel experience platform and a cloud-based travel SaaS platform i.e. Rezopia, which is another example of Sonata s vertical-specific platforms. An example of a horizontal platform oered by Sonata is Halosys, an enterprise mobility platform. Though mobility accounted for minuscule 1% of revenue in 2QFY17, we believe that this could expand amid substantial growth trend globally. Platform & New Services including Rezopia, Mobility, Cloud, E-commerce, BI & Microsoft Dynamix AX contributed ~36% to Sonata s revenue in 2QFY17, which is similar to its total digital revenue, which contributed ~32% to revenue during the quarter. These services clocked 3.5% USD revenue CQGR over last 8 quarters, ahead of 3.2% company average CQGR over the same period. Revenue contribution from its largest service line i.e. ADM declined to 26% in 2QFY17 from 35% eight quarters ago. In absolute term too, ADM revenue has declined over the same period. Infrastructure Management Services (IMS) which accounted for 18% of Sonata s revenue in 2QFY17 against just 9% in 2QFY15 is a major success story, with the service line witnessing a stupendous 12.5% USD revenue CQGR over the past 8 quarters. From an incremental revenue perspective also, IMS accounted for ~5% over the past 8 quarters. With this, IMS has become Sonata s 2nd largest service line after ADM (26%). We believe that this could soon become its largest service line given excellent traction in this space. A good chunk of Sonata s digital revenue (32%) is driven by IMS, aided by platform focus, cloud strategy, cloud-ops and dev-ops. Pricing models in IMS business vary as some projects are outcome-based. OPD & Retail are two key verticals where IMS is driving growth. Platformisation is a key trend that has driven growth in Sonata s IMS business. Focus on platforms has ensured major deal wins for Sonata on digital side, and IMS is best suited as the clients are moving IT infrastructure to the cloud. 2

3 Sonata also enjoys long-term relationships with major principals in its Domestic Products & Services (DPS) business. It is an alliance partner for Microsoft (24 years of relationship), IBM (18 years), Oracle, SAP, HP, Adobe, Red Hat and Symantec, among others. Sonata compliments its relationships as Systems Integrator with these principals to drive IMS growth. We expect this growth to continue in the medium-term and believe IMS will continue to remain a key revenue growth driver aided by platforms, digital and relationships with key principals. Exhibit 1: Vertical Break-up, Growth Retail, Travel Key Drivers (% of revenue) (% growth) (9.2) (2.4) FY13 FY14 FY15 FY (1) (25) OPD Retail & Distribution OPD growth (RHS) Retail & Distribution growth (RHS) TTL Others TTL growth (RHS) Others growth (RHS) Exhibit 2: Platforms and New Services Healthy Growth (% of revenue) (% growth qoq) % CQGR (3.2) (3.8) (3) (7.1) (1) 2QFY15 4QFY15 2QFY16 4QFY16 2QFY17 Platforms, new svcs % of revenue Platforms, new svcs growth (RHS) Exhibit 3: IMS Revenue Sustained Growth Up-tick (% of revenue) (% growth qoq) 12.5% 2 CQGR (1) (8.6) 2QFY15 4QFY15 2QFY16 4QFY16 2QFY17 (1) IMS % of revenue IMS growth (RHS) 3

4 Healthy Financials, Reasonable Valuation Led by platform focus and key verticals (Travel & Retail), Sonata s IITS revenue in USD terms witnessed a healthy 2.8% over FY13-FY16. We expect ~14% USD revenue in IITS business over FY16-FY18E, aided by niche vertical focus and strategic acquisitions including Rezopia, Halosys & IBIS. The increasing contribution of the IITS business to total revenue (36.1% in FY16 from 25.5% in FY13) and contribution of IITS EBITDA to total EBITDA (73.9% in FY16 from 65.9 in FY13) has been a prime driver for overall margin expansion over this period (9.9% EBITDA margin in FY16 vs 4.1% in FY13, EBITDA of 53%). While EBITDA margin is likely to decline by 169bps in FY17E due to margin pressure in IITS business (295bps decline), we expect FY18E to witness an 87bps expansion led by ~1bps expansion in IITS EBITDA margin, aided by growth leverage and tapering of sales investments made over the past few quarters. As a result, while we expect an EPS decline of 1% in FY17E, we believe growth leverage and margin expansion will drive a healthy 23.6% EPS growth in FY18E. At CMP, the stock currently trades at a PE multiple of just 8.3x FY18E EPS, which we believe to be reasonable taking into account expected growth in revenue and earnings over FY16-FY18E, niche presence in platforms and specific subverticals, high RoE (>35% in FY16) and high dividend yield (7.2% on estimated FY18E dividend per share). Exhibit 4: Segmental Revenue IITS Drives Growth (Rs mn) 13, 8.5% 1,8 8,6 28.2% 6,4 4,2 2, FY13 FY14 FY15 FY16 IITS DPS 4

5 Exhibit 5: Segmental Revenue Growth (%) (%) FY13 FY14 FY15 FY IITS growth DPS growth IITS % of revenue (RHS) DPS % of revenue (RHS) Exhibit 6: Consolidated EBITDA Margin On the Rise (%) FY13 FY14 FY15 FY16 Exhibit 7: Segmental Margins, Contribution IITS the Driver (%) (%) FY13 FY14 FY15 FY16 IITS EBITDA margin IITS EBITDA % of total (RHS) DPS EBITDA margin DPS EBITDA % of total (RHS) 5

6 High Dividend Yield Provides Cushion to Stock Price Sonata s dividend/share has seen a steady uptick over the last 4 years, going to Rs9 in FY16 up from Rs1.75 in FY13, entailing a dividend yield of 5.7% on FY16 DPS. Dividend payout ratio has ranged between 5-6% of PAT. Sonata had gross and net cash and cash equivalents of ~Rs3bn and ~Rs1.5bn, respectively at the end of 2QFY17, compared with Rs 946mn dividend paid out in FY16 (Rs 1.14bn including dividend tax). We expect sustained high dividend payouts looking ahead. Based on our FY18E DPS estimates (Rs11), dividend yield works out to 7%, providing good downside protection. Sustained dividend payments also boost confidence on Sonata s ability to generate cash flows for dividend payments, capex and making strategic acquisitions. Exhibit 8: Dividend per Share, Payout Ratio Impressive Rise (Rs) (%) FY13 FY14 FY15 FY16 Dividend per share Payout ratio (RHS)* ; * Payout ratio is irrelevant in FY13 as Sonata incurred a loss that fiscal year. No Equity Dilution, High Interest Coverage Reflect Healthy Cash Flow Sonata has not raised equity share capital since April 21. This is admirable, given the need for scaling-up business in fast-changing industry. Thus, minority equity shareholders stake has not been diluted for last 15-odd years. Even in terms of raising debt, Sonata s gross debt-equity ratio has been maintained at very comfortable levels ranging from.1x-.4x over last 4 years, while on a net basis Sonata has always been a net cash company. In terms of debt servicing capability, Sonata s interest coverage ratio (EBIT/interest) has ranged between 7-23x over last 4 years, reflecting a comfortable liquidity position and debt servicing capability. This drives further confidence in Sonata s ability to continue to generate healthy cash flows and maintain a prudent capital structure. 6

7 Exhibit 9: Debt-equity, Interest Coverage At Comfortable Levels (x) (x) FY13 FY14 FY15 FY Debt-equity ratio Interest coverage ratio (RHS) DPS Biz Strategic Partnerships, High Asset Turnover Ratio & RoE Sonata s DPS business run through its subsidiary Sonata Information Technology distributes product licenses of numerous large ISVs and principals including Microsoft, Oracle, IBM, SAP and HP, among others. Though DPS business contributed ~64% to Sonata s total revenue in FY16, it contributed just 26% to EBITDA due to lower EBITDA margins compared to that of IITS business (4.4% vs. 22%). While margins are low owing to its trading nature, the segment enables Sonata to establish strategic relationships with the above-mentioned ISVs, thus driving cross-selling eorts in IITS business. For instance, Sonata earns 15% of IITS revenue from Microsoft Dynamics AX ERP and 18% from IMS, which to some extent feed o these strategic SI relationships. Sonata is looking at focusing on higher value-added products i.e. Cloud & Security to drive growth and margins in this space. The key focus area for Sonata in the DPS segment are: improving margins (4.4% in FY16 vs. 2.3% in FY13) & RoCE, with its capex-light nature driving higher asset turns (over 18x in FY16, mainly owing to the DPS segment) and consequently, healthy RoE (35.3% in FY16). We expect Sonata to maintain >3% RoE in FY17E & FY18E. 7

8 Key Risks Any client-specific issues emanating from any Top-1 clients could impact revenue growth, Growth pangs in the OPD vertical, given the disruptive impact of SMAC, which could aect revenue growth, General growth volatility given Sonata s small size, Event-specific risks such as BREXIT, which could impact IT budgets, cutting discretionary spends and delaying new deals, With Donald Trump as US President, the risk of noise regards oshoring taking away US jobs, higher visa costs and a more punishing visa regime abound, Cannibalisation of existing revenue particularly on the ADM and ERP side by the shift to cloud architecture, and Currency risks. Comparative Analysis Exhibit 1: Sonata Software - Key Metrics vs. Select Peers Particulars Sonata Software Persistent Systems Mindtree USD revenue (FY16, US$ mn)* USD revenue (FY16-FY18E, %)* EBITDA margin (FY16, %)* RoE (FY16, %) Revenue/employee (FY16, US$)* 35,891 39,578 46,44 P/E (FY18E, x) EV/EBITDA (FY18E, x) Source: Respective companies, RSec Research; * These metrics are only for Sonata s IITS business, while the other metrics are for the consolidated entity. 8

9 Financials Revenue Forecasts We envisage 14% USD revenue (14.4% in INR terms) for Sonata s IITS business over FY16-FY18E. Expecting ~25% revenue for DPS business, we envisage consolidated revenue of 21%. We expect growth in the IITS business to be led by its key focus verticals including Retail & Travel, while platform focus should drive dierentiation. We estimate IITS revenue in USD terms to touch US$14mn in FY18E from US$18mn in FY16, while in INR terms we expect FY18E revenue at Rs9.25bn vs. Rs7.7bn in FY16. Our forecasts exclude impact of acquisitions - if any - that Sonata could make over this period. We believe given the need to drive growth in key focus areas like SMAC, Platforms & AX, Sonata could buy out firms with a presence in these areas, the way it has been active on this front over the past 2 years with the buys of Rezopia, Halosys & IBIS. Exhibit 11: IITS Revenue, Revenue Growth Forecasts USD (US$ mn) 14% (%) FY16 FY17E FY18E 5 IITS Revenue IITS revenue growth (RHS) Exhibit 12: IITS Revenue, Revenue Growth Forecasts INR (Rs mn) (%) 1, 14.4% 2 9, 18 8, , 6, 5, 13.1 FY16 FY17E FY18E IITS Revenue IITS revenue growth (RHS)

10 Exhibit 13: DPS Revenue, Revenue Growth Forecasts (Rs mn) 24.6% (%) 2, , 3 16, 25 14, 2 12, , FY16 FY17E FY18E 1 DPS Revenue DPS revenue growth (RHS) Exhibit 14: Total Revenue, Revenue Growth Forecasts (Rs mn) (%) 3, % 3 27, 26 24, 22 21, 18, , FY16 FY17E FY18E 1 Total Revenue Total revenue growth (RHS) Profitability Forecasts We factor in 169bps decline in EBITDA margin in FY17E, mainly due to margin pressures in the IITS business, whose EBITDA margin is expected to decline 295bps owing to higher investments in sales and currency volatility. We expect EBITDA margin to rise by 87bps in FY18E, led by 1bps margin growth in the IITS business, led by growth leverage and tapering o of sales investments made over last few quarters. We expect EBITDA margin to touch 8.2% & 9.1% in FY17E & FY18E, respectively from 9.9% in FY16. In absolute terms, we expect consolidated EBITDA to rise to Rs2.58bn in FY18E (Rs1.92bn in FY16, Rs 2bn in FY17E), implying a healthy 15.9% over FY16-FY18E. 1

11 Exhibit 15: IITS EBITDA, Margin Forecasts (Rs mn) (%) 2, 9.2% 25 1, ,6 1, ,2 17 1, FY16 FY17E FY18E 15 IITS EBITDA IITS EBITDA margin (RHS) Exhibit 16: DPS, EBITDA, Margin Forecasts (Rs mn) (%) 33.2% 1, FY16 FY17E FY18E DPS EBITDA DPS EBITDA margin (RHS) Exhibit 17: Total EBITDA, Margin Forecasts (Rs mn) (%) 3, 2, % ,4 2,1 1,8 1,5 FY16 FY17E FY18E Total EBITDA Total EBITDA margin (RHS) 11

12 Outlook & Valuation We like Sonata s dierentiated business model with its platform and digital focus, which in our opinion would drive revenue through key services like IMS & Microsoft Dynamics AX. We believe Retail & Travel will be key vertical drivers led by vertical-specific platforms, while the recent up-tick in OPD revenue in 2QFY17 is also an encouraging factor. Sonata has made investments in IP, S&M and in hiring senior level managers over last few quarters, which we expect will start to yield results over the next few quarters in the form of revenue growth, which in turn should be a key margin defence lever. High dividend yield provides a cushion for Sonata s stock price, apart from boosting comfort on the company s ability to generate cash. No fund raising for over 15 years leading to no equity dilution, debt-equity ratio remaining conservatively in.1-.4x range over last 4 years, and comfortable interest coverage ratio of 7-23x over this period drive further confidence in Sonata s ability to maintain a prudent capital structure. No equity dilution, EPS growth on the same equity capital base, high dividend payout ratio of 5-6% and attractive valuation (low PE multiple) are key reasons for Sonata s high dividend yield. Low capital investment required in the DPS business drives high asset turnover ratio and RoE, while strategic relationships with key principals and ISVs feed into the IITS business through growth in key services like Microsoft Dynamics AX & IMS. We believe these factors are critical for driving revenue growth and RoE in FY17E & FY18E. At the CMP, the stock trades at a PE of 8.5x FY18E EPS, which we believe to be attractive leaving a lot on the table for investors in light of Sonata s dierentiated business model, potential for improving revenue and profit growth, high dividend yield, high RoE and no equity dilution over the last 15+ years. We initiate coverage on Sonata Software with recommendation and Target Price of Rs185, which implies a PE of 1x FY18E EPS. Company Background Bangalore-headquartered Sonata Software is a mid-sized IT services company having presence in the US, the UK, Europe, APAC, & Middle East. It operates through two major business units i.e. International IT Services (IITS) and Domestic Products & Services (DPS). Within IITS (~36% of total revenue in FY16), Sonata caters to Travel, Retail & Distribution and OPD verticals. In terms of service lines, Sonata provides consulting, ADM, ERP, Microsoft Dynamics AX, testing, IMS, cloud, mobility and platform services. A key focus area for Sonata is platforms, both horizontal and vertical-specific. It oers platforms to Travel (Rezopia) & Retail (RETINA) verticals, and also oers Halosys (a vertical-agnostic enterprise mobility platform) to clients. In the DPS segment which accounted for ~64% of FY16 revenue Sonata sells software products including licences for Microsoft, SAP, Oracle, Abode, IBM, HP & TIBCO in India through its subsidiary Sonata Information Technology. 12

13 Profit and Loss Statement Y/E Mar (Rs mn) FY14 FY15 FY16 FY17E FY18E IITS Revenue (US$ mn) Growth (%) Consolidated Revenue 15,658 16,821 19,45 24,839 28,414 Growth (%) Total Operating Expenses 14,663 15,145 17,486 22,82 25,836 EBITDA 995 1,676 1,919 2,37 2,578 EBITDA (%) EBITDA Growth (%) Depreciation EBIT 915 1,616 1,857 1,958 2,49 EBIT (%) EBIT Growth (%) Other Income Interest PBT 999 1,787 2,216 2,244 2,814 Tax (incl deferred) Minority Interest and associate profit Extraordinary Items PAT 778 1,337 1,586 1,57 1,941 PAT Growth (%) N.A (1.) 23.6 EPS EPS Growth (%) N.A (1.) 23.6 Balance Sheet Y/E Mar (Rs mn) FY14 FY15 FY16 FY17E FY18E SOURCES OF FUNDS Share Capital - Equity Reserves 3,639 4,179 4,65 5,68 5,656 Total Shareholders' Funds 3,744 4,284 4,71 5,173 5,761 Total Debt ,713 1,713 1,713 Long Term Provisions & Others Creditors 1,996 2,496 2,655 3,436 3,893 Other Current Liabilities & Provns 785 1, Total Current Liabilities 2,782 3,533 3,334 4,191 4,692 TOTAL SOURCES OF FUNDS 6,59 8,81 9,919 11,239 12,327 APPLICATION OF FUNDS Net Block Capital Work in Progress Goodwill & Other Intangible Assets Deferred Tax Assets LT Loans & Advances, Others 1, Total Non Current Assets 1,619 1,252 1,989 2,158 2,354 Inventories Debtors 2,25 3,271 3,755 5,14 5,994 Cash & Bank 1,865 1,998 2,953 2,755 2,757 Liquid Investments Other Current Assets Total Current Assets 4,971 6,829 7,93 9,81 9,973 TOTAL APPLICATION OF FUNDS 6,59 8,81 9,919 11,239 12,327 13

14 Cash Flow Statement Y/E Mar (Rs mn) FY14 FY15 FY16 FY17E FY18E PAT 778 1,337 1,586 1,57 1,941 Non-operating & EO items Depreciation Working Capital Change 75 (663) 512 (492) (39) Cash Flow from Operations (a) ,159 1,158 1,64 Capex (37) (113) (258) (248) (284) Investments (21) Cash Flow from Investing (b) (238) (87) (258) (248) (284) Debt Issuance/(Repaid) (111) Dividend (279) (675) (1,676) (1,17) (1,353) Cash Flow from Financing (c) (389) (488) (1,489) (1,17) (1,353) NET CASH FLOW (a+b+c) (198) 2 EO items, others 24 (31) Closing Cash Balance 1,865 1,998 2,953 2,755 2,757 Free Cash Flow , ,355 Key Ratios Y/E Mar FY14 FY15 FY16 FY17E FY18E Profitability (%) EBITDA Margin APAT Margin RoE RoIC or Core RoCE RoCE Eiciency Tax Rate (%) Fixed Asset Turnover (x) Inventory (days) Debtors (days) Payables (days) Cash Conversion Cycle (days) Net Debt/EBITDA (x) (2.4) (1.4) (.9) (.8) (.6) Net Debt/Equity (x) (.6) (.6) (.4) (.3) (.3) Interest Coverage (x) Per Share Data (Rs) EPS CEPS DPS BV Valuation P/E (x) P/BV (x) EV/EBITDA (x) OCF/EV (%) FCF/EV (%) FCFE/mkt cap (%) Dividend Yield (%)

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