52 Ambit Tehcnology Thematic 24Mar2014

Technology

March 24, 2014 Ambit Capital Pvt. Ltd. Page 2

CONTENTS The underbelly of Indian IT – the ugly, the bad and the not so good…………………...4

THE UGLY………………………………………………………………………………………. 6

Geodesic………………………………………………………………………………………… 7

Educomp………………………………………………………………………………………….9

Financial Technologies (FTech)………………………………………………………………11

THE BAD………………………………………………………………………………………. 13

Rolta……………………………………………………………………………………………..14

MCX…………………………………………………………………………………………….. 16

THE NOT SO GOOD………………………………………………………………………… 18

Tech Mahindra………………………………………………………………………………… 19

Infosys…………………………………………………………………………………………...22

KPIT Technologies…………………………………………………………………………….. 24

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital

may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

The underbelly of Indian IT

The Indian IT sector is oft praised for its good corporate governance and

accounting excellence. However, our history of covering the sector over

the last four years indicates that this blanket assumption is misleading.

We present case studies of companies (classified as ‘ugly’, ‘bad’ and ‘not

so good’) that underperform on accounting and corporate governance

standards. Whilst some of these companies (such as FTech, Educomp and

Geodesic) are already understood by the market for what they are,

others (such as Rolta, MCX, Infosys, Tech Mahindra and KPIT) are yet to

be discounted appropriately by investors.

Misconceptions about the quality of Indian IT sector

Five years since the Satyam fraud, the IT Index is up over 300%, implying that

the Indian IT sector is still assumed to be a safe haven of relatively cleaner

promoters, strong and neat accounts, and sound corporate governance

practices. However, our analysis and experience of the sector suggests this is

probably the easiest sector to fudge accounts, particularly given its largely

services-led nature and given that it relies on B2B transactions that do not lend

themselves to the sanity checks that one can do in industrial sectors.

Range of tricks to window-dress accounts

Indian IT firms have used a variety of tricks to window dress their accounts,

ranging from recognising cashless revenues (Geodesic), recognising seemingly

non-existent revenues (Geodesic, Rolta and MCX), accelerated revenue

recognition (Educomp), margin management (Geodesic, Rolta and KPIT

Technologies), inflated balance sheet (Rolta) to cash flow management (Rolta

and Geodesic). Furthermore, we also highlight how choice of accounting

policies can sugar-coat the accounts (Tech Mahindra and KPIT).

Not the cleanest on corporate governance either

Significant related party transactions at MCX (not appearing to be arm’s length),

the NSEL fiasco at FTech, questionably low independent director involvement at

TechM and Satyam when the merger ratio was finalised, relatively high

promoter Board representation and peculiar guidance pattern creating stock

price volatility at Infosys are some examples of corporate governance

loopholes. Furthermore, less-than-adequate disclosures at Tech Mahindra,

Educomp and seemingly weak risk management at MCX are also concerns.

Traces of suspicion in MCX and Rolta

Whilst cases such as Satyam (with its artificially inflated bank balances) can be

difficult to detect in advance, other cases such as Geodesic, Educomp and FTech

had similar financial characteristics, which could have been spotted by investors

who were willing to dig deep into their accounts. We find somewhat similar

issues in the annual reports of MCX and Rolta India.

On the other hand, Tech Mahindra, Infosys and KPIT present less than desirable

standards of accounting and corporate governance. For firms rated as richly as

these three, this should weigh on their valuation multiples.

We reiterate our SELL stance on Infosys and Tech Mahindra. We do not

cover the other IT companies mentioned in this note.

Technology

THEMATIC March 24, 2014

Case studies in this note

The ugly

Geodesic

Revenue and cash flow

manipulation; corporate

governance concerns

Educomp

Solutions Accounts window dressing

Financial

Technologies

Suspicious subsidiary accounts;

corporate governance concerns

The bad

Rolta India Tricky accounting practices

MCX Suspicious related party deals

and seemingly artificial volumes

The not so

good

Tech

Mahindra/

Satyam

Weaker disclosure norms;

accounting not up to

international standards; flags on

governance

Infosys Letting down its own

governance standards?

KPIT

Technologies

Magnified margins

Source: Ambit Capital research

Key Recommendations

HCL Tech BUY

Target Price:1,614 Upside :13%

TCS BUY

Target Price:2,351 Upside : 11%

Tech Mahindra SELL

Target Price:1,471 Downside : 19%

Infosys SELL

Target Price: 2,945 Downside : 11%

Analyst Details

Ankur Rudra, CFA

+91 22 3043 3211

[email protected]

Nitin Jain

+91 22 3043 3291

[email protected]

Technology


The underbelly of Indian IT

Five years on from the Satyam fraud, the Indian IT sector is still assumed to be a safe

haven of relatively clean promoters, strong accounting and sound corporate

governance practices. This has been historically reflected in the lower discount rates

applied to the sector, leading to higher P/E multiples.

However, our analysis and experience of the sector suggests this is probably one of

the easiest sectors to fudge accounts for three reasons: (1) its largely services-led

nature (i.e. there is no tangible output that can be observed), (2) it is centred around

B2B transactions that do not lend themselves to typical sanity checks that one can do

in industrial sectors (limited capability to do ground level surveys), and (3) there is a

declining linear relationship in this sector between revenues and headcount. (Given

that employee cost is the single-largest input cost, a declining correlation with

revenues offers greater scope for manipulation.)

Based on our observations over the past four years, we present case studies of eight

IT companies, highlighting their accounting and corporate governance issues and

challenging the notion that Indian IT firms have high-quality accounts and strong

corporate governance. This is not an exhaustive study and is based on the

standout cases we have come across. Other firms may have similar or even

greater issues. We classify the accounting and governance issues in this sector into

six broad categories:

1. Revenue manipulation: This can be done by either booking cashless revenues

(with a corresponding increase in receivables), fictitious revenue booking (through

classification of other income as revenues) or accelerated revenue booking

through creative accounting methods. We find evidences of revenue manipulation

by firms such as Geodesic, Rolta, Educomp and MCX.

2. Margin management: This can be done through capitalising expenditures,

lower provisioning for doubtful debts or through creative accounting (such as not

accounting for client re-imbursements in revenues and costs). Geodesic, Rolta

and KPIT seem to follow such practices.

3. Accounting method/system not comparable to peers: The most apt example

is Tech Mahindra. It uses Indian GAAP, whilst most of its peers have already

migrated to US GAAP/IFRS many years ago. Use of Indian GAAP allowed it to

adopt the ‘Pooling of interest’ method (that records all balance sheet items at

book value) for merger accounting of Satyam. The use of Indian GAAP has

helped it maintain high RoEs. Had the transaction been recorded under

internationally accepted ‘Purchase method’, the RoEs would have been

significantly lower. Our back-of-the-envelope calculations suggest that FY13

/FY14E RoE could have been 14.8%/18.4% under the purchase method (with

Goodwill recognition) vs the RoEs of 36.3%/33.3% under the currently followed

‘Pooling of interest’ method (see pages 19-20).

4. Balance sheet and cash flow management: This can be done by removing

the borrowings from the balance-sheet through a separate Special Purpose

Vehicle (SPV) and accelerating cash flow receipts through factoring using this SPV

(example – Educomp) or through the use of creative accounting (Rolta –

revaluation of land to offset additional depreciation charges).

5. Corporate misgovernance: This can be done through under-representation of

independent directors (Tech Mahindra and Satyam), higher promoter

dominance (Infosys), related party transactions which do not appear to be at

arm’s length prices (MCX and FTech), less-than-adequate risk control measures

(MCX) and a peculiar pattern of representing the future outlook to investors

(Infosys).

6. Weaker disclosure norms: Relatively weak financial and event disclosures lead

to investor decision-making based on inadequate information. Educomp, FTech

and Tech Mahindra appear to fall in this category.

Tech Mahindra’s RoE sensitivity to

IFRS accounting

` mn

Current

(Pooling of

interest

method)

Purchase

method

(estimated)

FY13 FY14E FY13 FY14E

Adjusted net

income 21,157 27,674 13,694 20,211

Adjusted Equity 68,530 97,484 99,168 120,659

Adjusted RoE 36.3% 33.3% 14.8% 18.4%

Source: Ambit Capital research

Technology


We present case studies on the following companies:

The Ugly

1. Geodesic: Are the revenues real?

2. Educomp Solutions: The accounts appear to be window dressed

3. Financial Technologies (FTech): Suspicious subsidiary accounts; corporate

governance concerns

The bad

4. Rolta India: Tricky accounting practices

5. MCX: Suspicious related party deals and seemingly artificial volumes

The not so good

6. Tech Mahindra/Satyam: Weaker disclosure norms; accounting not up to

international standards; flags on corporate governance

7. Infosys: Letting down its own governance standards?

8. KPIT Technologies: Magnified margins

Technology


Part 1: The Ugly

Geodesic

Are the revenues real?

Geodesic’s receivable days have increased to 300 days in FY12 (from 120 days in

FY12), whilst the doubtful debt provisioning has increased to 11.9% of debtors (9.8%

of revenues in FY12). Cash yields remain at astonishingly low levels. All these raise

concerns whether the earlier year’s revenues were indeed real. Cash conversion

though improved over the last three years, the increase in current liabilities has been

a significant factor pushing up the cash conversion.

Educomp Solutions

Accounts window dressing

Educomp’s creation of a special purpose vehicle to transfer its receivables and then

securitise it was an attempt to improve its cash conversion and make its balance

sheet look lighter. Its change in revenue recognition policy was also intriguing. These

coupled with instances of poor disclosures make it an interesting case study.

Financial Technologies (FTech)

Suspicious subsidiary accounts; corporate governance concerns

From a stockmarket darling, riding on success in MCX and similar expectations from

the other exchange ventures, Financial Technologies is now struggling to retain

ownership of these exchanges on the back of the NSEL fiasco, bringing down

expectations from its other exchange ventures. Besides the corporate governance

issues (for not curbing the illegitimate activities at NSEL), our analysis also indicates

suspicious manipulation of subsidiary accounts to present a better picture at

standalone business. FTech does not publish consolidated quarterly results (despite

~40% revenues from subsidiaries), and hence, presenting good-looking standalone

numbers makes sense.

Technology


Geodesic

Are the revenues real?

Geodesic offers an interesting case study that shows several signs of revenue and

cash conversion manipulations. With a glorious historical track record (104% FY04-09

revenue CAGR and ~55% EBITDA margins), Geodesic was viewed as an internet and

mobile software company with exciting B2C products in instant messaging, cheaper

SMS, VoIP calling, mobile TV and several products in a fast-growing market. Although

its products were exciting, most of them failed to get commercial scale before they

commoditised. The quality of revenue growth was always under question given

significantly higher receivable days and low yield on investments (indicating

possibilities of fictitious revenue booking).

Whilst this remained unnoticed till the time the company was growing in triple digits,

the problems intensified FY10 onwards, when the company’s revenues declined for

the first time in FY10, with a consequent decline in margins. Geodesic’s receivable

days have increased to 300 days in FY12 (from 120 days in FY12), whilst the doubtful

debt provisioning has increased to 11.9% of debtors (9.8% of revenues in FY12).

Cash yields remain at astonishingly low levels. All these raise concerns whether the

earlier year’s revenues were indeed real. Cash conversion, though improved over the

last three years, increase in current liabilities has been a significant factor pushing up

the cash conversion.

Geodesic unsurprisingly finds itself in a greater mess now, with its auditor (Borkar

and Muzumdar) raising qualifications on revenue and expense accounting, default on

FCCBs, and forex hedging losses. The company has not yet published the

consolidated FY13 accounts, is yet to pay the final dividend for FY12 and is

functioning with just three directors – all executive (all of the independent directors

have resigned). This reflects in the market capitalisation which is down from `6.9bn

at the beginning of 2009 to `284mn.

Cashless revenues

We find at least three evidences raising concerns on Geodesic’s revenue recognition:

1. High receivable days and increasing doubtful debt provisions: Although

revenue growth recovered in FY11 and FY12, it came on the back of significant

increase in receivable days (see Exhibit 1 below). Receivable days increased from

120 days in FY10 to 174 in FY11 and further to 300 in FY12. This, coupled with

high bad debt provisioning in FY12, raises concerns on the quality of revenues

booked in earlier years.

Exhibit 1: Suspicious revenue accounting

` mn FY08 FY09 FY10 FY11 FY12

Revenues 3,164 6,530 6,374 8,732 11,627

Revenue growth 92% 106% -2% 37% 33%

Receivable days 120 168 120 174 300

Bad debts (P&L) as % of debtors 0.2% 1.8% 0.2% 0.8% 11.9%

Bad debts (P&L) as % of revenues 0.1% 0.8% 0.1% 0.4% 9.8%

Source: Company, Ambit Capital research

2. Low yield on cash and cash equivalents: The average yield on cash and

investments was moderate 1.5% during FY10-12, which also raises concerns over

fictitious revenue booking (see Exhibit 2). The proportion of cash in the current

accounts was not material enough to result in such low yields.

Exhibit 2: Fictitious revenue booking?


Interest and dividend income 118 206 75 183 212

Average Cash and investments 3,898 6,862 7,991 10,878 12,163

Yield on average cash and investments 3.0% 3.0% 0.9% 1.7% 1.7%


Five-year share price

performance

Source: Bloomberg

Financials

` mn FY11 FY12 FY13*

Revenues 8,732 11,627 NA

PAT 2,737 2,600 NA

FCF 4,707 1,363 NA


Note: * FY13 annual report is not yet

published

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Technology


3. Revenue reversals and auditor qualifications: Furthermore, as disclosed by

the company in its filing to the BSE, auditors raised qualifications on ‘inability to

verify the correctness of write-off of `2,778mn on licence sales’. This also raises

suspicion on the quality of revenues booked in earlier years. The auditors also

raised qualifications on lower doubtful debt provisioning to the extent of

`3,675mn.

Playing with current liabilities to shield cash conversion?

Whilst Geodesic reported better cash conversion in FY10, thanks to a 48 day YoY

decline in receivable days, FY11 and FY12 were marked by an unusually high

contribution from the current liabilities to offset the impact of the increase in

receivable days.

Exhibit 3: Cash conversion improved but was driven by current liabilities


CFO/EBITDA 57% 31% 125% 134% 92%

CFO 1,172 1,122 4,188 5,413 3,893

CFO before working capital changes 1,978 3,601 3,531 4,294 4,115

Increase in debtors -413 -1,959 905 -2,074 -5,396

Change in loans and advances -584 -663 -727 1,344 -2,230

Change in current liabilities 264 290 563 1,956 9,696

Others -74 -149 -84 -107 -2,292


Underestimation of expenses

Besides lower provisioning of expenses, as discussed above, auditors also raised

concerns over ‘correctness of write-back of `4,370mn in respect of software licence

returned to the supplier’. Furthermore, auditors also qualified on ‘non-provisioning

for depletion of the company’s investment in Geodesic Technologies Solutions Limited

(GTSL) amounting to `616mn.’

Corporate governance concerns

1. Lack of Board independence: Whilst Geodesic had more than 50%

independent directors on the board as on March 2012, all these independent

directors have resigned since then and the Board now comprises just three

directors, all of them executive. Departure of all the independent directors and

inability of the company to bring in new independent directors to replace them

further accentuates our concerns.

2. Non-payment of dividends: Furthermore, despite the cash crunch arising from

FCCB maturity in FY13, Geodesic proposed a dividend of `2/share in 2012,

which still remains unpaid.

Technology


Educomp Solutions

Accounts window-dressing

Educomp’s creation of a special purpose vehicle to transfer its receivables and then

securitise it was an attempt to improve its cash conversion and make its balance

sheet look lighter. Its revenue change in revenue recognition policy was also

intriguing. These coupled with instances of poor disclosures make it an interesting

case study.

SPV structure allowed accelerated revenues, better CFO and lower leverage

In FY10, Educomp changed its revenue recognition policy for the Smart_Class

business. It created an SPV (named Edu Smart) for this purpose. It created a model

whereby the Smart_Class receivables were securitised through Edu Smart. Rather

than following the earlier BOOT (Build, Own, Operate and Transfer) model, Educomp

sold the hardware and content as a package to Edu Smart (whom it called “a third

party vendor”), which then securitised the receivables with banks. This securitisation

process helped Educomp to window dress its accounts in three ways:

1. Accelerated revenue recognition: In the earlier BOOT model, Educomp

recognised contract revenues over a five-year period (i.e. only 20% of TCV was

recognised in any quarter). However, under the new securitisation model,

Educomp booked 75% of revenues for the total signed classrooms during the

quarter in two tranches, whilst 25% was passed on to the vendor (Edu Smart).

Out of the 75% revenues, 52.5% was recognised upfront during the particular

quarter whilst 22.5% was booked in the successive year same quarter. Since

Educomp had an economic obligation to provide content updates, Educomp

decided to recognise the content revenues over a two-year period. This

accelerated the revenue recognition as well as profitability.

2. Cash flow from securitisation boosted Educomp’s cash flows: Whilst the

proceeds from securitisation are ideally in the nature of borrowing, the SPV

structure allowed Educomp to account it as “cash flow from operations”. This

artificially improved Educomp’s cash conversion ratio.

3. Off balance sheet liabilities: The structure allowed recognition of liabilities on

the SPV’s balance sheet. However, Educomp had given corporate guarantees for

Edu Smart’s securitisation arrangement. (Given that Edu Smart was a new entity,

it would have been difficult for it to raise funds on its own.) This made it liable to

banks in the event of default by Edu Smart or any breach in the securitisation

covenants. However, the SPV structure allowed Educomp to keep its balance

sheet light, so that it can raise funds for its evolving K-12 business.

In FY10, Educomp disclosed “Corporate guarantee to banks for secured loans

to third party” of `6,650mn in the notes to accounts of the Annual Report. A

cross check with Edu Smart’s return filing at the Ministry of Corporate Affairs

(MCA) confirms that this was the guarantee given by Educomp to Edu Smart.

Through the SPV structure, Educomp managed to under-report the leverage

(Debt/Equity) by 39%. The actual reported leverage was 0.64x, whilst the

“real” leverage accounting for the liabilities on SPV’s balance sheet would

have been 1.04x. The extent of contingent liabilities and true leverage kept

rising significantly till this SPV was made redundant in FY13.

However, in the 3QFY13 results, the management announced the move back to the

BOOT model, feeling pressure from the institutional shareholders.


performance

Source: Bloomberg

Financials

` mn FY11 FY12 FY13

Revenues 13,509 14,913 12,109

PAT 3,354 1,355 -1,328

FCF -5,267 -2,281 -3,585


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Technology


Less-than-ideal disclosures

We also observed some disclosure lapses by Educomp, worth highlighting:

1. Promoter allotted warrants: Educomp increased the stake in Educomp

Infrastructure and School Management Ltd (EISML) from 69.4% to 78.2% at

`4.89bn in 2009. This gave EISML an implied valuation of `16.42bn. However,

the promoter (MD of Educomp) was awarded 800K warrants at the same

valuation as Educomp, over six months after Educomp’s equity infusion according

to filings to the Ministry of Corporate Affairs. We find the lack of disclosure on this

front unsettling although we recognise that the law might not require Educomp to

make such a disclosure.

2. Undisclosed JV with an existing school: Educomp established a JV with an

existing school called the Ambika Modern School in Jalandhar that has been

rebranded as Millennium Jalandhar. We find it intriguing that the management

did not disclose this explicitly.

Technology


Financial Technologies (FTech)

Suspicious subsidiary accounts; corporate governance

concerns

From a stockmarket darling, riding on the success in MCX and similar expectations

from the other exchange ventures, Financial Technologies is now struggling to retain

ownership of these exchanges on the back of the NSEL fiasco, bringing down

expectations from its other exchange ventures. Besides the corporate governance

issues (for not curbing the illegitimate activities at NSEL), our analysis also indicates

suspicious manipulation of subsidiary accounts to present a better picture at the

standalone business. FTech does not publish consolidated quarterly results (despite

~40% revenues from subsidiaries), and hence presenting good-looking standalone

numbers makes sense.

Significant related party transactions – standalone numbers appear

artificially attractive

FTech derives more that 40% of its revenue from subsidiaries (its investments in

several exchanges and related businesses), which make them an important part of

the overall financials. We have observed that FTech has allocated a higher proportion

of its expenses to subsidiaries. For example, it allocates all the advertisement and

promotion expenses and more than half of its ‘other expenses’ to subsidiaries. Given

that FTech reports only standalone results in its quarterly filing (despite subsidiaries

accounting for >40% of revenue), charging of significantly higher expenses to

subsidiaries raise concerns on accounting manipulations in company financials,

making the standalone financials look better.

Exhibit 4: Consolidated vs standalone

` mn FY10 FY11 FY12 FY13

Revenue

Consolidated (a) 3,292 4,079 5,012 7,519

Standalone (b) 3,286 3,577 4,255 4,509

a - b 6 502 757 3,010

Add: Sales by Standalone to Subsidiaries 1,519 1,434 1,785 1,176

Estimated Subsidiary revenue 1,525 1,936 2,542 4,186

Employee benefit expenses

Consolidated (a) 2,151 2,638 2,469 2,501

Standalone (b) 900 1,154 1,125 1,241

% of Standalone revenue 27% 32% 26% 28%

a - b 1,251 1,484 1,344 1,260

% of Subsidiary revenue 82% 77% 53% 30%

Other expenses

Consolidated (a) 2,430 2,572 2,607 3,053

Standalone (b) 1,004 1,089 1,019 651


a - b 1,425 1,484 1,588 2,402


Advertisement and business promotion expenses

Consolidated (a) 129 204 319 337

Standalone (b) 0 0 0 0


a - b 129 204 319 337


PAT

Consolidated (a) 1,401 -1,368 2,641 2,274

Standalone (b) 3,444 919 4,780 3,229

a - b -2,043 -2,287 -2,140 -954



performance

Source: Bloomberg

Financials

` mn FY11 FY12 FY13

Revenues 4,079 5,012 7,519

PAT -1,368 2,641 2,274

FCF -5,371 2,107 756


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Technology


NSEL fiasco – Corporate governance issue

National Spot Exchange (100% subsidiary of FTech) was promoted as a delivery

based market place for the purchase and sale of commodities. However, as it

eventually turned out, NSEL became an unregulated repo market for agricultural

commodities as collateral1

. Contracts were rolled over without mark to market (MTM)

adjustments, there was no physical transfer of commodities (indeed the underlying

commodities and warehouses did not exist in many cases) and there were also short

selling. The pair trades in various commodities were offered in forward contracts of

T+2 to T+25 (sometimes even T + 35) payment terms (bought and sold at the same

time), whilst the maximum allowed settlement period was T+11. Such pair trades

offered an arbitrage opportunity of about 12-15% return per annum.

The Ministry of Corporate Affairs took exception to this and appointed the Forward

Market Commission (FMC) to investigate. The Minister for Consumer Affairs, KV

Thomas, and the FMC sent a circular to NSEL to stop launching new forward

contracts and make deliveries on existing contracts to curb speculation2

. Given that

delivery never happened in the earlier scheme of things, sudden termination of

contracts in the absence of collaterals led to defaults by the borrowers.

The company is now looking to sell some of its assets. For example, Financial

Technologies sold its stake in Singapore Mercantile Exchange to the Singapore unit of

Intercontinental Exchange Group for US$150mn in November 2013. It also sold its

warehousing subsidiary (National Bulk Housing Corp) for ~US$40mn3

.

Financial Technologies now struggles to maintain ownership of its most profitable

venture, MCX and its other Indian exchange holdings such as MCX-SX, given

questions raised by regulators – SEBI (regulating stock exchanges) and FMC

(regulating commodity exchanges) – over its ‘fit and proper’ status to be a

shareholder in commodity and stock exchanges4

5

.

1

http://articles.economictimes.indiatimes.com/2013-0802/news/41008403 _1_national -spot exchange -

nsel-contracts

2 http://www.livemint.com/Money/N0hCBdRIbDKuOcD4o4ZW6M/NSEL-suspends-trading-of-all-contracts-

except-eSeries.html

3 http://www.moneycontrol.com/news/business/ftil-sells-nbhc-for-rs-242-crore_1054257.html

4 http://www.business-standard.com/article/markets/all-eyes-on-sebi-after-fmc-s-decision-on-ft-

113121800892_1.html

5 http://www.moneylife.in/article/sebi-rules-fintech-not-fit-and-proper-to-hold-stake-in-any-stock-

exchange/36774.html

Technology


Part 2: The Bad

Rolta India

Tricky accounting practices

An analysis of the financial statements of Rolta India indicates a couple of grey areas.

Its recent revaluation of land just coinciding with the change in depreciation policy (to

bring the depreciation rates to the industry norms) seems to be an accounting trick to

manage the net worth, whilst at the same time not hurting the future profitability (as

land is not subject to depreciation). Rolta’s capital employed turnover has also been

quite low (0.5x on an average over FY11-13). A deeper look indicates that despite

moderate revenue growth (6% USD revenue CAGR over FY10-13), the capital

expenditure has remained surprisingly high (average 46% of revenues over FY11-13).

This creates suspicion on expense manipulation (through capitalisation).

Furthermore, Rolta has an uneven accounting history with the SEBI probe on over-

reporting of revenues through booking of inter-divisional transfer of self-

assembled/integrated’ capital equipment as sales. Though Rolta has abandoned this

practice post the SEBI order in 2004, the other observations raise concerns on the

sanity of accounting practices.

Multi Commodity Exchange (MCX)

Suspicious related party deals and seemingly artificial volumes

Whilst MCX has been a success story and the only publicly listed commodity bourse in

India with ~77% market share, it does not have a clean accounting and operational

track record. The reported volumes seem to be overstated (evident from unnaturally

higher Average Daily Volume to Open Interest ratio), whilst transactions with

promoter entity do not seem to be at arm’s length. Lower margin to open interest

also reflect imprudent risk control, presumably in pursuit of higher volumes.

Technology


Rolta India

Tricky accounting practices

An analysis of the financial statements of Rolta India indicates a couple of grey areas.

Its recent revaluation of land just coinciding with the change in depreciation policy (to

bring the depreciation rates to the industry norms) seems to be an accounting trick to

manage the net worth, whilst at the same time not hurting the future profitability (as

land is not subject to depreciation). Rolta’s capital employed turnover has also been

quite low (0.5x on an average over FY11-13). A deeper look indicates that despite

moderate revenue growth (6% USD revenue CAGR over FY10-13), the capital

expenditure has remained surprisingly high (average 46% of revenues over FY11-13).

This creates suspicion on expense manipulation (through capitalisation).

Furthermore, Rolta has an uneven accounting history with the SEBI probe on over-

reporting of revenues through booking of inter-divisional transfer of ‘self-

assembled/integrated’ capital equipment as sales. Though Rolta has abandoned this

practice post the SEBI order in 2004, the other observations raise concerns on sanity

of accounting practices.

Accounting gimmicks to protect net worth

During the fourth quarter of FY13, Rolta changed its depreciation policy (by reducing

the estimated useful life of the assets) and at the same time re-valued land on the

balance sheet.

The management highlighted that “as a matter of prudence and to align depreciation

policy with the current replacement cycle taking into consideration various factors

such as technology up-gradation and industry best practices, the Company has

revised estimated useful life of all assets”. Consequently, Rolta India reduced the

estimated useful life of Computer Systems to 2-6 years against 4-10 years earlier,

Other Equipment at 10 years against 20 years earlier, Furniture & Fixtures at 10

years against 15 years earlier and Vehicles at 5 years against 10 years earlier.

Consequent to the above, it booked an additional charge for depreciation during the

quarter, amounting to `11,537mn as an exceptional item. Interestingly, the

management simultaneously revalued the freehold and leasehold land during the

quarter, booking the revaluation gains of `10,571mn directly in the reserves, with an

eventual impact of just `966mn on the net worth.

Had the company not revalued land, the depreciation estimate revision could have

eroded the net worth by 57%. Given ~2x Debt/Equity ratio, 57% erosion in net worth

could have a serious implication on Rolta, both in terms of re-financing the existing

debt at the same or better borrowing cost as well as raising additional funds. More

importantly, revaluation of land will also not impact the future profits and land is not

subject to depreciation. This clearly seems to be an accounting trick to manage

the net worth without hurting the future profitability at the same time.

Low capital employed turnover and high capitalisation raise concerns over

expense manipulation

Rolta’s asset turnover (sales/average capital employed) has been significantly below

the peer average over the last three years (0.5x vs tier-2 peer average of 1.6x). A

deeper look into the causes shows that capitalisation as a percentage of revenues has

been extraordinarily high (~46% on an average over FY11-13 vs tier-2 peers’

average of 6%). More surprisingly, this comes at a time when Rolta’s revenues have

grown at a moderate 12.3% CAGR over FY10-13 (6.6% in USD terms).

Given such a moderate growth rate, disproportionately high levels of capex

create suspicion regarding expense manipulation (through capitalisation).


performance

Source: Bloomberg

Financials

` mn FY11 FY12 FY13

Revenues 18,056 18,288 21,788

PAT 3,519 -959 -8,674

FCF -1,345 -4,418 -4,696

Capex -8,393 -13,932 -16,069


20

70

120

170

220

270

10,000

15,000

20,000

25,000

Mar-

09

Jun-

10

Aug-

11

Nov-

12

Jan-

14

Sensex Rolta

Technology


Exhibit 5: Low asset turnover coupled with high capitalisation raises concerns on expense manipulation

Company\Metric

Asset turnover

(sales/average net capital

employed)

Capitalised R&D (mentioned by

company) as % of revenue

Intangibles (Ex Goodwill) addition

as % of revenue Overall capex as % of revenues

FY11 FY12 FY13 Average FY11 FY12 FY13 Average FY11 FY12 FY13 Average FY11 FY12 FY13 Average

Rolta 0.6 0.5 0.4 0.5 2.7% 4.0% 5.4% 4.0% 9.7% 8.3% 4.3% 7.4% 18.7% 49.4% 68.9% 45.7%

Tier 2 peers

eClerx 1.6 1.6 1.7 1.6 NA NA NA NA 0.7% 0.3% 0.5% 0.5% 7.0% 5.3% 16.4% 9.6%

Persistent Systems 1.1 1.3 1.3 1.2 0.1% 0.1% 0.0% 0.1% 6.9% 4.1% 2.7% 4.6% 12.5% 15.1% 8.8% 12.1%

Hexaware 1.1 1.5 1.7 1.4 NA NA NA NA 0.2% 0.2% 0.4% 0.3% 3.2% 4.4% 3.8% 3.8%

Infotech Enterprises 1.2 1.4 1.5 1.3 NA NA NA NA 0.4% 1.1% 1.7% 1.1% 9.0% 5.3% 4.9% 6.4%

KPIT 1.6 1.7 1.9 1.7 1.5% NA NA 1.5% 2.5% 1.2% 0.8% 1.5% 4.3% 4.1% 3.1% 3.8%

NIIT Tech 1.8 1.8 1.9 1.8 NA NA NA NA 0.7% 1.1% 1.5% 1.1% 4.1% 5.9% 4.6% 4.9%

Mindtree 2.0 2.1 2.0 2.1 NA NA NA NA 0.4% 0.0% 0.0% 0.1% 5.6% 2.5% 4.5% 4.2%

Polaris 1.7 1.7 1.6 1.7 NA NA NA NA 0.4% 0.3% 0.5% 0.4% 7.1% 7.2% 2.5% 5.6%

Tech Mahindra 1.0 1.0 1.1 1.0 NA NA NA NA 0.0% 0.3% 1.0% 0.4% 3.0% 5.4% 2.6% 3.7%

Tier 2 peers’ average 1.5 1.6 1.6 1.6 0.8% 0.1% 0.0% 0.8% 1.3% 1.0% 1.0% 1.1% 6.2% 6.1% 5.7% 6.0%


Uneven accounting history - Inter-divisional transfers booked as revenues!

Rolta followed a practice of booking the ‘self-assembled/integrated’ capital

equipment transfer (including the fixed assets and estimated labour and overhead

costs) from its CAD/CAM division to internet and export divisions as revenues from

1996-2003. It booked the cost of these assets as expenses and then capitalised the

overall cost of the capital equipment. Whilst this did not impact the bottom-line of the

company, the revenues were overstated to the extent of these transfers. Furthermore,

~50% of these ‘capital equipment’ costs comprised overheads which were based on

management certification rather than an external audit. This left scope for significant

revenue manipulation.

Rolta was following this accounting practice for seven years (since 1996) and had

claimed that given the accounting treatment is EPS neutral, it should not impact

investor decision-making. However, post the SEBI order in July 20046

, Rolta India

abandoned reporting these inter-divisional capital equipment transfers as sales.

6

http://www.sebi.gov.in/cmorder/roltaorder.html

Technology


Multi Commodity Exchange (MCX)

Suspicious related party deals and seemingly artificial

volumes

Whilst MCX has been a success story and the only publicly listed commodity bourse in

India with ~77% market share, it does not have clean accounting and operational

track record. The reported volumes seem to be overstated (evident from unnaturally

higher Average Daily Volume to Open Interest ratio), whilst transactions with

promoter entity do not seem to be at arm’s length. Lower margin to open interest

also reflect imprudent risk control, presumably in pursuit of higher volumes.

Creating volumes in thin air?

The ratio of Average Daily Volume traded (ADV) to Open Interest (OI or the positions

kept open overnight) is often used to measure market depth. Given below is the

comparison of ADV (average daily volume) to OI (Open Interest) for the past three

years for Futures contracts on MCX as compared to NCDEX, CME and NSE Nifty

Futures (see Exhibit 6). This is the best measure of depth and hedging interest in an

exchange and separates speculative/artificial volumes from sustainable volumes

(lower the better). MCX’s ADV/OI has historically been significantly higher that of

NCDEX, NSE and CME.

Exhibit 6: Ratio of ADV to Open Interest

2011 2012 2013 Jan-14 Feb-14

MCX 7.48 4.79 4.13 3.65 3.29

NCDEX 3.78 1.49 0.84 0.81 0.64

NSE 1.17 1.56 1.37 1.63 1.47

CME 0.44 0.40 0.39 0.35 NA

CME - Metals and Energy 0.13 0.12 0.13 0.13 NA

Source: Company, Bloomberg, FMC, Ambit Capital research

Besides this, certain media reports7

also claim that a special audit report by PwC has

found the “Indian Bullion Markets Association, a firm related to MCX, indulged in

volume rigging on the commodity exchange”. The report claims the value of the

transactions to be `400bn. This corroborates our analysis of significantly higher ADV

to OI as compared to other exchanges.

Related party transactions – are these at arm’s length?

FT, the promoter entity of MCX, provides it the software and business support

technology. MCX’s technology charges (as a percentage of revenues) appear to be

too high relative to the other global bourses, which raises concerns whether these

technology service payments are at arm’s length.

Exhibit 7: Comparison of technology charges

As % of revenues FY10 FY11 FY12 FY13 FY14

MCX 20% 21% 16% 18% NA

CME 5% 4% 4% 5% 5%

SGX 8% 10% 10% 9% NA

ICE 4% 4% 4% 3% NA

Hong Kong Exchange 4% 4% 4% 5% 7%

Bursa Malaysia 5% 5% 7% 8% 8%


7

http://www.moneycontrol.com/news/business/pwc-audit-finds-ibma-rigged-

tradesmcx-sources_1046667.html


performance

Source: Bloomberg

Financials

` mn FY11 FY12 FY13

Revenues 3,689 5,451 5,240

PAT 1,763 2,867 2,992

FCF 2,387 3,305 68


0

500

1000

1500

2000

10,000

15,000

20,000

25,000

Mar-12 Dec-12 Oct-13

Sensex MCX

Technology


Indeed, according to media reports8

, interim findings of a special audit by PwC flag

several related issues regarding related party transactions:

1. “No documented policy was in place for buying services from group firms and

related parties, while certain contracts with the parent company Financial

Technologies were not discussed and approved in the exchange board

and directors' committee”.

2. MCX paid a mark-up of up to 32% on procurement of hardware by FTIL

and signed contracts with it that had "unprecedented long tenure" of 33-50 years

with a provision of automatic renewal for another 33 years.

3. Several other suspicious transactions have been highlighted in the report. (Click

here for the news release disclosing these transactions.)

Although these revelations are still preliminary and not publicly available, our

analysis of astonishingly high technology charges to FT certainly raises concerns.

Declining margins – Are the default risks managed well?

MCX collects margins from its members to deal with price volatility. This reduces

systemic risk of defaults in periods of high volatility. The growth in MCX's Open

Interest and Margin Money (as reported on the Balance Sheet) is shown in Exhibit 8

below. The percentage of margin money has declined from 12.7% in FY08 to 2.2% in

FY13. This indicates either of the below three possibilities:

1. The exchange is collecting lower margins per contract than before that indicates

rising systemic risk from defaults in case of high price volatility.

2. Increasing trades by some members that do not stump up margins.

3. Possibility of accepting off balance sheet collateral or assets in lieu of margin such

as liens on FDs or liquid investments. This still may not make such a big shortfall.

Moreover, brokers may accept this and this does not seem prudent practice for an

exchange.

Exhibit 8: Declining margin of safety

In ` mn Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13

Margin money disclosed in current liabilities 3,205 5,449 4,082 5,283 6,096 4,324

Total Open Interest Amount 28,780 50,562 74,017 138,430 155,868 192,935

Margin to OI 12.7% 10.8% 5.5% 3.8% 3.9% 2.2%

Source: Company, FMC, Ambit Capital research

8

http://articles.economictimes.indiatimes.com/2014-0224/news/47635734_1_

shreekant -javalgekar- year-mcx-ftil-group

Technology


Part 3: The not so good

Tech Mahindra

Weaker disclosure norms; accounting not up to international standards; flags

on governance

Whilst many see Tech Mahindra as the next tier-1 Indian IT service company, its

quality of disclosure lags that of other tier-2 companies such as Mindtree. TechM

does not publish quarterly cash flow and balance sheet statements and it provides no

service-line break-up.

Secondly, whilst all the tier-1 firms publish IFRS financial statements, along with the

Indian GAAP accounts (with the exception of HCL Tech that reports under US GAAP),

Tech Mahindra reports financials only under Indian GAAP. This makes comparisons

with peers less meaningful due to differences in accounting methods.

Finally, lack of adequate independent director representation on the Satyam Board at

the time when the swap ratio between Satyam and TechM was finalised raises

concerns on corporate governance.

Infosys

Letting down its own governance standards?

Ever since its IPO in 1993, Infosys has been regarded as a paradigm of corporate

governance in India. Whilst this image earned Infosys goodwill from investors, clients

and employees, there are signs that these high corporate governance standards are

fraying. NRN Murthy’s entry into Infosys in an executive capacity (even after Infosys’

well-articulated policy of executives retiring at the age of 60), bringing with him his

son as executive assistant, higher promoter representation at the Board and peculiar

guidance pattern resulting in high volatility in the share price – none of this gels with

Infosys’ image of a leader when it comes to corporate governance.

KPIT Technologies

Magnified margins

KPIT Technologies’ margins appear to be overstated given the accounting policies

and estimates that are different from its peers. Its accounting policy of excluding re-

imbursements both from income and cost (contrary to accounting policy followed by

companies such as Infosys, TCS and Persistent Systems) benefits its margins by

~50bps according to our calculations. Furthermore, its actuarial assumption of salary

increase for retirement benefit obligations is significantly below that of peers (5% vs

peer average of 7%).

Technology


Tech Mahindra

Weaker disclosure norms; accounting not up to

international standards; flags on governance

Whilst many claim Tech Mahindra is the next tier-1 Indian IT services company, its

quality of disclosure still lags that of several tier-2 companies such as Mindtree.

TechM does not publish quarterly cash flow and balance sheet statements and it

provides no service-line break-up. Secondly, whilst all the tier-1 firms publish IFRS

financial statements, along with the Indian GAAP accounts (with the exception of HCL

Tech that reports under US GAAP), Tech Mahindra reports financials only under

Indian GAAP. This makes the comparison less meaningful due to differences in

accounting methods. Finally, lack of adequate independent director representation

on the Satyam Board at the time when the merger swap ratio with TechM was

finalised raises concerns on corporate governance.

Weaker disclosure norms

Tech Mahindra’s disclosures (in the quarterly financials) still lag that of tier-1 Indian

firms and even the tier-2 firms such as Mindtree and Persistent Systems. Tech

Mahindra does not report the quarterly balance sheet and cash flow statements.

Given cash flow (and working capital intensity) is the most widely tracked metric for

an IT service company, this creates information asymmetry. Furthermore, absence of

a service-line breakup makes the analysis of underlying revenue growth drivers

difficult.

Cash flow and cash conversion are amongst the most keenly tracked financial metrics

for IT companies. Non-reporting of quarterly balance sheet and cash-flow statements

makes this analysis very difficult. Our back calculation of cash flow from operations

using changes in net debt, capex and other expenses indicate that cash conversion

has remained weak for Tech Mahindra in 9MFY14 (even weaker than 57% cash

conversion in FY13).

Furthermore, there was no satisfactory explanation for the US$22mn stamp duty

payment for the Tech Mahindra and Satyam merger by the company management. It

was neither mentioned in the notes to the accounts although we understand that this

payment was made during 3QFY14.

Exhibit 9: Unexplained weakness in cash conversion*

` mn FY13 1QFY14 2QFY14 3QFY14 9MFY14

Net debt 24993 29,081 29,376 31,177 31,177

Net change in cash

4,088 295 1,801 6,184

Capex

2333 1497 1316 5,146

Adjustment for stamp duty payment (US$22mn)

0 0 1320 1,320

Adjustment for final dividend (incl dividend tax) for FY13

(assumed to be paid in 2QFY14) 0 750 0 750

CFO 16382 6,421 2,542 4,437 13,400

EBITDA (Adjusted for BT deferred revenues) 28627 8092 10557 10810 29,459

Revenues (Adjusted for BT deferred revenues) 141315 40479 47162 48432 136,073

CFO/EBITDA 57% 79% 24% 41% 45%

CFO/Revenues 12% 16% 5% 9% 10%

Receivable days 96 97 102 100 100

Source: Company, Ambit Capital research *Our estimates as company does not disclose quarterly cashflow statement

Accounting systems though legitimate, not comparable with tier-1 peers

Whilst all the tier-1 firms publish IFRS financial statements, along with the Indian

GAAP accounts (with the exception of HCL Tech that reports under US GAAP), Tech

Mahindra reports financials only under Indian GAAP. This makes an apple-to-apple

comparison difficult, particularly in the areas where Indian GAAP provisions differ

significantly with those of international accounting standards.


performance

Source: Bloomberg

Financials

` mn FY11 FY12 FY13

Revenues 102,852 117,024 143,320

PAT 5,965 18,431 19,556

FCF -121 2,474 6,132


200

700

1200

1700

10,000

15,000

20,000

25,000

Mar-

09

Jun-

10

Aug-

11

Nov-

12

Jan-

14

Sensex Tech Mahindra

Technology


One such area of difference is merger accounting. Indian GAAP allows the use of

two methods for merger accounting:

1. Pooling of interest method: In this method no goodwill is recognised and all

the assets and liabilities are accounted at book value. The applicability criteria

are: (a) all assets and liabilities should be transferred, (b) the consideration

should be through share swap, and (c) at least 90% of the shareholders of the

‘acquired company’ should become the shareholders of the acquirer.

2. Purchase method: If the merger fails the conditions for ‘Pooling of interest’

method, ‘Purchase method’ applies. Here, the assets and liabilities are recorded

at fair value and hence goodwill is recognised.

On the other hand, US GAAP and IFRS prohibit the use of ‘Pooling of interest’

method. Hence in the event of a merger, the merged entity needs to account for all

the assets and liabilities at ‘fair value’. Consequently, goodwill is recognised in

mergers in US GAAP and IFRS.

The method of accounting for merger has a significant bearing on the RoE post-merger.

If the assets and liabilities of the ‘acquired company’ are accounted at ‘fair value’

(‘Purchase method’ - the general internationally accepted norm) and the consideration

is greater than the book value, a goodwill is recognised (which is then amortised over

five years unless a longer period is justified) that inflates the ‘equity base’ and

eventually results in relatively lower RoE for the merged entity. Indeed, in layman’s

language, the goodwill is effectively written-off against equity in the ‘Pooling

of the interest’ method, whilst it is routed through P&L in ‘Purchase method’.

Given the Satyam merger met the ‘Pooling of interest’ method’s criteria under Indian

GAAP, Tech Mahindra recorded the merger under ‘Pooling of interest’ method. The

use of Indian GAAP has helped it maintain high RoEs. Had the transaction

been recorded under the internationally accepted ‘Purchase method’, the

RoEs would have been significantly lower. Our back-of-the-envelope

calculations suggest that FY13/FY14E RoE could have been 14.8%/18.4% under

the purchase method (with Goodwill recognition) vs the estimated RoEs of

36.3%/33.3% under the currently followed ‘Pooling of interest’ method (see

Exhibit 10 below).

Exhibit 10: RoEs could be significantly lower under the ‘purchase’ method of merger accounting

In ` mn

Pooling of interest method

(currently followed by TechM) Purchase method (estimated)

FY12 FY13 FY14E FY12 FY13 FY14E

Adjusted net income 18,062 21,157 27,674 18,062 21,157 27,674

Goodwill amortization 0 0 0 -11,306 -11,306 -11,306

Tax benefit on above (@33.99%) 0 0 0 3,843 3,843 3,843

Proforma net income 18,062 21,157 27,674 10,599 13,694 20,211

Equity at TechM's share price as on the appointed dated of merger* 48,158 68,530 97,484 86,259 99,168 120,659

RoE

36.3% 33.3%

14.8% 18.4%

Source: Ambit Capital research; Note: * Appointed date of the merger was 1 April 2011

Please reach out to us for greater details on the calculations and underlying

assumptions.

Questionable attendance on Satyam’s Board whilst deciding the merger ratio

From 19 September 2011 to 23 January 2012, the Board comprised less than 50% of

independent directors. This was the period when Satyam’s merger ratio was decided

(announced in March 2012). Also, the merger ratio was announced shortly after two

new independent directors (Mr Ashok Kacker and M Rajyalakshmi Rao) were

appointed (Jan and Feb 2012) who presumably had limited understanding of the firm

to push for a fairer ratio for minority shareholders. The swap ratio seems relatively

unfair to Satyam’s minority shareholders. Although there have been departures in

independent directors, board meeting attendance has been appalling, particularly in

Technology


FY11 and FY12, which was also the period when the merger ratio was accepted by

the board.

Exhibit 11: Satyam – independent directors’ poor attendance track-record during the

time merger ratio was finalised

Name/Attendance FY10 FY10 FY11 FY12

Deepak Parekh (Independent) 12/13 5/10

Keeran Karnik (Independent) 13/13 7/10

Vineet Nayyar 5/10 6/6 8/8

CP Gurnani 3/10 6/6 7/8

C Achuthan (Independent) 13/13 9/10 4/6 1/8

Tarun Das (Independent) 10/13 5/10

TN Mahoharan (Independent) 11/13 8/10 6/6 6/8

SB Mainak (Independent) 12/13 7/10

M Damodaran (Independent) 1/10 2/6 4/8

Ashok Kacker (Independent) 1/8

M Rajyalakshmi Rao (Independent) 1/8

Sanjay Kalra 5/10 3/6

Gautam S Kaji (Independent) 1/6

Ulhas N Yargop 5/10 6/6 5/8

Ravindra Kulkarni (Independent) NA

Source: Company, Ambit Capital research Note: Independent directors in Grey shade

Similarly, the independent directors’ participation in the Board meetings was not

particularly strong at the time Tech Mahindra was bidding for Satyam in FY09-10 (see

Exhibit 12 below).

Exhibit 12: Tech Mahindra –independent directors’ poor attendance track-record at

the time of bidding for Satyam

Name/Attendance FY09 FY10

Anand G Mahindra 5/6 8/8

Akash Paul (Independent) 4/6 4/8

Al-Noor Ramji 2/6 1/8

Anupam Puri (Independent) 3/6 6/8

Arun Seth 4/6 4/8

Bharat N Doshi 6/6 8/8

B H Wani (Independent) 8/8

Clibe Goodwin 4/6 2/8

CP Gurnani NA

M Damodaran (Independent) 2/6 4/8

Nigel Stagg * NA

Paul Zuckerman (Independent) 4/6 4/8

Dr Raj Reddy (Independent) 4/6 4/8

Nigel Stagg 1/8

Ravindra Kulkarni (Independent) 8/8

Richard Cameron* 1/8

Vineet Nayyar 5/6 5/8

Ulhas N Yargop 6/6 8/8

Source: Company, Ambit Capital research Note: Independent directors in Grey shade

Technology


Infosys

Letting down its own governance standards?

Ever since its IPO in 1993, Infosys has been regarded as a paradigm of corporate

governance in India. Whilst this image has earned Infosys goodwill from investors,

clients and employees, there are signs that these high corporate governance

standards are fraying. NRN Murthy’s entry into Infosys in an executive capacity (even

after the firm’s well-articulated policy of executives retiring at the age of 60), bringing

with him his son as an executive assistant, higher promoter representation at the

Board and peculiar guidance pattern resulting in high volatility in share price – none

of this gels well with Infosys’ image of a leader in corporate governance.

Breach of corporate policies

Infosys has historically followed a well-articulated policy of executive retirement at the

age of 60, with Mr NRN Murthy himself being a strong proponent of the policy.

Similarly, all the founders have time and again mentioned about not letting family

manage the business. More surprising was Rohan Murthy’s entry into Infosys as Mr

NRN Murthy’s Executive Assistant. Whilst this is a position of power but not of control,

the manner in which Rohan Murthy was brought in raised eyebrows to put it mildly.

High promoter representation on the board

The promoters’ Board representation is significantly higher relative to their

shareholding in the company. Whilst NRN Murthy, S Shibulal and Kris

Gopalakrishnan collectively hold ~10% stake in the company, they represent 23% of

the voting rights on the Board. With the highest promoter representation and the

lowest proportion of independent directors on the Board, Infosys’ Board

independence appears to be the weakest among the tier-1 firms.

Exhibit 13: Infosys – ownership structure

Promoter representation on the board 23.08%

Promoter ownership 15.94%

Active promoters

NRN Murthy 4.47%

S Shibulal 2.20%

Kris Gopalakrishnan 3.41%

Combined shareholding of active promoters 10.08%

Source: NSE, Ambit Capital research

Exhibit 14: Measuring the board independence

Company Promoter shareholding Promoter representation

on the Board

Non-independent

directors on the Board

Infosys 15.9% 23.1% 46.2%

TCS 73.9% 9.1% 45.5%

Wipro 73.5% 7.7% 23.1%

HCL Tech 61.8% 20.0% 20.0%

Source: Company, NSE, Ambit Capital research

Peculiar guidance pattern leading to extreme volatility

There has been a pattern in Infosys’ guidance and outlook over the last three years. It

sets a lower expectation in the fourth quarter of the year and over-delivers in the

following quarters, causing extreme volatility in the share price. Indeed, Infosys has

repeated this pattern yet again by indicating on 12 March 2014 that it will settle at

the lower end of the guidance for FY14 and giving a weaker outlook for 1HFY15.


performance

Source: Bloomberg

Financials

` mn FY11 FY12 FY13

Revenues 275,010 337,340 403,520

PAT 68,230 83,210 94,210

FCF 46,070 66,800 86,510


1000

1500

2000

2500

3000

3500

4000

10,000

15,000

20,000

25,000

Mar-

09

Jun-

10

Aug-

11

Nov-

12

Jan-

14

Sensex Infosys Tech.

Technology


Exhibit 15: Playing with investors’ expectations?

Source: Company, Bloomberg, Ambit Capital research; Note: Infosys abandoned the quarterly guidance from 1QFY13 * Infosys management announced in an

Investment Banking Conference that it will meet the lower end of the FY14 revenue guidance (11.5-12%)

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

-6%

-4%

-2%

0%

2%

4%

6%

8%

1Q

FY10

2Q

FY10

3Q

FY10

4Q

FY10

1Q

FY11

2Q

FY11

3Q

FY11

4Q

FY11

1Q

FY12

2Q

FY12

3Q

FY12

4Q

FY12

1Q

FY13

2Q

FY13

3Q

FY13

4Q

FY13

1Q

FY14

2Q

FY14

3Q

FY14

Mar-2

014

*

Actual vs guidance (mid-point) -

LHS

Change in next year guidance

(mid-point of guidance) - LHS

Share price performance on the

day of results - RHS

Absolute volatility range (RHS)

Setting lower expectation

in 4Q

Technology


KPIT Technologies

Magnified margins

KPIT Technologies’ margins appear to be overstated given the accounting policies

and estimates that are different from its peers. Its accounting policy of excluding re-

imbursements both from income and cost (contrary to accounting policy followed by

companies such as Infosys, TCS and Persistent Systems) benefits its margins by

~50bps according to our calculations. Furthermore, its actuarial assumption of salary

increase for retirement benefit obligations is significantly below that of peers (5% vs

peer average of 7%).

Margin management through change in accounting policy

During FY12, KPIT Technologies changed its policy of booking re-imbursement

expenses. KPIT mentioned in its FY12 annual report that “the reimbursement expense

billing has been netted off against the actual expenses whilst previously the

reimbursement billing was accounted as income in revenues and as expense in the

costs. The third-party license sale amount now appear in revenues only to the tune of

the margins on such sale (earlier the full sale amount used to appear as revenue and

the cost of the license as direct cost)”.

The new policy is not consistent with that followed by Infosys, TCS and Persistent (the

other companies do not mention the accounting policy in this regard). These

companies follow the policy of booking the third-party licence sales under revenue as

well as costs (these companies book it under “third-party items”, “Equipment and

software cost” and “Purchase of software license and support services”, respectively).

This change in policy makes the operating margins appear artificially better than the

historical margins and that of competitors, because operating margin is now

calculated by dividing the operating profit by a lower denominator (revenues).

Indeed, our calculations suggest that just because of this change in accounting

policy, FY11 EBITDA margins were overstated by 50bps.

Exhibit 16: Margin impact from change in re-imbursement accounting policy

` mn Earlier policy New policy

FY11 Revenue 10,230* 9,870**

FY11 EBITDA 1,484 1,484

EBITDA margins 14.5% 15.0%

Source: Company, Ambit Capital research *reported revenue in FY11 annual report ** restated FY11 revenue in

FY12 annual report

We have assumed that all the restatement in FY11 revenues is due to change in

accounting policy of excluding the re-imbursement from the revenues and costs.

Given this change in accounting policy is margin neutral (reimbursements are

removed from both revenue and costs), we have used re-stated FY11 EBITDA (from

FY12 annual report) for margin calculations.

Lower salary increase estimate for retirement benefit accounting

The retirement benefit obligations of a firm depend to a large extent on the

underlying variables such as discount rate (to calculate present value of future

obligations), long-term salary increase rates, attrition, demographics, return on plan

assets etc. Manipulation of any of these variables could materially impact the

eventually calculated liability.

Whilst KPIT Technologies’ discount rate estimates are conservative as compared to

the industry average (8.5% vs industry average of ~8%), its salary increase estimate

of 5% appears to be too low relative to the industry average of ~7% (see Exhibit 17).

Furthermore, KPIT’s retirement benefit obligations are unfunded (i.e. there are no

plan assets).


performance

Source: Bloomberg

Financials

` mn FY11 FY12 FY13

Revenues 1,484 2,166 3,214

PAT 946 1,454 1,990

FCF 221 396 503


20

120

220

320

420

520

10,000

15,000

20,000

25,000

Mar-

09

Jun-

10

Aug-

11

Nov-

12

Jan-

14

Sensex KPIT

Technology


Exhibit 17: Retirement benefit – actuarial assumptions

Company

Discount rate Salary increase

FY11 FY12 FY13 FY11 FY12 FY13

KPIT 8.3% 8.5% 8.5% 5.0% 5.0% 5.0%

Tier 2 peers

Mindtree 8.0% 8.5% 8.0% 10-12% 6.0% 6.0%

Hexaware 8.0% 8.6% NA 10% for first year and

7.5% thereafter

10% for first year and

7.5% thereafter NA

Tech Mahindra 7.7% 8.6% 8.6% for funded and

8% for non-funded


8% thereafter


9% thereafter

9% for non-funded

and 7.5% for

funded

Infotech Enterprises 8.0% 8.5% 8.0% 7.5% to 10% 7.5% to 10% 6% to 8%

NIIT Tech 8.1% 8.6% NA 9.15% to 9.4% 9.15% to 9.4% NA

eClerx 8.0% 8.5% 8.0% 4.0% 4.0% 5.0%

Persistent Systems 8.5% 8.7% 8.3% 7.0% 7.0% 7.0%

Tier 1 peers

TCS 8.0% 8.25% to 8.5% 8.0% 4% to 12% 4% to 9% 4% to 7%

Infosys 8.0% 8.6% 8.0% 7.3% 7.3% 7.3%

HCL Tech 8.4% 8.1% 7.5% 6% to 10% 7.0% 7.0%

Wipro 8.0% 8.4% 7.8% 5.0% 5.0% 5.0%


Poor cash flow generation at subsidiaries

KPIT Technologies’ cash conversion has been materially weaker than the peers,

largely due to poor cash generation at the subsidiaries. As shown in Exhibit 18 below,

KPIT has infused significant amounts of cash into the subsidiaries with weak cash

generation profile.

Exhibit 18: Burning cash at subsidiaries

` mn FY11 FY12 FY13

CFO 645 1,005 1,203

Capex -422 -609 -701

Investment in equity shares of subsidiaries -463 -2,088 -1,255

Investment in equity shares of associates 0 -98 0

Investment in preference shares of associates 0 -278 0

Cash & Cash Equivalent from acquisition of subsidiaries 37 146 0

FCF 222 396 503

FCF including acquisitions and investments in subsidiaries

and associates -203 -1,922 -753

Cash conversion

KPIT (Consolidated) 43% 46% 37%

KPIT (Standalone) 46% 100% 70%

KPIT (Subsidiaries) 41% 4% 3%


Higher use of subcontractors

KPIT uses subcontractors to a significantly larger extent as compared to its tier-2

peers. This artificially inflates the revenue per employee (given sub-contractors are

not included in the reported headcount) and gives a prima facie impression of better

employee productivity.

Technology


Exhibit 19: Higher subcontractors use artificially inflates the employee productivity

Company/Metric

Subcontracting cost as % of

Revenue

Subcontracting cost as

% of Operating Cost

Subcontracting cost as % of

Total Cost

Revenue per employee

(INR mn)

FY11 FY12 FY13 FY11 FY12 FY13 FY11 FY12 FY13 FY11 FY12 FY13

KPIT (Consolidated) 14.5% 17.2% 17.7% 46.5% 50.5% 52.0% 17.1% 20.1% 20.7% 1.5 1.9 2.7

KPIT Standalone 2.8% 2.2% 3.3% 13.5% 9.6% 12.4% 3.3% 2.7% 4.2% NA NA NA

KPIT (Subsidiaries) 28.0% 27.6% 24.5% 65.1% 66.5% 64.9% 33.8% 31.9% 27.3% NA NA NA

Tier 2 peers

eClerx NA NA NA NA NA NA NA NA NA 0.9 1.1 1.1

Persistent Systems 4.0% 4.2% 4.1% 22.6% 23.6% 19.7% 5.0% 5.4% 5.4% 1.2 1.5 1.9

Hexaware 7.2% 7.7% 8.9% 26.3% 30.3% 36.0% 7.9% 9.4% 11.3% 1.6 1.7 2.1

Infotech Enterprises 2.6% 2.2% 3.9% 11.7% 11.1% 18.8% 3.1% 2.7% 4.8% 1.4 1.7 1.8

NIIT Tech NA NA NA NA NA NA NA NA NA 2.1 2.1 2.5

Mindtree 3.0% 3.5% 3.6% 13.2% 16.7% 17.9% 3.4% 4.1% 4.5% 1.6 1.7 2.0

Polaris 6.5% 5.8% 5.9% 40.6% 37.3% 40.3% 7.5% 6.8% 6.7% 1.5 1.6 1.7

Tech Mahindra 9.6% 10.6% 9.6% 28.7% 52.2% 59.3% 12.0% 12.7% 11.9% 1.3 1.3 1.4

Tier 2 peer average 5.5% 5.7% 6.0% 23.9% 28.5% 32.0% 6.5% 6.8% 7.4% 1.5 1.6 1.8


Technology


Institutional Equities Team

Saurabh Mukherjea, CFA CEO, Institutional Equities (022) 30433174 [email protected]

Research

Analysts Industry Sectors Desk-Phone E-mail

Aadesh Mehta Banking & Financial Services (022) 30433239 [email protected]

Achint Bhagat Cement / Infrastructure (022) 30433178 [email protected]

Aditya Khemka Healthcare (022) 30433272 [email protected]

Akshay Wadhwa Banking & Financial Services (022) 30433005 [email protected]

Ankur Rudra, CFA Technology / Telecom / Media (022) 30433211 [email protected]

Ashvin Shetty, CFA Automobile (022) 30433285 [email protected]

Bhargav Buddhadev Power / Capital Goods (022) 30433252 [email protected]

Dayanand Mittal, CFA Oil & Gas / Metals & Mining (022) 30433202 [email protected]

Deepesh Agarwal Power / Capital Goods (022) 30433275 [email protected]

Gaurav Mehta, CFA Strategy / Derivatives Research (022) 30433255 [email protected]

Karan Khanna Strategy (022) 30433251 [email protected]

Krishnan ASV Banking & Financial Services (022) 30433205 [email protected]

Nitin Bhasin E&C / Infrastructure / Cement (022) 30433241 [email protected]

Nitin Jain Technology (022) 30433291 [email protected]

Pankaj Agarwal, CFA Banking & Financial Services (022) 30433206 [email protected]

Pratik Singhania Real Estate / Retail (022) 30433264 [email protected]

Parita Ashar Metals & Mining / Oil & Gas (022) 30433223 [email protected]

Rakshit Ranjan, CFA Consumer / Real Estate / Retail (022) 30433201 [email protected]

Ravi Singh Banking & Financial Services (022) 30433181 [email protected]

Ritika Mankar Mukherjee, CFA Economy / Strategy (022) 30433175 [email protected]

Ritu Modi Automobile (022) 30433292 [email protected]

Tanuj Mukhija, CFA E&C / Infrastructure (022) 30433203 [email protected]

Sales

Name Regions Desk-Phone E-mail

Deepak Sawhney India / Asia (022) 30433295 [email protected]

Dharmen Shah India / Asia (022) 30433289 [email protected]

Dipti Mehta India / USA (022) 30433053 [email protected]

Nityam Shah, CFA USA / Europe (022) 30433259 [email protected]

Parees Purohit, CFA UK / USA (022) 30433169 [email protected]

Praveena Pattabiraman India / Asia (022) 30433268 [email protected]

Sarojini Ramachandran UK +44 (0) 20 7614 8374 [email protected]

Production

Sajid Merchant Production (022) 30433247 [email protected]

Sharoz G Hussain Production (022) 30433183 [email protected]

Joel Pereira Editor (022) 30433284 [email protected]

Nikhil Pillai Database (022) 30433265 [email protected]

E&C = Engineering & Construction

Technology


Explanation of Investment Rating

Investment Rating Expected return

(over 12-month period from date of initial rating)

Buy >5%

Sell <5%

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