3QFY16 results - Better than estimates

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1 RESULT UPDATE Dipen Shah NIIT LTD (NIIT) PRICE: RS.79 RECOMMENDATION: BUY TARGET PRICE: RS.92 FY17E P/E: 11.1X NIIT's 3QFY16 performance was better than our expectations, largely led by CLS, which saw revenues grow by 15% YoY in CC terms. They grew by 8% QoQ in USD terms, we estimate. S&C also reported growth of 2.5% on a YoY basis, bettering the 0.6% growth witnessed in 2Q. Margins improved by 392bps on a YoY basis, above expectations. NIIT has shown improvement in revenue growth and margins over the past three quarters with the margin improvement taking us by surprise. We remain optimistic on the future prospects of NIIT. NIIT has also launched new programs in S&C business and added new clients in CLS, which should support future growth. We await more clarity on growth prospects and the corresponding profitability in the Skills business, though. Our FY17 EPS estimates stand marginally increased to Rs.7.1 (Rs.6.8), respectively. Our DCF-based PT stands revised to Rs.92 (Rs.90 earlier). The recent sharp fall in price has made valuations attractive. We upgrade the stock to BUY (SELL, earlier). Summary table (Rs mn) FY15 FY16E FY17E Sales 9,573 10,260 11,508 Growth (%) EBITDA ,084 EBITDA margin (%) Net profit (1,385) 739 1,180 EPS (Rs) (8.4) Growth (%) (873.7) (153.4) 59.6 CEPS (Rs) (4.6) BV (Rs/share) Dividend / share (Rs) ROE (%) (23.4) ROCE (%) (7.3) Net cash (debt) (542) (104) 454 NW Capital (Days) P/E (x) (9.4) P/BV (x) EV/Sales (x) EV/EBITDA (x) Source: Company, Kotak Securities - Private Client Research 3QFY16 results - Better than estimates (Rs mn) 2QFY16 3QFY16 QoQ (%) 3QFY15 YoY (%) Income Expenditure EBIDTA Depreciation EBIT Interest Other Income PBT Tax PAT Share of profit Adjusted PAT E O items Shares (mns) EPS (Rs) EBIDTA (%) EBIT (%) Net Profit (%) Source: Company S&C revenues reported YoY growth for second successive quarter S&C revenues grew by 2.5% YoY, after reporting and 0.5% rise in the previous quarter. This is the second successive quarter of YoY growth in this business and reflects the benefits of the turnaround strategy adopted for the domestic and Chinese markets. The growth rates of S&C are being driven by the Beyond-IT courses and Skill courses. Beyond IT business grew by 8% YoY and formed 38% of revenues (40% in 2Q and 39% in 1Q). The muted growth in IT course revenues reflects the continuing negative sentiments in the minds of the prospective students. Kotak Securities Limited has two independent equity research groups: Institutional Equities and Private Client Group. This report has been prepared by the Private Client Group. The views and opinions expressed in this document may or may not match or may be contrary with the views, estimates, rating, target price of the Institutional Equities Research Group of Kotak Securities Limited. Kotak Securities - Private Client Research Please see the disclaimer on the last page For Private Circulation 8

2 We opine that, despite some momentum in the revenue growth of IT services exports industry the recruitments have not picked up as companies try to improve utilization rates, look at just-in-time hiring and also increase non-linear revenues. While the higher capacity utilization levels at major IT companies in recent quarters do provide an opportunity, the bend towards non-linear revenues can pose a challenge to ILS, going ahead. However, we do believe that, if the IT services exports continue to do well, the positive sentiments will rub-off on NIIT over the next few quarters. Overall enrolments were at 65,989 as against 61,370 in the previous quarter. The capacity utilization of own centres was at 34%, as against 36% in 2Q v/ s 31% as at FY15-end. New programs to support growth in Beyond-IT NIIT has been introducing new programs to improve the growth rates in the Beyond-IT business. During the quarter, it introduced new programs with HP and Metascale. While the partnership with HP has led to a new certificate course in Software Testing, NIIT has attacked the Big Data market through its tie-up with Metascale. We believe these are high-growth opportunities, with Big Data professionals seeing significant demand in the new Digital world. We expect these programs to attract significant enrolments, in line with the demand seen for 'StackRoute.' StackRoute and NIIT TV scaling up NIIT has already introduced StackRoute - a specialised program offering training across various technologies. This is directed at IT companies, which can use this program to re-skill their employees, especially in emerging areas of digital technologies. Individual students can learn the full stack of digital technologies, with a view to enter the start-up world and also develop IPs. The first batch of 72 students was initiated in 2Q (average fees Rs.200,000 / student). Two new batches were started and have been over-subscribed by students already. NIIT TV is an initiative which is offering courses free of charge (as of now) on the net. It is an extension of the cloud-based training being currently offered to NIIT students. This initiative has increased visibility for NIIT and will help the company in moving ahead towards its target of skilling 10mn students over the next five years. During 3Q, NIIT has introduced CBSE Board Exam preparatory classes for Std 10th and 12th students. NIIT IFBI has also launched new programs during the quarter. CLS revenues (USD terms) grew strongly at 8% QoQ Revenues in the CLS business grew by 8 % on a QoQ basis in USD terms. On a YoY basis, the CC revenue growth was at 15%, which is impressive. Revenues were higher than estimates. Revenues rose as the contracts won in the past few quarters started scaling up at a rapid pace. The business has been scaling well, especially in the back-drop of good order wins by the company in Managed Training Solutions (MTS) business. Kotak Securities - Private Client Research Please see the disclaimer on the last page For Private Circulation 9

3 Managed Training Services has continued to be the growth driver for NIIT. Revenues from MTS formed 91% of CLS revenues in 3QFY16 as against 90% in 2Q and 89% in 1Q. After transferring the Element K business, the company has been left with about 1/3rd of the overall revenues in CLS. Of this, about 90% is contributed by Managed Training Services (MTS), which has been growing at a very fast pace. The business signed 1 new customer in 3Q, similar to 1Q and 2Q. NIIT is developing into a major player in the MTS business with 27 clients. Most of these are large corporations. We believe that, with the developed economies likely stabilizing, the opportunity is huge and demand may pick up over the next few quarters. The contribution of CLS to NIIT's EBIDTA was at about 76% in FY14 and 128% in FY15 (S&C reported negative EBIDTA) and is expected to remain significant at about 83% in FY17. Thus, CLS profitability will greatly influence NIIT's margins in the near term. We expect CLS profits to grow strongly in FY16 and FY17. NIIT is now turning its focus to the domestic markets and will be offering learning solutions to corporates in India, on a selective basis. Revenue break up (Rs mn) 3QFY16 2QFY16 3QFY15 Skills & Career Institutional Corporate Source: Company SLS (Institutional) SLS revenues were down on a YoY basis because of the discontinuance of 2 state Government projects of 698 schools in 1Q. The company had completed 2 school projects each in 1QFY16 and 4QFY15. These projects had covered 698 and 531 schools, respectively. The non-government schools business now contributes about 70% of SLS revenues (68% in 2Q). Within private schools, the company has stopped supplying hardware as a part of the overall project. Thus, pure IP-led private Schools business now form about 20% of the overall SLS revenues (26% in 2Q, though). The business added 38 non-government schools to take the total number to The company witnessed continuing momentum in IP based orders. N Guru, the company's offering in the private schools business is gaining increasing acceptance, as is reflected in the additional schools bookings. K-12 business hived off NIIT has hived off its K-12 learning business (Revenues of Rs.209mn) into a separate subsidiary named MindChampion Learning Systems Ltd. This separate subsidiary will invite strategic partners and chart its own independent growth path. We await further details on the same. However, we feel this is an emerging business with significant potential. Kotak Securities - Private Client Research Please see the disclaimer on the last page For Private Circulation 10

4 NIIT to participate in 'Skill India' initiative; finer details awaited NIIT has announced that, it will impart skill-based training to 10mn students in 16 different sectors over the next 5 years. These sectors are largely in the services arena though the company will also provide skills in manufacturing sectors at a later date. NIIT is clear that, it will be selective in choosing courses and will select only those courses wherein the working capital requirements are minimal. We are encouraged by this decision of the company. NIIT is already working with the Government on the Skills initiative. However, a significant scale up will be seen only over a period of time, we understand. We would like to get further details on the scale up plans of NIIT, funding commitments, profitability levels in this business, etc. The funding of courses will be important because the Government may not be able to fully or substantially fund these numbers. Thus, it remains to be seen as to how many students are able to fund their skill requirements. There may be initial headwinds which may restrict the pace of growth in this business and there may be a corresponding impact of the profitability levels of the business. We have assumed steady growth in the S&C business as well as improvement in margins in FY16 and FY17. Cloud expected to be a growth driver for S&C NIIT is now focusing on the Cloud Campus as the next growth area for this business. The company has invested significantly in building the Cloud infrastructure which had impacted margins during FY13. About 71% of the physical outlets (59% in 2Q) are now cloud-enables and so are 78% of the courses. (76% in 2Q). We expect this to be a driver of future revenue growth. We believe that, successful acceptance of this model can lead to faster roll-out of programs, wider reach of programs as well as better employee productivity, leading to higher revenues and margins. Margins rose YoY Headline margins for the quarter were higher by 392bps YoY to 6.2%. The main contributor was the S&C business where company reported marginal profits (0.6% margin) as compared to (-)13% margins in 3QFY15. S&C margins have shown YoY improvement for the second successive quarter and that is a positive. CLS maintained margins at about 11.7% QoQ. CLS had the tailwind of the depreciating rupee and that helped margins sustain on a YoY basis. NIIT has been reinvesting the benefits of the rupee, to improve growth rates. In fact, CLS margins have been stable for the past 8 quarters now. The rise in margins comes on the back of an improvement in profitability in 1Q and 2Q also. The company had initiated a restructuring exercise in 4QFY15 and had reorganized its business. This had a beneficial impact on profitability in 1QFY16. Consolidation, including capacity recalibration, had led to lower cost during the quarter. NIIT has reduced several of the low-margin owned centres as well as reduced number of business associates. It has also reduced geographical presence by shutting down smaller locations. Moreover, the company has also cut down on the number of courses offered from 200 to about 100. Kotak Securities - Private Client Research Please see the disclaimer on the last page For Private Circulation 11

5 Increased implementation of Cloud Campus also helped in restricting the impact on margins. The company has exited several geographies and is also rationalizing capacity to cut costs and improve profitability. The fixed cost base in 3QFY15 in this business was about Rs.550mn, which included people, facilities and marketing spends. NIIT has brought the same down by about Rs.60mn on a quarterly basis. With the cost rationalization exercise, NIIT was looking at annualized savings of about Rs.252mn over the next few quarters. The same was already achieved in 1Q. EBIDTA margins (%) 3QFY16 2QFY16 3QFY15 Skills & Career Institutional Corporate Source: Company Future prospects We have our tweaked our FY16 and FY17 earnings. We have built in an improved scenario for the S&C and CLS businesses (on assumption of improvement in developed economies) and have also assumed profitability improvement due to the cloud initiative. We expect the S&C business to report 1% growth in revenues in FY16 and a 6.5% growth in FY17. CLS revenues are expected to rise by 22% in FY16 and 18% in FY17. Revenue break up (Rs mn) FY15 FY16E FY17E Skills & Career Institutional Corporate Source: Company, Kotak Securities - Private Client research We have assumed margins to improve to 8% in FY16 and 9.4% in FY17. The cloud initiative is expected to help improve the S&C margins. Also, the recent restructuring initiatives like exit from various locations and rationalization of capacity should support margins. NIIT has achieved annualized savings of Rs.250mn from these initiatives. On the other hand, SLS margins are expected to rise on higher contribution of private schools and lower bought-outs. CLS should see margins improve due to higher proportion of MTS revenues. After accounting for its 24% share in NIIT Technologies' profits, we expect the net profit to be at Rs.1.18bn in FY17. EBIDTA margins (%) FY15 FY16E FY17E Skills & Career Institutional Corporate Source: Company, Kotak Securities - Private Client research Kotak Securities - Private Client Research Please see the disclaimer on the last page For Private Circulation 12

6 We recommend BUY on NIIT Ltd with a price target of Rs.92 Valuations and recommendation The performance in 9mFY16 inspires optimism. The initiatives taken by the new management have led to earlier-than-expected benefits on margins. We are optimistic about the growth in CLS as well as on the S&C business. While we have upgraded our estimates for the CLS and S&C businesses, we await more clarity on growth prospects and the corresponding profitability in the Skills business. At our TP of Rs.92, FY17E earnings will be discounted by 13x which, we feel, is reasonable. Post the sharp fall in price, we upgrade the stock to BUY (SELL, earlier). Concerns A slower-than-expected recovery in the global economy could impact revenue growth of NIIT. Steep rupee appreciation v/s major global currencies may impact the financials of NIIT. Kotak Securities - Private Client Research Please see the disclaimer on the last page For Private Circulation 13