SQS India BFSI Ltd BUY. World s Leading Specialist in Financial Services Testing. Valuation and Outlook. Key Risks

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1 Technology - Application Software Bloomberg Code: SQSI IN India Research - Stock Broking World s Leading Specialist in Financial Services Testing Benefits from SQS Group drive growth opportunities: SQS India BFSI is now part of the SQS group, which is world s largest independent specialist testing company. Before acquisition, the consolidated revenue was Rs. 1,614 mn in FY13. Over FY13-FY15, the company recorded revenue growth at a CAGR of 15%. We estimate the revenue will grow at a CAGR of 14% in FY15-FY18E. Going ahead, margin expansion will continue from 17.3% in FY15 to 19.3% in FY18E due to revenue acceleration, changing business mix and employee cost rationalization. Focus continues to be on the US and Europe: USA is 5% of the global market in IT services, but SQS presence has been only 22%. Post acquisition by SQS AG in Nov 213, they have entered US software testing market in a big way. Management is very keen to focus its presence in US for which they have recently acquired two US based consulting companies with strong clientele across various verticals. Revenue growth 19%; PAT increase 31% compared with previous year Nine Months period: During 9MFY16, operating revenue is Rs. 1,919 Mn as compared to Rs. 1,616 Mn during the corresponding period of previous year reflecting an increase of 19% in rupee terms; and Net profit stood at Rs. 263 Mn during 9MFY16 as compared to Rs. 2 Mn in the corresponding period of the previous year; an increase of 31%. Valuation and Outlook At CMP of Rs. 926, SQS India BFSI is trading at a P/Ex of 25.5x and 23.1x on FY17E and FY18E earnings respectively. On the back of demand environment in BFSI, robust pipeline, quality of deals signed, other favourable factors, improving cost efficiency and economies of scale, we initiate coverage on SQS India BFSI Ltd with a BUY rating with a target price of Rs. 1124, based on 28.1x P/E FY18E, representing an upside potential of 21% in a 9-12 months period. Key Risks yforeign exchange rate fluctuations. yincreasing competition. yuncertainties in economic, business and geo-political conditions. yfinancial Services domain Risk. Exhibit 1: Valuation Summary YE Mar (Rs. Mn) FY14 FY15 FY16E FY17E FY18E Net Sales EBITDA EBITDA Margin (%) Adj. Net Profit EPS (Rs.) RoE (%) PE (x) , *Represents multiples for FY14 & FY15 are based on historic market price For private circulation only. For important information about Karvy s rating system and other disclosures refer to the end of this material. Karvy Stock Broking Research is also available on Bloomberg, KRVY<GO>, Thomson Publishers & Reuters Recommendation (Rs.) Mar 23, 216 BUY CMP (as on Mar 22, 216) 926 Target Price 1124 Upside (%) 21 Stock Information Mkt Cap (Rs.mn/US$ mn) 121 / wk High/Low (Rs.) 1291 / 55 3M Avg. daily volume (mn) 284 Beta (x).7 Sensex/Nifty 2533 / 7714 O/S Shares(mn) 1.6 Face Value (Rs.) 1. Shareholding Pattern (%) Promoters 54.2 FIIs 1. DIIs 4.8 Others 4.1 Stock Performance (%) 1M 3M 6M 12M Absolute 5 (18) Relative to Sensex () (16) Source: Bloomberg Relative Performance* Dec-14 Jan-15 Feb-15 Mar-15 Source: Bloomberg; *Index 1 Analyst Contact Prasanth Victor Apr-15 May-15 Jun-15 Jul-15 v.prasanth@karvy.com Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 Sensex Feb-16 Mar-16 1

2 Company Financial Snapshot Profit & Loss (Rs. Mn) FY15 FY16E FY17E FY18E Net sales Optg. Exp (Adj for OI) EBITDA Depreciation Interest Other Income PBT Tax Adj. PAT Profit & Loss Ratios EBITDA margin (%) Net margin (%) P/E (x) EV/EBITDA (x) Dividend yield (%) Balance sheet (Rs. Mn) FY15 FY16E FY17E FY18E Total Assets Net Fixed assets Current assets Others Total Liabilities Networth Debt Current Liabilities Balance Sheet Ratios RoE (%) RoCE (%) Net Debt/Equity Equity/Total Assets P/BV (x) Exhibit 2: Shareholding Pattern (%) Company Background SQS India BFSI Limited (formerly Thinksoft Global Services) was acquired by SQS Software Quality Systems AG in November 213. The company is an India based software service provider primarily delivering software validation and verification services to the banking and financial services industry worldwide. The company has achieved over 15M person hours of track record in Financial Services testing. SQS India has a total employee strength of over 1 with client base of more than 2 across 23 countries. The company has invested in five wholly owned subsidiaries in Singapore, USA, Germany, UK and UAE for market development and service delivery in the respective regions. With over 7, completed projects, SQS has a strong customer base, including half of the DAX-3, almost a third of the STOXX-5 and 2 FTSE-1 companies. Cash Flow (Rs. Mn) FY15 FY16E FY17E FY18E PBT Depreciation Interest (net) Tax (12) (131) (157) (173) Changes in WC () 2 Others CF from Operations Capex (28) (26) (19) (79) Investment (21) Others 2 CF from Investing (29) (26) (19) (79) Debt (23) (15) (12) (9) Dividends & interest paid (97) (266) (116) (114) Others 8 (52) (22) (22) CF from Financing (112) (332) (149) (145) Change in Cash Exhibit 3: Revenue Segmentation (%) DIIs 4.8% Other 4.1% Cards & Payments 33.% Insurance 7.% FIIs 1.% Promoters 54.2% Capital Markets & Treasury 8.% Banking 52.% Source: BSE, Karvy Research 2

3 Industry Outlook: According to Nelson Hall, the global software testing market is estimated at ~$ bn per annum. The testing market is likely to grow much faster at over 8% CAGR over CY14-17E. Testing market can be split into four key categories: Functional Testing, Enterprise Resource Planning/Business Intelligence/Data warehouse, Non-functional testing, Consultancy and Other. Highest growth rates expected in Financial Services, Energy & Utilities, Retail & Logistics. The main challenge of the industry is to move from labour-intensive activities towards more automated ones. Vendors are proactively developing proprietary tools and Intellectual Patents (IPs) to increase automation levels. Several vendors are aiming to sell their IPs as license products. This initiative may prove favourable to clients or not, will depend if vendors spend the additional revenue from licensing IPs in additional R&D or use it for increasing their profitability. It will also depend whether vendors start behaving like Independent Software Vendors (ISVs), e.g. in terms of feature roadmaps. Platform-based testing is an emerging trend, with testing work managed, decided and carried out by the client, deciding on personnel allocation, with some level of personnel sharing across clients. This approach is perceptive in mobile app testing. Cloud testing is another platform-based testing offering, again with delivery being organized by the vendor and increasing based on using its tools and processes, rather than the clients. Mobile app testing and cloud sourcing testing in their platform-based versions are emerging phenomena. India Ratings & Research Agency expects the growth of IT service providers to remain soft and range between 8-9% in FY17E on the back of the flat-to-marginally negative IT budgets of clients. Tighter budgets would compel clients to offshore the traditional labour-based offerings to India while they would also press for a pass-on of benefits of automation. Although increasing, the budget allocation for the new cloud based technologies and digitalisation remains low; and the contract size remains small as these projects are still in the pilot phase. Exhibit 4: World market testing services Exhibit 5: Market split by services (%) EMEA* 63 4% 214, in $m Total 15,675 North America % APAC/LatAm** 2 13% Change per year CY15 CY16E CY17E North America + 14% + 14% + 14% EMEA + 12% + 12% + 12% APAC/LatAm + 11% + 11% + 13% Functional Testing 76% ERP/BI/Data warehouse 12% Nonfunctional testing 7% Consultancy + Other 5% Source: Nelson Hall 214, Karvy Research, *EMEA: Europe, Middle East & Africa, **Asia-Pacific/Latin America Benefits from SQS Group drive growth opportunities: Source: Nelson Hall 214, Karvy Research SQS India BFSI Limited (formerly Thinksoft Global Services) was acquired by SQS Software Quality Systems AG in November 213. SQS has a three decade experience specifically in software testing serving to verticals like BFSI, Retail, Manufacturing, Energy & Utility and Telecommunications. BFSI became the part of leading testing company. More than 5% of SQS revenue is derived from BFSI; and going forward, maximum of it may be delivered through SQS India BFSI, due to its deep BFSI domain knowledge expertise. With over 15M person hours of track record in Financial Services testing, SQS has a strong client base, including half of the DAX 3, nearly a third of the STOXX 5 and 2% of the FTSE 1 companies. These include Allianz, Beazley, BP, Centrica, Commerzbank, Daimler, Deutsche Post, Generali, JP Morgan, Meteor, Reuters, UBS and Volkswagen. Due to SQS strong client base, SQS India BFSI is poised for better earnings in the foreseeable future. As a result of this acquisition, Thinksoft name changed to SQS India BFSI. With the result of this acquisition, SQS India BFSI turned to an organization of increased size and scale which created a platform for accelerated growth with the potential to propel Thinksoft into new orbit. 3

4 The revenue growth traction would continue going forward as well, as it would be driven by a multipronged strategy that includes direct client acquisition, inorganic additions through group and outsourced business from the parent. Before acquisition, the consolidated revenue was Rs. 1,614 mn in FY13. Over FY13-FY15, the company recorded CAGR revenue growth of 15%. We estimate the revenue will grow at a CAGR of 14% in FY15-FY18E. Going ahead, margin expansion will continue from 17% in FY15 to 19% in FY18E due to revenue acceleration, changing business mix and employee cost rationalization. Exhibit 6: Revenue (Rs. Mn) & Revenue Growth (%) % 32.9% % 4% 3% 2% 2.4% 18.9% 1% 1.1% 8.9% 12.7% % FY12 FY13 FY14 FY15 FY16E FY17E FY18E Revenue (Rs. Mn) Revenue Growth (%) Exhibit 7: EBITDA (Rs. Mn) & EBITDA Margins (%) % % 2.4% 19.3% 17.3% 18.4% 18.9% % 2% 15% 1% 5% % FY12 FY13 FY14 FY15 FY16E FY17E FY18E EBITDA (Rs. Mn) EBITDA Margins (%) New Customers bringing in higher onsite revenue: In FY15, in geographic terms, 46% of revenues came from Europe, 32% from India, Middle East & Africa (IMEA) and Australia Regions and 22% from North America and the proportion of onsite to offshore revenues stood at 55:45 percent. However, before acquisition in FY13, the revenue split was 35% from Europe, 38% from IMEA and 27% from North America. In FY15, revenue from onsite services increased slightly from 53% to 55% due to the addition of new customers where initial requirements were onsite; plus existing customers requiring short term increases in onsite projects. Currently, SQS India BFSI is having 54 active clients from different regions; and in FY16E, for the past three quarters, the company added 24 new clients. The company currently serves several Tier I banks such as Barclays, RBS, JPM, UBS, Lloyds, Allianz, Generali etc., As Europe contributes 46% of revenue which includes many German clients, the company is training its employees in German language which is creating an opportunity to serve the clients in more desirable way. The revenue per client has increased significantly from Rs. 22 mn in FY11 to ~Rs.37 mn in Q3FY16. Further, continuous strategy of SQS to improve profitability by terminating lower margin clients and bag long term contracts helping to improve attractive margins. Also, the company is having client concentration of 5% revenue from top 5 clients and 7% from top 1 clients. The company has diversified the revenue distribution with many clients rather than depending only on top 5 clients which shows that the company is playing safe and reducing the client concentration risk. Exhibit 8: Revenue Per Client 8 Exhibit 9: Client Concentration - Revenue Contribution (%) FY11 FY12 FY13 FY14 FY15 Q3FY16 FY12 FY13 FY14 FY15 FY16YTD Active Clients (in No.) Revenue Per Client (Rs. Mn) Top 5 Top 1 4

5 Focus continues to be on the US and Europe: Exhibit 1: Geographic Distribution (%) US 16.% MENA* 18.% Asia 17.% Europe 48.% ANZ** 1.% Mar 23, 216 By geography, the company focus continues to be on the US and Europe. In FY15, geographically, 46% of revenues came from Europe, 32% from IMEA and Australia Regions and 22% from North America. SQS AG has ~75% client from non-english speaking countries and ~25% clients from English speaking countries. The company has recently trained more than 5 employees for german speaking and over 2 already have level A1 language certification in anticipation of starting offshoring requirements from Germany, Austria and Switzerland., *MENA: Middle East and North Africa **ANZ: Australia and New Zealand According to Nelson Hall 214 report, US is the largest market of $7,375 mn over for software testing over the total market of $15,675 mn. SQS AG was having very less presence in US and mainly into BFSI, so post acquisition of Thinksoft in Nov 213, they have entered US software testing market in a big way. Management is very keen to focus its presence in US for which they have recently acquired two US based consulting companies with strong clientele across various verticals. Acquired Galmont for US$ 22 Mn which is a leading software testing consultancy in the Mid-west region of the US, with a presence in Chicago, Dallas, New York and Kentucky with revenue of US$ 17 Mn in 214 and PBT of US$ 1.1 Mn. SQS also acquired Trissential for US$ 3.7 Mn which is a leading IT project, programmer and portfolio management consultancy in the Mid-West region of the US with a presence in Minneapolis, Milwaukee and Chicago. Going ahead, SQS India BFSI may garner maximum portion of parent s US BFSI revenue for its offshore delivery model and due to its deep domain expertise. Revenue growth 19%; PAT increase 31% compared with previous year Nine Months period: During 9MFY16 period, operating revenue was Rs. 1,919 Mn as compared to Rs.1,616 Mn during the corresponding period of previous year, reflecting an increase of 19% in rupee terms; and Net profit stood at Rs. 263 Mn during 9MFY16 as compared to Rs. 2 Mn in the corresponding period of the previous year, reflecting an increase of 31%. This is due to management is geared to deliver high growth over Medium-to-Long-term on the back of increasing presence in US and higher share from parent. Management is very keen to keep the attrition at its optimum level of less than 2%. EBITDA Margin is at 17.3% in FY15. We expect the margins will move further to hit the 19.3% level in FY18E. The current EPS stood at Rs. 2.9 in FY15 and this will move further to Rs. 4. in FY18E. Finally, the company is expected to benefit from SQS brand leverage, incremental migration revenue from parent and better prospects for independent testing/quality companies. We believe its profitability will improve further as the migration revenue share increases going forward. Exhibit 11: Q3FY16 Financial Summary Q3FY16 Q2FY16 QoQGrowth (%) Q3FY15 YoYGrowth (%) 9MFY16 9MFY15 YoY Growth (%) Revenue (Rs. Mn) EBITDA (Rs. Mn) (8.3) PAT (Rs. Mn) (3.4) EPS (Rs.) (28.9) EBITDA Margins (%) (19) bps bps (6) bps 5

6 Exhibit 12: Business Assumptions Y/E Mar (Rs. Mn) FY15 FY16E FY17E FY18E Comments Revenue The revenue growth traction would continue going forward as well. We estimate the revenue will grow at a CAGR of 14% in FY15-FY18E. This is due to expected synergy benefits from SQS AG and management is geared to deliver high growth over Medium-to-Long-term on the back of increasing presence in US and higher share from parent. Revenue Growth (%) EBITDA By improving the top line, higher utilization and a higher share of business which lead to an increase of EBITDA by 12% from FY15-FY18E. EBITDA Margins (%) PAT (normalized) Fully Diluted EPS (Rs.) Capex We expect that there is no major capital expenditure involved except maintenance capex. Net CFO Debt Free Cash Flow As the company is not planning for any major investments, there is a possibility of debt to come down in FY16E & FY17E. Balance sheet is supported with healthy cashflow generation. 6

7 Exhibit 13: PAT (Rs. Mn) & PAT Margin (%) % 12.% 12.7% 13.9%13.6% 9.4% 1.1% 114 FY FY13 3 FY FY FY16E 386 FY17E 425 FY18E 2% 15% 1% 5% % PAT (Rs. Mn) PAT Margin (%) We expect profitability to improve significantly over FY15-18E with a CAGR of 25% driven by increasing revenue, low interest cost, depreciation and stable operational expenses. Exhibit 14: EPS (Rs) SQS India BFSI witnessed EPS of Rs.2.9 in FY15. It is expected to reach Rs.4. in FY18E driven by significant growth in PAT on the back of increasing top line, stable operational expenses and low finance cost. FY12 FY13 FY14 FY15 FY16E FY17E FY18E EPS (Rs) Exhibit 15: RoE (%) & RoCE (%) 5% 4.7% 39.4% 39.5% 36.4% 4% 31.9% 29.7% 25.7% 3% 3.6% 2% 29.% 28.8% 26.3% 23.7% 2.6% 1% 15.6% % FY12 FY13 FY14 FY15 FY16E FY17E FY18E The company s RoCE and RoE are expected to improve due to increased EBIT margins moving forward. RoE & RoCE are expected to improve to 26.3% & 36.4% by FY18E as the company is maintaining low debt and increasing profitability, thereby the company is expected to witness improvement in RoE & RoCE. RoE (%) RoCE (%) Exhibit 16: Company Snapshot (Ratings) Low High Quality of Earnings 33 Domestic Sales 33 Exports 33 Net Debt/Equity 33 Working Capital Requirement 33 Quality of Management 33 Depth of Management 33 Promoter 33 Corporate Governance 33 7

8 Valuation & Outlook SQS India BFSI is expected to benefit from SQS brand leverage, incremental migration revenue from parent and better prospects for independent testing/quality companies. We believe its profitability will improve further as the migration revenue share increases going forward. At CMP of Rs. 926, SQS India BFSI is trading at a P/Ex of 25.5x and 23.1x on FY17E and FY18E earnings respectively. On the back of demand environment in BFSI, robust pipeline, quality of deals signed, other favourable factors, improving cost efficiency and economies of scale, we initiate coverage on with a BUY rating with a target price of Rs. 1124, based on 28.1x P/E FY18E, representing an upside potential of 21% in a 9-12 months period. Exhibit 17: PE Band Jan-14 Jan-14 Feb-14 Mar-14 Mar-14 Apr-14 May-14 May-14 Jun-14 Jul-14 Jul-14 Aug-14 Sep-14 Oct-14 Oct-14 Nov-14 Dec-14 Dec-14 Jan-15 Feb-15 Feb-15 Mar-15 Apr-15 Apr-15 May-15 Jun-15 Jul-15 Jul-15 Aug-15 Sep-15 Sep-15 Oct-15 Nov-15 Nov-15 Dec-15 Jan-16 Jan-16 Feb-16 Mar-16 PE Band Source: Prowess, Karvy Research Exhibit 18(a): Comparative Valuation Summary CMP Mcap EV/EBITDA (x) P/E (x) EPS (Rs.) (Rs.) (Rs. Mn) FY14 FY15 FY16E FY17E FY14 FY15 FY16E FY17E FY14 FY15 FY16E FY17E SQS India BFSI Zensar Technologies Source: Bloomberg, Karvy Research Exhibit 18(b): Comparative Operational Metrics Summary CAGR % (FY15-17E) RoE (%) Price Perf (%) Net Sales (Rs. Mn) Sales EBITDA EPS FY14 FY15 FY16E FY17E 3m 6m 12m FY14 FY15 FY16E FY17E SQS India BFSI (18.3) Zensar Technologies (2.9) Source: Bloomberg, Karvy Research Key Risks yforeign exchange rate fluctuations: Exchange rate of the Rupee vis-à-vis the US Dollar and the other currencies could affect its ability to compete, also results in fluctuation in operating margins. yincreasing competition: SQS India BFSI is an exclusive software testing company. However, there is a strong competition from other big players in the market. yuncertainties in economic, business and geo-political conditions: Since the company operates in geographies like US and Europe mainly, so any economic downturn in these geographies might impact the company s growth. y Financial Services domain Risk: SQS India BFSI revenue represents completely from BFSI segment, which can affect the business when financial market declines. 8

9 Financials Exhibit 19: Income Statement YE Mar (Rs. Mn) FY14 FY15 FY16E FY17E FY18E Revenues Growth (%) Operating Expenses EBITDA Growth (%) 31.5 (6.6) Depreciation & Amortization Other Income EBIT Interest Expenses PBT Tax Adjusted PAT Growth (%) 54.5 (27.9) Exhibit 2: Balance Sheet YE Mar (Rs. Mn) FY14 FY15 FY16E FY17E FY18E Cash & Equivalents Sundry Debtors Loans & Advances Investments Gross Block Net Block Miscellaneous Total Assets Current Liabilities & Provisions Debt Total Liabilities Shareholders Equity Reserves & Surplus Total Networth Total Networth & Liabilities

10 Exhibit 21: Cash Flow Statement YE Mar (Rs. Mn) FY14 FY15 FY16E FY17E FY18E PBT Depreciation Interest Tax Paid (142) (12) (131) (157) (173) Inc/dec in Net WC (83) () 2 Others (35) Cash flow from operating activities Inc/dec in capital expenditure (25) (28) (26) (19) (79) Inc/dec in investments (13) (21) Others 11 2 Cash flow from investing activities (27) (29) (26) (19) (79) Inc/dec in borrowings (24) (23) (15) (12) (9) Issuance of equity 8 24 Dividend paid (95) (98) (34) (128) (128) Interest paid (18) (15) (13) (1) (8) Cash flow from financing activities (129) (112) (332) (149) (145) Net change in cash Exhibit 22: Key Ratios YE Mar FY14 FY15 FY16E FY17E FY18E EBITDA Margin (%) EBIT Margin (%) Net Profit Margin (%) Dividend Payout Ratio (%) Net Debt/Equity (x) RoE (%) RoCE (%) Exhibit 23: Valuation Parameters YE Mar FY14 FY15 FY16E FY17E FY18E EPS (Rs.) DPS (Rs.) BV (Rs.) PE (x) P/BV (x) EV/EBITDA (x) EV/Sales (x) ; *Represents multiples for FY14 & FY15 are based on historic market price 1

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