The Hindu Business Line : KPIT Cummins: Sell

SHAREHOLDERS can consider pruning their exposures in the stock of KPIT Cummins in the light of the downward revision in the revenue and post-tax earnings guidance for 2005-06 and disappointing first quarter performance. The company that started off the year with a guidance of 31 per cent growth in revenues and 33-40 per cent growth in post-tax earnings has revised both the estimates downwards.

The revenues have been marked down to Rs 308-317 crore, 22-25 per cent growth and post-tax earnings to Rs 32-35 crore, 14-25 per cent growth range for the year. The company has attributed the revision in guidance to postponement of IT investment by some of its Star (or Fortune 500) customers, excluding Cummins, its key client.

Relative to its peers, the stock is pricey at a price-earnings multiple of 13-14 times the revised FY-06 per share earnings. Some of the mid-sized peers are trading at PEMs that are lower or equal to that of KPIT Cummins but are also expected to show higher growth in profits. In this backdrop, three elements have to be considered from the first quarter (April-June) earnings performance of KPIT Cummins:

Client concentration: The contribution of Cummins, the largest client of KPIT Cummins, has shot up to 44 per cent in the latest quarter from 36 per cent on a sequential (quarter-on-quarter) basis.

This is partly on account of the Star customers (Star customers are some Fortune 500 customers such as HP, Deutsche Bank and Unilever), excluding Cummins, postponing their IT investments in the latest quarter. On a sequential basis, the contribution of Star customers was 4.7 per cent lower. In the coming quarter, the company's revenue growth may be affected in two ways. Revenues from Cummins that grew by 27.3 per cent in the latest quarter may remain flat or register a negative growth.

Also, if the revenues from the Star customers (excluding Cummins) also remain sluggish on account of lower IT spending, there will be a sharp impact on revenue growth. It is significant that 85 per cent of the company's revenues accrue from Cummins and its Star customers.

Operating margins: On a sequential basis, the operating profit margins dipped by 0.50 percentage points to 12.5 per cent. This decline reflects the higher salary hike and employee headcount absorbed by the company in the latest quarter.

Though this is only a marginal dip, it appears that the company will have lesser leeway to improve margins in the coming quarters by stepping up the offshore mix and leveraging on lower selling and marketing expenses. While the offshore contribution has come down from 35 per cent to 31 per cent over the past four quarters, it may stabilise at this level, at least for a couple of quarters.

If the IT spending sluggishness continues among the Star customers, the company may not have the flexibility to trim its marketing expense. The company has increased its investment in the German and Japanese markets recently.

Portfolio to watch: The dip in the contribution from its BFSI (banking, financial services and insurance) clients to 15 per cent from 21 per cent has accounted for the slower revenue growth in the latest quarter.

Unless this contribution starts rising again, the revenue growth momentum may not pick up sharply. Second, Lehman Brothers made an 8 per cent investment in the equity of KPIT Cummins. Though this is only a financial investment for the time being, it creates potential for KPIT Cummins to generate offshoring revenues from Lehman Brothers in the near term.

Recently, the company has also started offering BPO services in the area of accounting, human resources and technical support through its wholly owned subsidiary, KPIT Cummins Global Business Solutions.

Finally, having put through two acquisitions successfully in the last three years, any inorganic moves can provide the trigger to its somewhat muted growth expected in FY-06.

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