Virtusa: A Very Dusty Quarter That Hides An Extraordinary Valuation

| About: Virtusa Corporation (VRTU)

Summary

In the wake of some one-time events, Virtusa shares now sell at an extraordinary valuation of 1.1X EV/S - one of the lowest in its space.

Virtusa announced the results of its fiscal Q3 little more than a week ago and the shares are down 26%.

Virtusa shares had already decreased significantly in the wake of a significant acquisition of Polaris Consulting and in the midst of the overall rout in tech shares.

Virtusa actually had strong results for the December quarter and its guidance was far better than might meet the eye for both the current quarter and beyond.

I believe the Polaris merger will ultimately turn out to be a home run.

Introduction:

Ever notice just how few dusty corners are there in the investment world these days. There are loads of reasons for that but basically with the advent of the web, it is easy to find out a little bit about a lot of companies. But that is the point; there is really very little the web is going to tell you about companies in those dusty corners to help you make an investment decision. To the extent these smaller companies are covered, lots of that coverage is not particularly useful in trying to determine if it makes sense to take a position in a company within the dusty corner such as that where Virtusa has taken up residence. Virtusa (NASDAQ:VRTU), despite expectations of achieving revenues in the current year (ends 3/31/16) of over $600 million and of reaching top line levels of nearly $900 million including accounting for a full year of the Polaris acquisition in the fiscal year that will start 4/1/16 is only covered by 6 analysts. That being said, I think that Virtusa is one of the 2nd tier Indian outsourcing vendors that deserves a second look, particularly in light of the shellacking the shares have experienced in the wake of its delayed acquisition of a majority stake in Polaris Consulting. In addition to the issues in conjunction with the Polaris acquisition, Virtusa revenues and EPS were marginally below the prior consensus for the December quarter although essentially all of that was the result of one-time, non-operating factors, particularly the lost billable hours due to the flooding in Chennai. (Chennai is the Indian name for the city that is perhaps better known to Americans as Madras - it is located near the southeast coast of the Indian sub-continent) Overall, Virtusa shares are down 44% in a little more than 2 months, and at current levels, represent one of the better buys in the Indian IT outsourcing space.

Background:

For many investors, it is hard to distinguish between the various Indian outsourcing companies. Many investors are familiar with Cognizant (NASDAQ:CTSH), Infosys (NYSE:INFY) and Wipro (NYSE:WIT), and if you are an American who evaluates alternatives amongst Indian IT vendors, you have probably heard of Tata Consulting Services (NYSE:TCS). You have probably not heard of Virtusa which today has a market capitalization of less than $1 billion and an enterprise value of under $800 million. The company has about 10,000 employees and was founded in 1996 by 2 brothers from Sri Lanka and two brothers from the US. It is actually headquartered in Westboro, MA, but most of its employees are located in India. BT (NYSE:BT) has been a key strategic partner of Virtusa essentially since the birth of the company and it continues to be a key customer. As a result, investors should consider both the exchange rate between the GBP and the dollar as well as the INR and the dollar in evaluating both the financial performance and the outlook for this company. There have been times during which Virtusa, in an effort to hedge its currency exposure has either had a significant expense or benefit from foreign exchange rate movements. At the moment, the GBP/dollar rate is quite unfavorable for Virtusa and will cost the company as much as 2% of revenues in its current quarter. On the other hand, the INR/Dollar stands at a recent high which benefits all Indian outsourcing vendors. BT continues to own a small percentage of Virtusa shares, but in some years it has represented as much as 20% of revenues although it is presently less than a 10% customer.

While it is convenient to think about all Indian outsourcing companies as similar, and they are to the extent that most of them have 75%-80% of their service delivery personnel resident in India or in the case of this company, India and Sri Lanka, there are differences with regards to precisely the kind of projects that are outsourced by the different competitors in the space. This company derives almost all of its revenues from application development and consulting; most of its peers have a significant amount of revenues that are derived from outsourcing application maintenance. Application maintenance, even after all of this time is still highly profitable and AD and consulting really much less profitable. The company has a focus on what it calls Banking, Financial Services and Insurance (BFSI) which represents 51% of total revenues, down quite bit in the past year due to some specific pressures on the company's insurance practice as the result of problems that are internal to one of the company's major clients. The slack has been taken up by strong growth in technology that is substantially underappreciated and might have significant growth implications over the intermediate term. Despite all of the pressures that have buffeted this company, overall Virtusa has seen minimal changes in its utilization rates over the course of the current fiscal year which is no mean achievement, given that consultants are really not fungible between different verticals.

Most recently, Virtusa's margins and revenue growth have been fighting headwinds from pressures in its insurance vertical. The problems of AIG (NYSE:AIG) are well known and AIG is a very significant Virtusa customer. (Just for the record, Virtusa management has not disclosed that AIG is its problem customer but it is well known within the industry that this is the case, and I base my comments on a back drop of industry "gossip.") Basically, AIG has stopped every IT project that it can and this has had, and will have, a visible impact on Virtusa and so far as that goes on other IT software and services vendors as well. In addition to the issues at AIG, Virtusa, with a major development center in Chennai has had to deal with the costs associated with the floods that swept the region last December. And if all of that were not enough, the material deterioration in the exchange rate between the GBP and the USD is also pressuring near-term reported results. A trifecta of woes, so to speak!

Regardless of the quarter by quarter specifics, Virtusa has been significantly less profitable than most of its competitors with consistent non-GAAP margins in the mid-teens compared to just under 20% for Cognizant and in the mid-20% range for Infosys. The pending acquisition of Polaris, which is going to add 7500 employees to the current base is likely to have some salutary impact on operating margin attainment over time as I will discuss further. On the other hand, that is obviously not going to be the case in fiscal 2017 and indeed the acquisition will result in material dilution in its first year.

The company has enjoyed fairly consistent, if not spectacular, revenue growth since the Great Recession with revenues increasing in the range of 20% or thereabouts mainly in its core area of BFSI. More recently, growth has accelerated significantly in both its telecoms vertical, and most recently, in its technology practice.

Although, it would not be evident from current valuations or recent share price performance, the results of the current fiscal year will actually turn out to be consistent in terms of growth with the results the company has recently achieved. Indeed, excluding any impact from the floods in Chennai - hopefully a one-time event, and the significant impacts/costs of the pending consolidation with Polaris, core growth, however one cares to measure it, is probably a bit better than the growth achieved during the past several years.

This company is evaluated by the analysts who cover it based on both GAAP and non-GAAP presentations. That is likely to change in the new fiscal year when the company ceases to provide guidance for its GAAP financial results. While this is not the time or the place to argue why or why not stock-based compensation should be included or not in evaluating the operating performance of otherwise comparable companies, it seems to this observer quite evident that the expenses of a major business consolidation, such as the acquisition of Polaris, might be better excluded in any apples to apples evaluation. The fact that published GAAP EPS estimates for this company now average $1.36 for FY '17 compared to non-GAAP estimates of $2.42 that were the average a few weeks ago is not a function of any real deterioration in the business outlook for Virtusa. Earnings estimates on an apples-to-apples basis are down somewhat - from about $2.42 to $2.15 which mainly has to do with a series of one-time events and most particularly to the short-term dilution of the Polaris merger.

Virtusa grew at a greater rate than almost all of its peers last quarter both sequentially and year on year, and it is forecast to continue that growth into its fiscal Q4, partially offset by the material impact of the devaluation of the GBP and the revenue impact from the problems at AIG. Absent those considerations, it seems as though the company continues to grow organically about 10%-15%+/year, certainly faster than its principal competitors.

I would be hard pressed to speculate as to exactly the reasons for the company's relative and consistent success. I could, to be sure, reprise the company's emphasis on platforming and domain expertise and overall process. If there is any reader who is fascinated by such things, they are available on the company's website and are no worse and no better than the propaganda its peers maintain detailing their own expertise. l certainly am not likely to be successful in judging any real differentiation based on those factors between the various Indian vendors. All of the competitors in this space say they do the same things, and it is hard for any objective observer to really know if either there is real differentiation or if potential clients perceive that there is.

I would guess that the fact that Virtusa does proportionately more AD and consulting compared to its peers coupled with it focus on the BFSI space might be partial explanations for its steady and above average growth. If there is something more to the company's success in technology that persists for more than a couple of quarters that might be a factor going forward in differentiated revenue growth, but I think it is simply too soon to really tell.

That being said, however, I do not believe I can have or that there is a definitive explanation for the company's steady and above average growth within the Indian IT outsourcing space and the Polaris acquisition is so large relative to this company's size that it would most likely change any answer that I could offer in any event.

The Polaris Consulting Acquisition

Late last year, after some dramatic ups and downs, Virtusa finally announced that it was going to acquire Polaris Technology, a sub-major Indian outsourcing firm closely allied with Citibank (NYSE:C). Polaris currently has a revenue run rate of about $240 million/year based on the latest commentary by Virtusa management during the course of its earnings conference call. This level is down quite significantly, with Polaris having suffered through a huge revenue diminution based on a material change in the IT consulting spend rate at Citi, its principal client. Management has said, and I am inclined to believe, that Citi has made a strategic decision to reduce its IT investment for the time being and that the problems Polaris has suffered are not unique to that vendor, but are a function with issues internal to Citi. This is not all that unusual in the IT outsourcing space, and as I have pointed out, Virtusa itself is suffering from something similar with another large client.

Virtusa is paying $270 million for 78% of the shares in Polaris. That is a valuation of just shy of $350 million, or just a bit more than 1.5X revenue - the current revenue run rate for the company. Polaris was reported to have made $29 million for its latest reported financial year.

Virtusa has the opportunity to achieve both revenue and cost synergies in acquiring Polaris in what will clearly be the largest transaction in the history of Virtusa. Management spoke to greater than $100 million of revenue accretion over 3 years. While it did not speak to cost synergies, the numbers alone suggest that simply getting the same level of revenue per employee that Virtusa realizes from its staff would drive significant cost savings. Virtusa gets about $60,000/revenues per year/per employee. Polaris gets less than $30,000/year per employee which suggests that there is substantial room for the combination to achieve significant cost synergies.

Management has indicated that most of the revenues for Polaris are on a T&M basis and that it has mid-single digit operating margins. It suggested that it wouldn't see any material SG&A synergies in the first year of the merger, but it is almost inevitable that cost rationalization is going to be part of the plan. It would be hard to imagine that Virtusa has in mind making an acquisition that would then plod operate with mid-single digit margins when its own margins are almost 3 times greater and almost inevitably the Polaris brand and operating structure will ultimately be subsumed within Virtusa as a whole.

A key to the transaction was the designation by the Citigroup Technology Group, a subsidiary of Citi that the new entity would be designated as a preferred vendor for the provision of IT services to Citi on an enterprise-wide basis. A significant amount of the revenue synergies that Virtusa anticipates will be that it now will become a provided supplier to Citi for consulting services of the retail bank - Polaris had no capabilities in that area and thus never could compete for the available business.

That same capability is probably going to have other salutary impacts on revenue synergies. Heretofore, Virtusa was limited to retail banking deals and Polaris was limited to competing for deals that it could staff with its consultants who have knowledge of the corporate and investment banking worlds. It seems highly likely that with Virtusa now having broad expertise in both commercial, retail and investment banking, it will simply be able to sell both its existing and new banking clients on broader and more numerous engagements.

While this is a cash deal from the point of view of the Polaris stockholders, it will be financed by a combination of cash and debt by Virtusa that has entered into a $300 million credit arrangement with JPMorgan and Bank of America. I would imagine that Virtusa might take down less than $100 million on its line of credit, and given current interest rates, the pre-tax interest cost on that level of borrowing would be around $3 million/year which works out to about $.07/share after tax or something close to $.02/in EPS per quarter.

When the deal was announced back on November 5th, it was greeted by the market with a negative reaction because of the short-term dilution and the fact that Polaris gets more than 30% of its revenues from a single client. The shares decreased by 10% on the day the transaction was disclosed and ultimately declined by 30% in the two months after the deal was initially announced before bouncing a bit. There was no real change in opinion on the part of the analysts that cover the shares either after the merger announcement or after the earnings release and indeed, the mean price target for the shares is still $53, or 65% above present quotes. I think that ultimately the Polaris transaction is likely to be a home run for Virtusa and perhaps a grand slam. I think the concept of expanding the company's footprint in the banking industry beyond the retail banking sector is by itself a huge win. I think the synergies at Citi alone are going to be significant beyond the first year of the acquisition and the synergies beyond Citi are more or less incalculable. I look at this acquisition as reasonably producing an annual revenue run rate of at least $350 million within the next year or two. I see no reason why that revenue will not achieve at least a 15% non-GAAP margins. With a 27% tax rate and 30 million shares outstanding, it seems to me that incremental EPS could be in the range of $1.00 and perhaps more which is not a bad day's work and certainly worth the short-term pain, in my opinion.

The Very Short Term and the Investment Case for Virtusa Shares

We have all heard about the devil being in the details and that is certainly what appears to have happened to Virtusa shares in the light of the release of its Q3 earnings and Q4 guidance. I am pretty much going to stick to a non-GAAP presentation as it makes little sense to look at the one-time costs of the Polaris acquisition when attempting to value the shares, and furthermore all of the analysts who cover the company and the company itself are now relying heavily on a non-GAAP presentation. Just for the record before I go on, stock-based comp. is about 18% of reported non-GAAP operating income and a little less than that as a percentage of current cash flow.

As I mentioned earlier, the results of fiscal Q3 were in line with prior expectations and perhaps slightly greater when accounting for the extra expenses of the Polaris acquisition, the Chennai floods and the expenses of the company's business continuity program.

But guidance for both fiscal Q4 and for FY 2017 obviously was very troubling to investors - although objectively it should not have come as to much of a surprise.

The company has a very large insurance client, AIG. AIG has announced a series of cost saving moves that are designed to improve its operating performance. I am not really in a position to comment on the specifics of what is going on at AIG, and how long its IT diet is going to last, but it seems hard to believe that the spending freeze will last indefinitely - it would simply cripple the company if it is not undone in the near-term future. But the net is that Q4 results are going to be impacted by as few cents a share since revenues will be less and it is going to be difficult to maintain utilization at current levels with a major customer out of service. Of equal, if not greater, importance is the impact of the exchange rates. BT alone was apparently a 9% customer last quarter and the GBP/USD rate has dropped by about 8% in a single quarter. Like most Indian outsourcing companies, Virtusa has few expenses in local currency, so it takes a large hit when something like that happens in a given quarter. In addition, there is still a bit of additional expense due to the impact of the Chennai flood. And finally, the Polaris acquisition is scheduled to close at the end of this month and Virtusa is forecasting a bit more dilutive impact from the transaction - not in terms of the transaction costs, but in terms of operating the business itself. The wheels are not coming off Virtusa's business and indeed the company's business outlook does not appear to be deteriorating; the reverse is true but the details say that the EPS forecast for the current quarter is going to be $.13/less than the $.57 that had been the case at the last time guidance was given.

The company does not formally provide guidance beyond the end of its current fiscal year but due to the circumstances of the Polaris acquisition, it chose to provide markers that would be useful in constructing a model. Its guidance is for core Virtusa to grow at faster than the industry average and for Polaris to achieve single digit revenue growth off the expected annualized Q4 run rate. Core Virtusa revenues are expected to be about $580 million for the FY '16 and I think an above average industry growth rate might be conservatively put at 8%. Given current commentary by industry participants, it really would be just as easy to suggest that the space would actually grow in the 10%-14% range, but given the financial turmoil of the past few weeks, it seems to me that a more conservative stance is warranted. So that says that core Virtusa should do at least $625 million for fiscal year 2017 and Polaris ought to achieve an additional $255 million in revenues, which brings the estimate for the full year to $880 million. On a blended basis, that is about 7% organic growth for the combined company. Guidance suggests that fiscal 2017 EPS growth is supposed to exceed revenue growth, and given some of the significant headwinds including currency, and the impact of the flood that doesn't seem to be too surprising. In any event, if EPS growth is 9% for the period, that yields an estimate of about $2.15/share non-GAAP which is probably less than the average expectations that were extant before the earnings conference call. (My guess is that the average that estimates were then around EPS of $2.40, but it is hard to be sure because of the transition on the part of analyst estimates from GAAP to non-GAAP). I think it is self-evident that if one were less than conservative in forward estimates, it would be possible to add as much as $30 million to fiscal 2017 revenue estimates and to add more than $.10 to EPS expectations.

So, overall, at current prices and assuming that ultimately Virtusa owns 100% of Polaris, the combined company is going to have an enterprise value of about $1.1 billion on just less than $900 million of sales in its fiscal year '17 for an EV/S ratio of 1.2X. Just for the record, based on my horseback calculations, the company's forward PE is about a bit less than 15X. By comparison, Cognizant has an EV/S value of 2.1X on current estimates for its fiscal year and its P/E is about 14X. The same statistics for INFY are 3.5X EV/S with a forward P/E of 16.4X. And neither Infosys or CTSH have the opportunity set in front of them that VRTU has in the wake of the Polaris merger. It seems pretty straightforward to me that on a relative basis, Virtusa shares are at a significant discount to its peers in the space and offer an excellent value to investors willing to look at a dusty corner and take advantage of valuation anomalies.

Conclusion

Virtusa shares have been in a nose dive recently, since the company announced its pending acquisition of Polaris Consulting. Overall, the shares have given up 44% of their value since the merger was announced and have fallen more than 25% in the wake of the company's earnings release for its fiscal Q3 and its guidance for fiscal Q4 of 2016 and beyond.

In point of fact, Virtusa grew its revenues both sequentially and year on year faster than its competitors by most organic measures. Its reduction in guidance is the combination of a series of one-time events such as FX, the flood impact in Chennai and internal difficulties at a significant customer. All indications suggest that this company is actually outgrowing the industry average and it seems reasonable to believe that Polaris will be a homerun for the company over the next 18-24 months.

Obviously, there are risks to the hypothesis. AIG's troubles could persist and worsen and it could spend even less on IT than it is currently forecasting to Virtusa. Citi, despite the massive IT spending haircut that it has taken, could elect to spend even less than currently forecast. Virtusa might have trouble executing on the revenue synergies that ought to accrue from its new domain expertise.

It might take longer and be more difficult to bring the margins from Polaris closer to the corporate average than is currently seems likely. And to me, most serious of all, is that with the company now concentrated significantly in the banking sector, bank IT spending could be more severely constrained in the event of a global recession.

But it also seems to me that when profitable and growing companies sell for close to 1 time EV/S and are valued at half or less the levels of their principal competitors, there is a significant valuation anomaly. I suggest that investors take advantage of the yawing valuation gap between the shares of Virtusa and those of its much better known and much more highly valued competitors.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.