The Hindu Business Line : KPIT Cummins: Buy

Mr Girish Wardadkar (left), President and Executive Director; Mr Ravi Pandit, Chairman and Group CEO; and Mr Raghav N. Gulur, President and COO, CG Smith Software. Using acquisitions to broadbase its portfolio.

Investors may use the current weakness in the KPIT Cummins stock to consider accumulations with a one-year perspective. At a price of Rs 411, this mid-size software stock is trading at a price earnings multiple (PEM) of 18 times its 2005-06 earnings.

While the PEM appears stiff, it factors in the robust earnings growth in 2006-07. The variables bolstering this picture are the company's strong focus on manufacturing and banking/financial services verticals, good client momentum from a select set and prudent inorganic moves to broadbase its offerings.

However, the high client concentration (with Cummins as its key customer), the ramp down in contributions from key clientele linked to IT spending or possible vendor consolidation, and the integration challenges related to its recent acquisitions present downside risks.

Though KPIT has been among the few software plays not to lose as much as the broad indices since May 10, the continuing market volatility may put pressure on the stock.

Investors will be better off taking exposure in small lots and enhancing them steadily in the coming quarters. Investors also need to tone down their overall return expectations.

EARNINGS GUIDANCE

For 2006-07, the company has forecast annual revenue growth of 37-42 per cent and post-tax earnings growth of 54-64 per cent. While the revenue guidance appears achievable, given the inorganic moves, the post-tax earnings forecast may be on the high side. Assuming a conservative 35-40 per cent growth in post-tax earnings, the per share earnings works out to Rs 30-32 (compared to the projected Rs 35-37). The PEM based on the conservative EPS works out to 13 times, leaving scope for capital appreciation.

A conservative call is in order as the company had marked down its revenue and post-tax earnings guidance in the first quarter of 2005-06. This was due to a ramp-down in IT spending by its key clients (excluding Cummins). The initial post-tax earnings guidance of 33-40 per cent for 2005-06 was revised downwards to 14-25 per cent and the company ended the year notching up 16 per cent. We had put out a "Sell" call on the stock in that week in late-July, following this revision in guidance.

CORE BUSINESS

KPIT's core strategy of focussing on two verticals — manufacturing and BFSI (banking, financial services and insurance) — remains valid.

For 2005-06, manufacturing contributed 82 per cent of the revenues of Rs 312.8 crore, with 13 per cent coming from BFSI.

To consciously broad base its range of offerings within the manufacturing vertical, KPIT has forayed into package implementation, business intelligence and advanced technology solutions. Its first acquisition was Panex Consulting for entry into package implementation in August 2003.

After a quiet phase, the past nine months saw KPIT turn active on the acquisition front, The company has put through three acquisitions since November 2005, starting with SolvCentral for business intelligence, Pivolis for a beachhead in France, and CG Smith for automobile electronics and semiconductors.

From a strategic client perspective, KPIT has chosen to service Cummins Inc, US, one of the biggest designer and manufacturer of diesel engines, as its strategic client.

KPIT is also one of its three preferred vendors. Cummins contributed 47 per cent of its revenues for 2005-06.

Besides this, based on growth prospects, it has chosen 7-10 key clients, including HP, Unilever, BNP Paribas and Renesas. The non-Cummins clients contributed about 37 per cent of the revenues, down from 48 per cent in 2004-05.

THE KEY DRIVERS

In achieving its guidance for 2006-07, KPIT is expected to face two challenges. One, the ability to expand its operating margins holds the key to its financial guidance for the year.

The company increased the operating margin by about 1.2 percentage points to 14.4 per cent in 2005-06 over the previous year. Its ability to expand it further hinges on increasing the offshore component and employee utilisation levels, apart from maintaining the high margins from its acquisitions. Increases in billing rates from its new clients will be a positive.

Two, the expansion in Europe will hold the key to its growth fortunes. In 2005-06, the contribution from Europe declined to 28 per cent from 35 per cent, attributable to a probable ramp down of client/clients in this geography.

Recent reports show that manufacturing growth from the Eurozone (comprising 12 regions) has touched a six-year high.

In the backdrop of such buoyancy, KPIT's ability to capture new clients and ramp up existing customers in Europe will be crucial to its financial forecast.

INVESTMENT RISKS

The dependence on Cummins as its largest customer will remain a key risk. However, since earnings estimates from Cummins Inc. show that the company is likely to post yet another strong year of growth, the risk of sharp revenue deceleration for KPIT is low.

Two, in the event of Cummins Inc. crossing a certain threshold of KPIT revenues (of above 50 per cent) in 2006-07 and 2007-08, there is a possibility of equity dilution of over 20 per cent in two tranches from the current equity base of Rs 7.28 crore.

The prospect of equity dilution, however, looks quite unlikely at this stage.

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