CMC: Buy

Among the developed markets, the US has seen a significant revival in outsourcing of IT projects. Proof of this is the growth in revenues from this geography for most top-Tier as well as several mid-Tier software companies.

CMC, a provider of system integration and IT applications services, benefits from this trend. Also, increasing spends on technology within India, especially from the State and Central governments, is a positive.

Investors with a two-year horizon can consider buying the shares of the company, in the light of its strong positioning in the domestic and American markets. At Rs 1,018, the share trades at 15 times its likely FY-13 per share earnings. Although this is at a slight premium to mid-Tier IT players as well as its peers such as HCL Infosystems, it may be justified on account of better operating margin that it enjoys (around 17 per cent).

Strong deal wins, a healthy geographic-mix in the light of increasing international revenues and synergies from TCS are key positives for the company. In the first nine months of FY11, CMC's revenues grew 34 per cent over the same period last year to Rs 1,070.9 crore, while net profits fell 19.6 per cent to Rs 108.9 crore. While the growth in revenues has been among the best in the industry, the fall in profits has been due to steep increase in subcontracting costs and higher tax outflows. The company resorts to the subcontracting route largely to take care of execution during the initial phase of a project. This also results in some one-time contracts being completed without taking on permanent manpower.

Subcontracting costs amounted to Rs 309.3 crore so far this fiscal and rose over 80 per cent over last year. Tax outflow has more than doubled as CMC transitions operations to SEZs with the tax incentives from Software Technology Park schemes ending last year. Both these costs are likely to moderate over the next one year.

Business Positives

From being heavily hardware-intensive, the service offerings of CMC have evolved considerably. It now derives over 88 per cent per cent of its revenues from projects that have services component in them, with pure hardware contracts accounting for the rest.

Also, CMC has expanded its client base significantly over the past few years. The company has added 60 customers in this fiscal, including from India. International revenues (largely from the US with minor contribution from Europe) now account for about 61 per cent of overall revenues, up from 55 percent last year.

The association with TCS (of which it is a subsidiary) has helped considerably in terms of both client references and also winning deals. Taken together, these factors have meant that the company has been able to climb the services value chain, apart from being a key player in hardware intensive deals as well.

About 64 per cent of CMC's revenues from international projects are executed onsite, which has escalated staff and subcontracting costs. The company hopes to bring that proportion to around 50 per cent over the next two-three quarters, which would optimise costs.

Strong domestic clientele

Government sector, where spends on areas such as rural connectivity, and e-governance is increasing rapidly, is a key client for CMC.

Among others, clients include entities such as Indian Railways and the Election Commission where heavy volume of data is likely to provide sustainable revenues for the company. These apart, the UIDIA and several state transport companies that are looking to implement GPS solutions are also customers.

India provides around 39 per cent of CMC's revenues. Despite deals having significant hardware component, solutions such as GPS and UIDAI would provide steady annuity revenues for the company over the long-term.

A recent report from Gartner has indicated that enterprise IT spending in India would grow at 11.2 per cent annually from 2010 to 2015 to $50.2 billion. Within this, the Government vertical would grow at a faster rate (12.5 per cent) and account for $9.3 billion.

CMC with entrenched relationship with several institutions would be well placed to tap into the market.

Risks

Competition in the system integration space from Wipro Infotech and HCL Infosystems would mean pricing pressure.