Verdict: Pricing not the most attractive
Happiest Minds has entered the primary market on Monday 7th September 2020, to raise Rs. 702 crore, via an IPO of equity shares of Rs. 2 each, comprising fresh issue of up to Rs.110 crore and an offer for sale (OFS) of up to 3.57 crore shares by promoter Ashok Soota and PE fund JP Morgan, in the price band of Rs. 165-166 per share. The issue represents 29% of the post-issue share capital, with only 10% reservation for retail shareholders (as against the conventional 35%). Issue will close on Wednesday 9th September, with listing likely on 17th September.
Founded 9 years ago by Ex-Mindtree founder and 78 year-old Ashok Soota, Happiest Minds is an IT services company focussed on 3 key geographies – US (77% of revenue), India (12%) and UK (7%), with 97% of its revenues coming from digital services, which is way lower for listed peers averaging 30-40%. Based on verticals, edutech and hi tech account for 21% each, BFSI 18%, telecom media entertainment 17% while retail is 8%.
Company’s 2,700 employees serve 157 active customers. However, client concentration risk is high, as for all small and mid-sized companies, as single client accounted for 14% of company’s FY20 revenue.
While attrition reduced from 25% in FY19 to 19% in FY20, it is still high in the absolute sense as compared to peers, which average about 13-15%. Going forward, due to covid-induced uncertainties, attrition rates are likely to remain low for IT firms.
In Sep 2019, a discrimination case was filed in the US by a former American employee against the company accusing it of employing Indians and South Asians. While the case is currently pending, it highlights risks of operating in US geography (besides changing visa regulations), which accounts for 77% of its revenues.
Objects of Issue and Shareholding:
OFS makes up for 83% of the issue size, primarily to provide exit to PE fund JP Morgan, which is selling its entire holding of 19.43%. It is little unusual to see a PE investor make a complete exit, especially if the company has healthy growth visibility. However, the fund is making about 40%+ IRR on its 5 year old investment! Promoter Ashok Soota’s shareholding of 61.8% will shrink to 53.2% post IPO. Currently, 50% of promoter holding is pledged against Rs. 40 crore loan facility from Avendus, since July 2019, which will be removed post IPO. Fresh issue proceeds will fund long term working capital of Rs. 101 crore.
In the RHP, company has reported financials since FY18 and performance has been a mixed bag. On Rs. 463 crore revenue in FY18, it reported loss before tax of Rs. 23 crore, despite being profitable in the earlier years. In FY19, revenue and profit before tax (PBT) rose to Rs. 590 crore (up 27% YoY) and Rs.26 crore respectively. And FY20 revenue grew 18% YoY to Rs. 698 crore, with PBT of Rs. 85 crore, translating PBT margin of 12%. Important to benchmark PBT performance with peers (and not PAT) as company has tax breaks till FY21-end. Company’s FY20 effective tax rate was as low as 2% in FY20, but from FY22 onwards its tax rates will move to 25%. Coming back to the FY20 PBT margin of 12% is still lower, compared to peers averaging anywhere between 16-22%.
So while digital market is growing at 20% vis-à-vis overall industry growth of 10%, company enjoys tailwinds in terms of revenue growth. However, profitability is yet to catch-up. One of the reasons for lower margins is high employee costs, which at 61-62% of sales, are substantially higher than industry mean of 50-55%.
For Q1FY21, revenue stood at Rs. 177 crore, implying FY21 growth rates may be impacted due to the current pandemic. Due to tax credit in the June quarter, Q1FY21 PAT of Rs. 50 crore was higher than PBT of Rs. 41 crore, leading to an EPS of Rs. 3.72 for Q1FY21, as against Rs. 5.4 EPS for FY20.
Important to note that Q1FY21 PBT margin of 23% was supported by multiple factors such as (i) depreciating INR vs USD (ii) lower attrition rates witnessed across the IT industry (iii) improved employee efficiency during work from home (iv) lower selling, general and admin expenses (SG&A) due to travel curbs, reduced lease rentals and overall cost controls, which may not be sustainable for a long period of time in future. Thus, a realistic EPS for FY21 is seen in Rs. 8-8.25 range.
Company’s current equity stands at Rs.28 crore, comprising 14 crore equity shares of Rs. 2 each. It net worth as of 30-6-20 was at Rs.314 crore, with surplus cash and equivalent of Rs.47 crore.
At Rs. 166, company’s market cap will be Rs. 2,438 crore, which discounts FY21E and FY22E earnings by PE multiples of 19x and 17x respectively, which are very rich. It will be incorrect to annualize Q1FY21 EPS to arrive at FY21 estimates, due a one-off tax incidence in the first quarter, as explained above.
Company is a small cap IT services company, with 27% RoE with fluctuating margins in the recent past. All positives such as accelerated adoption of digital technologies, expanding margins due to depreciating rupee, cost controls, lower attrition, have been priced in. Effective tax rate will increase from FY22 onwards, which must be borne in mind.
Mid-and-small sized companies like Mindtree, Cyient, Zensar, Mastek, Persistent, KPIT are ruling at PE multiples in low-to-mid teens, with healthier margin profile. Thus, not much appears to be left on the table for the prospective investors, while promoter being an industry stalwart and lower size for retail portion of 10%, as against general 35%, is keeping a lot of interest alive in the issue. However, we do not find the pricing to be attractive.
Better to wait for few a few more quarters to gauge margin picture before riding the digital IT momentum, as all positives appears to be baked in while pricing is not leaving much on the table. Hence, one can skip this IPO.
Grey Market Premium (GMP) of Happiest Minds: Grey Market Premium of Happiest Minds is an unofficial figure, against guidelines of SEBI. We strongly recommend investors against following the grey market premium. To know more about grey market premium and how it operates, read our article on ‘grey market premium’ in Pathshala column.
Disclosure: No Interest.