Ashish R. Thadhani (Gilford Securities) recently sent a note to clients outlining the investment risks for Indian outsourcing firm Wipro Limited (NYSE:WIT). In it, Thadhani raises his estimates for 2007 fiscal growth while outlining his case for doing so. Excerpts follow:
WIT: Running Flat-Out In a Flat World; Raising Est.
• Investment Conclusion. After factoring in broad-based revenue momentum and recent acquisitions, we are raising our estimates as follows: fiscal 2007 EPADS to $0.43 on revenue of $3.301 billion (38% YoY growth) from $0.41 on revenue of $3.129 billion; and fiscal 2008 EPADS to $0.53 on revenue of $4.461 billion (35% YoY growth) from $0.50 on revenue of $4.060 billion. We are also introducing a fiscal 2009 EPADS estimate of $0.65 on revenue of $5.902 billion (32% YoY growth). Our estimates imply 35%/23% compound revenue/EPADS growth in calendar 2006-08. Based on prevailing investor sentiment, we are raising our target price from $16.50 to $20. In 12-months, this would correspond to 30-35x forward EPADS of $0.62 – a discount to the current valuation (36x).
Wipro remains differentiated by its leading presence across fast growing practices such as Infrastructure Management and BPO; penetration of the Technology vertical; significant margin levers, e.g., utilization and employee-mix; an acquisition program emphasizing domain and geographic expansion; focus on quality and process excellence; and exposure to consumer and infrastructure spending.
• 3Q07 Results. EPADS of $0.12 vs. $0.08 a year ago on revenue of $898.6 million (46% YoY growth including acquisitions) beat our estimate of $0.10 on revenue of $797.1 million. Results reflect higher growth and profitability in the core segment; consolidation of acquisitions ($35 million contribution); robust growth in the Asia-Pacific segment, including ~$15 million of PC shipments to government clients; and offsetting forex/other items. Highlights included ~35% YoY and 9% QoQ organic revenue growth in the Global IT Services segment (based on realized and not quarter-end exchange rates); firm operating margin (23.7% in this segment vs. 24.1% a year ago – despite currency, acquisition and wage headwinds); reduction in employee attrition to 16% from 18% in 2Q07 with scope for further improvement; and a Credit Suisse win that offers annual revenue potential approaching $100 million in 18-months. Wipro will hold its annual Analyst Day on January 30 at the NYSE.
• Takeaways. Wipro disclosed that 60-70% of the top-100 clients have come up for renewal in the recent past, of which 75-80% agreed to a price increase. Top-50 clients recorded 9.7% QoQ growth. Product rationalization by merging Telecom OEMs could result in some near term project delays. Wipro extended its acquisition program to nine transactions since December 2005. In November, it acquired 3D Networks for $22 million in cash (note fiscal 2006 revenue rose 39% YoY to $36 million). 3D Networks is a profitable entity and leading provider of business communication solutions that is positioned to benefit from strong call-center demand. Acquisitions in the core Global IT Services segment matched overall growth and posted a narrower operating deficit of $0.5 million on revenue of $31.6 million.
• Revenue at the core Global IT Services segment advanced 37% YoY to $654.6 million and surpassed our $635.9 million estimate. Growth was driven by the Technology Infrastructure practice (77% YoY) and Financial Services vertical (51%). Operating income of $174.6 million (19.4% margin) exceeded our estimate of $158.0 million (19.8% margin). Profitability on a QoQ basis was hurt by a scheduled offshore wage hike (180 bps), rupee appreciation (80 bps) and seasonal price realizations (20 bps) – offset partially by acquisitions and SG&A/operational efficiencies. Near-term, Wipro expects a relatively stable operating margin despite a 3% YoY salary increase (120 bps) for onsite employees effective January 1. Available levers for offsetting annual wage pressure comprise utilization, lower-cost campus recruitment and acquisition contributions.
• Hourly price realizations averaged $65.55 for onsite work (flat QoQ and up 4% YoY) and $24.93 for offshore (flat QoQ and down 1% YoY). Billed volume rose 9% QoQ and 34% YoY. The utilization rate (excluding trainees) stood at 67% vs. 68% in the year ago period. High-margin offshore work contributed 45.1% of service revenue vs. 45.1% in the September quarter. IT Services headcount rose 8% QoQ and 35% YoY to 49,313 in December. Attrition deteriorated to 16% from 14% in the year ago period – but improved from 18% in 2Q07.
• By industry, Telecom & Technology ranked largest (at 34% of Global IT Services revenue), followed by Financial Services (23%), Retail (11%), Energy & Utilities (10%), Manufacturing (10%) and Others (12%). Top-10 clients accounted for 24.7% of IT Services revenue, down from 25.7% in the September quarter. Wipro has 39 clients (vs. 35 in September) with an annual revenue run-rate of $20+ million, 31 (vs. 30) with $10-20 million and 31 (vs. 37) with $5-10 million. Wipro added 37 new IT Services clients (before acquisitions) compared with 53 in the immediately prior period. It exited the quarter with an active roster of 592, down from 593 in the September quarter.
• BPO revenue rose 7% QoQ to $53.8 million accompanied by a 22.2% operating margin. Pricing, utilization and attrition trends should support a 20-22% operating margin while offering reinvestment opportunities. Wipro is emphasizing transaction processing (over commoditized work) and integrated solutions (more difficult to un-bundle or drive down price).
• Wipro generated CFFO of $187 million (or $0.13 per ADS) in the quarter. Proceeds from exercise of options amounted to $27 million. Major outflows comprised capital expenditures ($71 million) and acquisition payments ($54 million). Wipro exited the quarter with net cash of $866.5 million (~$0.60 per ADS), up from $767.3 million on September 30. Accounts and unbilled receivables improved to 73 DSOs from 77 in September.
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• WIT shares are suitable for aggressive investors. In our opinion, principal risks include the following: rising offshore salaries; appreciation of the Indian currency, which would translate into higher expenses incurred in rupees; correction in the Bombay Stock Exchange and/or U.S. markets; political opposition in the U.S.; and geopolitical uncertainty in the Indian subcontinent.