Hexaware Technologies: Buy

Investors with a penchant for risk and a one-year perspective can consider taking exposure in the Hexaware Technologies (Hexaware) stock in the run-up to its third-quarter earnings announcement on October 19. At the current price, the stock trades at a multiple of 18 times its likely calendar year 2006 per share earnings.

As technology stocks have rallied in the past quarter, investors need to temper their return expectations and utilise any broad market declines to step up exposure. The sustained traction in PeopleSoft revenues in the latest quarter, the healthy client additions and the robust second quarter performance lend confidence to the stock.

However, the risks to our recommendation are the high client concentration/client replacement risk among its top five clients, the unexpected slowdown in PeopleSoft revenues on account of restructuring by Oracle, and the pressures from high salary inflation and attrition for a mid-cap stock vis-à-vis frontline stocks.

Hexaware's core business model is its positioning as a niche software services provider of PeopleSoft suite with specialisation in the HR services domain, apart from addressing the airlines/transportation vertical and the German geography.

Established by the company in 2002-03, this model has been broad-based to include SAP and Oracle-related services in package implementation and an expanded focus into major European markets beyond Germany. While enterprise packages accounted for 32.6 per cent of its revenues, Europe contributed 26.5 per cent in the second quarter ended June 30, 2006.

In March, Hexaware also entered into an agreement with General Atlantic LLC, under which the latter invested Rs 300 crore through a preferential allotment of equity and optionally convertible preference shares.

The turbulent phase...

Hexaware's financial performance went through a turbulent phase in 2005 and early 2006. After clocking double-digit revenue growth for seven straight quarters till December 2004, the company faltered in March 2005 and went into a serious decline for almost a year. Two key factors contributed to this drop in financials. One, following the PeopleSoft-Oracle merger, Hexaware, which was running an India Services Centre for PeopleSoft, set up under the BOT model since 2003, had to transfer this centre to Oracle with effect from November 2005.

About 13 per cent of Hexaware's revenues were derived from the PeopleSoft ISC. Two, in July 2005, Hexaware had to sharply scale down its financial guidance on account of "unexpected delays in project ramp-ups in recent months and sluggish revenue growth from new clients."

... and the recovery

For Hexaware, revenues from PeopleSoft were derived both as a partner and competitor. Out of a third of revenues contributed in 2005, 13 per cent came from the PeopleSoft ISC and the rest was derived directly as PeopleSoft's implementation partner. Since PeopleSoft's acquisition by Oracle, the future of PeopleSoft implementation has been uncertain.

Since then, clarity has emerged on the PeopleSoft front. Oracle has committed that it will support PeopleSoft customer installations until 2013 and recently also released the latest version of PeopleSoft suite in the market.

As one of the largest vendors in India for PeopleSoft, Hexaware still services under one per cent of the installed base for PeopleSoft and the potential for scale-up is fairly significant from this level. In the second quarter-ended June 30, 2006, the company reported a 17.4 per cent growth in revenues on a sequential (quarter-on-quarter) basis, with this service offering continuing to power its growth.

On the new client additions front, out of 15 clients added in the second quarter of 2006, four were on PeopleSoft platform, with the balance from other verticals such as BFSI and transportation, among others. With the uncertain variables behind it, Hexaware's revenue and earnings visibility may be stronger than in the past.

Key growth drivers

A look at Hexaware's performance over the past three quarters reflects the following drivers of growth:

In the second half of 2006, Hexaware is likely to enhance its operating profit margins through higher offshore contribution, lowering its sales, general and administrative expenses (to at least 20 per cent of revenues compared to 21 per cent in the latest quarter) and improved employee utilisation.

In the quarter ended June 30, 2006, Hexaware's operating profit margins fell by 1.3 percentage points to 12.6 per cent on account of the annual salary hike and higher visa costs.

But in the third quarter, the company has projected a sequential earnings growth of 10 per cent (on revenue growth of 5 per cent), which will be dictated by enhanced operating margins.

The company has created a separate sales organisation for "hunting and farming" of new and existing clients. The management has claimed that by farming (or cross-selling) smartly among its existing clients, it will be able to enhance revenues from its top clients.

Between the first and second quarter of 2006, Hexaware added five clients in the $1-million revenue bracket taking the total to 36. And, as of the latest quarter, Hexaware had 141 clients, with 40 belonging to the Fortune 500/Global 500 category.