Description

Author – Moneyball                                                                                                   January 9, 2014

iGate is an Indian information technology outsourcing firm that competes with Cognizant and Infosys. The stock trades at a 20% P/E discount to its peers as its +8% year over year sales growth has trailed that of the industry. Wall Street analysts are forecasting +11% EPS growth in 2014, but they are wrong. iGate is benefitting from a major improvement in its marketing practices that is going to lead to industry leading sales growth of +25% in 2014 that will cause its P/E to further expand.

Three factors are going to drive 50% EPS growth in 2014  to $2.88,  which is substantially above consensus.

These factors are:

1. Sales growth accelerating from +8% to +25% year over year in 2014 adds $0.47 EPS
2. A large reduction in interest expense that adds $0.43  to  EPS after May 2014
3. Costs will decline by $0.52/share as iGate benefits from the depreciation of the Rupee currency.

The positive factors above will not all contribute a full year of benefit in 2014.  Once one adjusts for timing considerations here are the summary earnings estimates compared to Wall Street consensus in the table below.

 Moneyball EPS estimates

2013 $1.90 EPS

2014 $2.88 EPS which is 37% above consensus of $2.09

2015 $3.56 EPS which is 45% above consensus of $2.44

Forecasting earnings is always  subject to error, but the analysis below will show that iGate has many ways to earn robust results in 2014 and beyond.  First lets provide some background  information.

Business Description:

iGate has over 28,000 employees and $1.1 Billion in sales

The largest customers are (GE 13% of rev, Royal Bank of Canada 11% of rev) with no other customer above 5% of rev.

The Indian IT Outsourcing industry generates $85 Billion in sales with expected growth of 13% in 2013 according to NASSCOM.  iGate’s market share is just above 1%.

The industry has grown rapidly due to a labor arbitrage model. A group of skilled Indian software programmers have been able to do the same work as their American counterparts at a 30% cost savings. This cost saving opportunity led to a massive off-shoring trend.

iGate is further differentiating itself with an “outcomes driven model.” Instead of charging customers on an hourly basis, iGate will offer to do the work at a fixed cost. This is higher risk for iGate, but allows them to re-architect a companies internal work flows to structurally reduce costs.

In 2013 about 30% of sales are generated from this outcomes model versus the historical hourly model. The new business model has been helping iGate to win large new contracts in 2013 that will generate much faster sales growth by 2014.

BELOW ARE THE FACTORS THAT WILL DRIVE 2014 EPS GROWTH  ABOVE CONSENSUS

Sales Growth Will Surpass +25% in 2014, While Wall Street Forecasts +8%

In the first half of 2013 iGate substantially increased the size of its sales-force with the objective to reignite sales growth. New contracts typically have a duration of 3-5 years. As a result the firms $1.1 Billion in annual sales has recurring revenue rate in excess of 90%.  By September 2013 the new salespeople had won $1 Billion in awards in the prior 6 months  and still had a sales pipeline of $3.5 Billion. The expectation is that 20% of the pipeline will be converted into new contracts worth $700 million. In November and December 2013 the company announced a $200 million contract with UBS and a $80 million contract with Orange Switzerland the wireless carrier. Let’s assume that iGate does close $1.7 Billion in new 4 year contracts by March 2014 since they are almost there. This translates into $425 million in new recurring annual sales that will be realized later in 2014. These new contracts represent a 36% addition to iGate’s expected sales of $1.15 Billion in 2013.

About one fourth of iGate’s current sales contracts will expire annually or $287 million. Ninety percent retention is common, but I will be very conservative and assume only 50% of the business is retained or $143 million. The simple arithmetic to arrive at 2014 sales is $1,150 Billion sales  minus ($143M) plus $425M equals $1,432 Billion in sales for growth of +25%. At current margins this adds $0.47 EPS in 2014. 

Refinancing High Cost Debt Adds $0.43 EPS/year After May 2014:

As part of the Patni Computer acquisition in May 2011, iGate issued a 5 year note with a 9% coupon.

This principal of $770 million can be refinanced in May 2014 for the first time. I am assuming that iGate will use cash on its balance sheet to pay off one third of the debt and will issue $500 million in 5 year debt with a 4.5% coupon. This will reduce annual interest expense by $23 million for after tax EPS accretion of $0.43/share.

These assumptions are conservative as in November 2013 the company began to refinance its debt with 5 year credit facilities that had average interest rates of 3.18%.

5% Share Buyback is Possible.

Once iGate refinances its debt it may elect to start buying back stock. The company will generate over $135 million in free cash flow annually. This could purchase 3 million shares at $45/share. This can add $0.10 EPS annually or 5% to base earnings.

Rupee Currency Depreciation Can Add $0.51 to EPS After Hedging Contracts Expire.

iGate is an exporter with 94% of sales earned in USA dollars, and Euros.

The good news is that 50% of costs are paid in Rupees since most of the employees work in India.

Since April 2013 the Rupee has depreciated by (13%).

iGate has about $880 million in annual costs in 2013 of which $440 million or 50% was paid in Rupees.

A 13% depreciation on 440M leads to a 57 million savings as iGate is paying Rupee wages with revenue earned primarily in the USA.  With a 30% tax rate this translates into cost savings of $0.52 EPS.

iGate only hedges 40% of its currency exposure as opposed to Cognizant that hedges 100% of its annual currency exposure. As a result iGate already began to benefit from the weaker Rupee in the September 2013 quarter as gross margins rose from 37.9% to 41.4% sequentially  in 3 months.  Some of these higher profits were offset by losses on currency contracts that are reported in “other income.”  

For 2014 these currency contracts will have expired and iGate will see the full benefit from a weaker Rupee.

Valuation:

P/E valuation metrics are in the table below for nine Indian IT outsourcing firms.

Fiscal year differences have been adjusted to end in December. 

The average 2013 P/E for this growth industry is 25x, while iGate trades at 21x  P/E.

The average 2014 P/E for these 9 companies is 22x with iGate at 19x P/E.

If one uses our more optimistic $2.88 EPS estimates for 2014 then iGate has a 13.9x P/E

iGate’s rapid +25% sales growth in 2014 should at least lead to a group average P/E of 21x  for investors by January 2015. A combination of $2.88 EPS and a 21 P/E leads to a $60 stock price.

Downside Case:

The biggest threat to iGate’s stock price is a new immigration reform bill with language that threatens profits at Indian firms. In June 2013 this threat led to lower P/E multiples of 15x for the Indian IT firms.  I will also reduce my most likely 2014 EPS by 10% to $2.60 due to possible changes in the H-1B Visa rules. Multiply that by a 15 P/E and one arrives at a $39 downside price target for iGate in 2014.

The Indian IT outsourcing industry is very resilient. Well run firms like Cognizant have grown profits rapidly even in horrific recessions such as 2008.

RISKS:

USA Immigration Bill is Passed in 2014 That Restricts H-1B Visas For Indian Employees:

The current law has a 65,000 annual cap on the number of H-1B visas for foreign born college educated professionals.

A number of Wall Street analysts estimated that the 2013 Immigration bill would have a one-time reduction in earnings at Cognizant by (15%) as they would have been forced to replace Indian employees on VISAs with higher cost USA citizens. This threat caused the (25%) share price decline in many of the Indian IT outsourcing firms in the March – June 2013 time-frame. Once it was clear that immigration reform would not pass in Congress, the Indian IT stocks began a sharp rally in July 2013.

A reintroduction of an immigration bill in 2014 with greater restrictions on the issuance of H1-B Visas would clearly cause iGate’s stock price to fall.  Congress will reintroduce an immigration reform bill in 2014. The most important issue is defining a pathway to citizenship for the 10 million undocumented immigrants in the United States.  A change in the H1-B Visa policy may not be discussed this time which would be good news for iGate. We shall see what happens later in 2014.

iGate shares should outperform its peers in 2014. Thus one way to hedge against immigration reform risk would be to short another Indian IT outsourcing stock.

Indian Rupee Appreciates in Value Relative to the USA dollar

The Indian Rupee is a weak currency. The currency was created at par with the USA dollar in 1947. Today one needs 62 Rupees to purchase one dollar. No wonder Indians prefer to store wealth in gold.

An appreciating Rupee would harm earnings at iGate, but my assessment is that the Rupee is more likely to devalue relative to the USA dollar. The drivers for a weaker currency are in place. The inflation rate is 10%. The government must print money due to a budget deficit equal to 9% of GDP. Imports exceed exports. A national election will take place in 2014 so any reforms will be delayed.

At iGate 94% of sales are generated from the US dollar and Euro, with 50% of costs paid for in Rupees.

Sales Growth Slows Below +10% Annual Growth

In the December 2012 quarter iGate grew sales year over year by only +1%, despite the industry growth rate of +13%.  Investors saw this lack of growth and placed a value of 10 times trailing EPS on the stock.

A big factor in the valuation for Indian IT services firms is a function of their growth rates. Thus a renewed slowdown in sales growth at iGate would depress the valuation. Right now new contract awards at a $2 billion run-rate suggest that far more rapid sales growth is to be expected.

Labor Troubles From Wage Inflation or Higher Employee Turnover

iGate’s success or failure is highly dependent on its highly skilled IT professionals. Employee turnover is no worse than industry averages and iGate has won awards for being the best Indian IT employer in 2012. India has a high inflation rate and wages have consistently increased 10%/year. iGate has priced its contracts in such a way that it has been able to handle these higher hourly wage costs. The recent depreciation of the Rupee is going to make it even easier for iGate to pay future inflation driven wage increases.

Competition Emerges from Lower Cost Countries

iGate has been building software development centers in other countries, but none of these provide the combination of plentiful skilled  low cost labor that is found in India.

Major Cost Over-Runs on Multiple Contracts

Fixed price work (which also includes the “outcomes driven business model”) now represents 64% of wages at iGate. This is a higher risk business model versus time and materials, but so far iGate has avoided any systematic cost overruns.

Customer Contracts lost due to Merger and Acquisition Activity

Many Fortune 500 firms have used 2 Indian IT vendors for their outsourcing of software development work.  Some firms are trying to save even more money by consolidating this work to one vendor. So far iGate has not been harmed in a meaningful way by this trend.

Over-Pay For A Large Acquisition

iGate paid  $1.22 Billion to acquire Indian competitor, Patni Computer in 2011 for  29 times trailing net income.  They overpaid!!   This was a transformational deal as Patni sales were 50% bigger than iGate at the time. The merger helped iGate to enter the big leagues as an IT outsourcing firm, but customer losses after the acquisition resulted in sales growth slowing to +5% year over year.

There are two factors that may prevent iGate from over-paying for another large acquisition. First, the two founders own 35% of the company shares and have a vested interest in learning from their mistake and protecting their $840 million of wealth. Second, the private equity firm APAX Partners owns through its Preferred and common shares about $880 million in iGate. They have a seat on the board and are probably more interested in monetizing their iGate investment today, than approving a risky acquisition.

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