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Exceptional performance in Direct business

Diminishing DXC impact a positive

* Mphasis (MPHL)’s 1QFY22 performance was led by 9.8% CC QoQ growth in the Direct business, while the DXC vertical (<10% of revenues now) declined once again (-18.1% QoQ CC). The EBIT margin remained stable (-20bp QoQ), as increased hiring was compensated by lower SG&A costs. It reported the highest ever TCV of USD505m in 1QFY22 (including USD250m announced on the 1QFY22 call).

* With the MPHL management reiterating its guidance for industry-leading growth in the Direct business, we expect the standout growth in Direct to continue (26% YoY in FY22E) – led by the acceleration of deal wins (+62% on LTM basis). We view the large deal momentum and increase in deal sizes (USD96m; 3x of FY20) at MPHL as key positives, as this should lead to better medium-term growth visibility in the business.

* This growth – despite the expected moderation in the Mortgage business (DR) – implies performance in line with midcap IT services peers such as LTI, COFORGE, and MTCL (which are trading at a 20–30% premium valuation to MPHL).

* The DXC business should continue to operate below the remaining MRC commitment over the next few months. MPHL’s DXC business would post 29% CAGR decline over FY21–23E and settle at a mid-single-digit contribution by FY23E.

* Reduced exposure to DXC should help alleviate growth concerns in the overall business to some extent, and aid in comparing MPHL on Direct business solely (FY21–23E CAGR of 16%), lowering the valuation discount v/s peers.

* We expect margins to improve in FY22 (+40bp YoY) and see MPHL performing near the upper end of its guidance of 15.5–17%, aided by operating leverage and lower exposure to DXC. This should help the company deliver PAT growth of ~24% over FY21–23E.

* We raise our estimates by 2%/5% for FY22/FY23, factoring in higher growth in the Direct business. Despite the DXC overhang, with strong digital capabilities and client relationships, MPHL is well-positioned to be a key beneficiary in the current context. Our TP implies 28x FY23E EPS. Maintain Buy.

Strong beat on topline, led by Direct channel

* In USD terms, revenue/EBIT/PAT grew 19%/19%/24% YoY (est. 17%/17%/22%) in 1QFY22.

* Revenue grew 6% QoQ to USD363m, above our estimate of 3.6% QoQ. In CC terms, revenue growth stood at 5.9% QoQ and 16.3% YoY.

* The EBIT margin fell 20bp QoQ to 15.9%, 20bp below our estimate of 16.1%.

* PAT grew 7.2% QoQ and 23.5% YoY to INR3.4b.

* The stellar growth in the Direct channel (+9.8% QoQ CC; +32.5% YoY CC) was encouraging. However, the strong momentum was partially offset by an 18.1% QoQ / 48.7% YoY decline in the DXC business.

* DXC now contributes just 9% to overall revenue (v/s 20% a year ago).

* Vertical-wise, Banking grew 8.4% QoQ, while Insurance declined 3.7% QoQ. IT, Communications, and Entertainment grew 3.6% QoQ. Emerging Technologies grew 6.7% QoQ.

* Among services, growth was driven by Application Services (10% QoQ) and BPO (+8.1% QoQ), while Infrastructure Services declined (-14.8% QoQ).

* The total headcount stood at 31.4k employees, implying a net addition of 1,981 employees, one of the highest ever by the company.

* Offshore utilization, including trainees, fell 300bp to 81%.

* MPHL bagged deals worth USD505m in the Direct channel, of which 85% were in new-gen services. This includes a single landmark deal win of USD250m.

Key highlights from management commentary

* The company reported TCV of USD505m in 1QFY22, of which USD250m is attributed to a large deal. The management stated that the number of large and multi-year deals composed of digital transformation activities has increased.

* Public/Private cloud adoption, data modernization, and the creation of digital platforms are the key themes playing out in the market. MPHL’s play in these trends is helping the company increase its market share.

* MPHL has been able to undertake some value-based pricing. The increase in pricing is helping to mitigate supply-side challenges.

* The management has guided for industry-leading growth in the Direct business and top-quartile growth for the overall company in FY22.

* The company is prioritizing growth, for which investments would be required, rendering the margin range-bound. The management has guided for margins to be in the range of 15.5–17% for FY22.

Valuation and view

* Impressive deal wins over the last three quarters and a healthy deal pipeline are expected to drive near-term growth. While the overhang related to the DXC business (~9% of revenue) persists, the strong traction in Direct International should continue to drive overall performance. The management guidance on its ability to defend margins is a key positive.

* The ability to win multiple large digital transformation deals proactively and in vendor consolidation scenarios indicates strength in its sales and delivery capabilities.

* Higher exposure to largely stable verticals (BFSI – ~60% of revenue) should help mitigate risks to some extent.

* The stock is currently trading at ~25x FY23E EPS. We value the stock at ~28x FY23E EPS. Maintain Buy.

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