Given strong near-term momentum in deal intake, revenue growth and margin expansion, we upgrade Mphasis to Hold from Reduce.
We met V. Suryanarayanan, CFO of Mphasis, for an update on the business. Commentary on business fundamentals was constructive across all dimensions of growth in the DXC and Direct Channel segments as well as for further expansion in margins. We would expect DXC and Direct Core segments to grow materially faster than the industry average in FY19 (11.5% and 14.3%, respectively) with Digital Risk revenues remaining in the quarterly range of $28 mn-$30 mn. USD revenues and INR Ebit are expected to increase by 12.2% and 20.5% in FY19. Given strong near-term momentum in deal intake, revenue growth and margin expansion, we upgrade Mphasis to Hold from Reduce.
However, we hold some concerns over the medium term, key amongst them being: (i) eventual loss of momentum at certain large BFSI clients where Mphasis has done well, but which have been challenging for other industry participants. Mphasis has significant client concentration with top 10 clients constituting 55% of revenues (up from 47-48% 2 to 3 years ago), (ii) continued drag on Digital Risk revenues despite recent large deal wins if residential mortgage volumes react further negatively to an increase in interest rates in the US. We are also surprised with the near doubling of hedges over the past 4-5 quarters which might seem as an attempt to support margins.
Structural growth opportunity in the DXC channel: Though Mphasis expects revenue growth in the DXC channel to just be in line with the industry in FY19 given that DXC may still be losing some market share on its own, we sense conservatism in the commentary and as such model a higher 11.5% USD revenue growth in FY19. Pipeline of deals within the DXC channel remains strong given the company’s differentiated positioning around service delivery transformation through cloud and automation.
Non – DXC entities (HPE, Micro Focus and HP Inc), which currently represent just 14% of overall HP/DXC revenues, can scale up meaningfully over a period of time as well given Mphasis’ strategic vendor status in all of these accounts. We believe leadership changes at both Mphasis and DXC have led to a meaningful improvement in relationship between the two entities relative to prior levels, which should help structural scaling up of revenues from the HP/DXC channel.
We expect revenues from the Direct Core segment to increase by 14.3% in FY19. New deal TCV in the Direct International segment has been $436mn in 9MFY18 and may be in excess of $100mn in Q4FY18 as well. Given that Mphasis sees structural opportunities in both DXC and Direct Core channels, backed by strong order execution, we upgrade the stock to Hold. We also expect Ebit margins to break out of the current target range of 14-16% in FY19.