52 Ambit Tehcnology Thematic 24mar2014

Technology
March 24, 2014 Ambit Capital Pvt. Ltd. Page 2

CONTENTS

The underbelly of Indian IT the ugly, the bad and the not so good... 4
THE UGLY. 6
Geodesic 7
Educomp. 9
Financial Technologies (FTech)11
THE BAD. 13
Rolta.. 14
MCX.. 16
THE NOT SO GOOD 18
Tech Mahindra 19
Infosys... 22
KPIT Technologies.. 24

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital
may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

The underbelly of Indian IT
The Indian IT sector is oft praised for its good corporate governance and
accounting excellence. However, our history of covering the sector over
the last four years indicates that this blanket assumption is misleading.
We present case studies of companies (classified as ugly, bad and not
so good) that underperform on accounting and corporate governance
standards. Whilst some of these companies (such as FTech, Educomp and
Geodesic) are already understood by the market for what they are,
others (such as Rolta, MCX, Infosys, Tech Mahindra and KPIT) are yet to
be discounted appropriately by investors.
Misconceptions about the quality of Indian IT sector
Five years since the Satyam fraud, the IT Index is up over 300%, implying that
the Indian IT sector is still assumed to be a safe haven of relatively cleaner
promoters, strong and neat accounts, and sound corporate governance
practices. However, our analysis and experience of the sector suggests this is
probably the easiest sector to fudge accounts, particularly given its largely
services-led nature and given that it relies on B2B transactions that do not lend
themselves to the sanity checks that one can do in industrial sectors.
Range of tricks to window-dress accounts
Indian IT firms have used a variety of tricks to window dress their accounts,
ranging from recognising cashless revenues (Geodesic), recognising seemingly
non-existent revenues (Geodesic, Rolta and MCX), accelerated revenue
recognition (Educomp), margin management (Geodesic, Rolta and KPIT
Technologies), inflated balance sheet (Rolta) to cash flow management (Rolta
and Geodesic). Furthermore, we also highlight how choice of accounting
policies can sugar-coat the accounts (Tech Mahindra and KPIT).
Not the cleanest on corporate governance either
Significant related party transactions at MCX (not appearing to be arms length),
the NSEL fiasco at FTech, questionably low independent director involvement at
TechM and Satyam when the merger ratio was finalised, relatively high
promoter Board representation and peculiar guidance pattern creating stock
price volatility at Infosys are some examples of corporate governance
loopholes. Furthermore, less-than-adequate disclosures at Tech Mahindra,
Educomp and seemingly weak risk management at MCX are also concerns.
Traces of suspicion in MCX and Rolta
Whilst cases such as Satyam (with its artificially inflated bank balances) can be
difficult to detect in advance, other cases such as Geodesic, Educomp and FTech
had similar financial characteristics, which could have been spotted by investors
who were willing to dig deep into their accounts. We find somewhat similar
issues in the annual reports of MCX and Rolta India.
On the other hand, Tech Mahindra, Infosys and KPIT present less than desirable
standards of accounting and corporate governance. For firms rated as richly as
these three, this should weigh on their valuation multiples.
We reiterate our SELL stance on Infosys and Tech Mahindra. We do not
cover the other IT companies mentioned in this note.
Technology

THEMATIC March 24, 2014

Case studies in this note
The ugly

Geodesic
Revenue and cash flow
manipulation; corporate
governance concerns
Educomp
Solutions
Accounts window dressing
Financial
Technologies
Suspicious subsidiary accounts;
corporate governance concerns
The bad

Rolta India Tricky accounting practices
MCX
Suspicious related party deals
and seemingly artificial volumes
The not so
good
Tech
Mahindra/
Satyam
Weaker disclosure norms;
accounting not up to
international standards; flags on
governance
Infosys
Letting down its own
governance standards?
KPIT
Technologies
Magnified margins
Source: Ambit Capital research
Key Recommendations
HCL Tech BUY
Target Price:1,614 Upside :13%
TCS BUY
Target Price:2,351 Upside : 11%
Tech Mahindra SELL
Target Price:1,471 Downside : 19%
Infosys SELL
Target Price: 2,945 Downside : 11%

Analyst Details
Ankur Rudra, CFA
+91 22 3043 3211
ankurrudra@ambitcapital.com
Nitin Jain
+91 22 3043 3291
nitinjain@ambitcapital.com

Technology


The underbelly of Indian IT
Five years on from the Satyam fraud, the Indian IT sector is still assumed to be a safe
haven of relatively clean promoters, strong accounting and sound corporate
governance practices. This has been historically reflected in the lower discount rates
applied to the sector, leading to higher P/E multiples.
However, our analysis and experience of the sector suggests this is probably one of
the easiest sectors to fudge accounts for three reasons: (1) its largely services-led
nature (i.e. there is no tangible output that can be observed), (2) it is centred around
B2B transactions that do not lend themselves to typical sanity checks that one can do
in industrial sectors (limited capability to do ground level surveys), and (3) there is a
declining linear relationship in this sector between revenues and headcount. (Given
that employee cost is the single-largest input cost, a declining correlation with
revenues offers greater scope for manipulation.)
Based on our observations over the past four years, we present case studies of eight
IT companies, highlighting their accounting and corporate governance issues and
challenging the notion that Indian IT firms have high-quality accounts and strong
corporate governance. This is not an exhaustive study and is based on the
standout cases we have come across. Other firms may have similar or even
greater issues. We classify the accounting and governance issues in this sector into
six broad categories:
1. Revenue manipulation: This can be done by either booking cashless revenues
(with a corresponding increase in receivables), fictitious revenue booking (through
classification of other income as revenues) or accelerated revenue booking
through creative accounting methods. We find evidences of revenue manipulation
by firms such as Geodesic, Rolta, Educomp and MCX.
2. Margin management: This can be done through capitalising expenditures,
lower provisioning for doubtful debts or through creative accounting (such as not
accounting for client re-imbursements in revenues and costs). Geodesic, Rolta
and KPIT seem to follow such practices.
3. Accounting method/system not comparable to peers: The most apt example
is Tech Mahindra. It uses Indian GAAP, whilst most of its peers have already
migrated to US GAAP/IFRS many years ago. Use of Indian GAAP allowed it to
adopt the Pooling of interest method (that records all balance sheet items at
book value) for merger accounting of Satyam. The use of Indian GAAP has
helped it maintain high RoEs. Had the transaction been recorded under
internationally accepted Purchase method, the RoEs would have been
significantly lower. Our back-of-the-envelope calculations suggest that FY13
/FY14E RoE could have been 14.8%/18.4% under the purchase method (with
Goodwill recognition) vs the RoEs of 36.3%/33.3% under the currently followed
Pooling of interest method (see pages 19-20).
4. Balance sheet and cash flow management: This can be done by removing
the borrowings from the balance-sheet through a separate Special Purpose
Vehicle (SPV) and accelerating cash flow receipts through factoring using this SPV
(example Educomp) or through the use of creative accounting (Rolta
revaluation of land to offset additional depreciation charges).
5. Corporate misgovernance: This can be done through under-representation of
independent directors (Tech Mahindra and Satyam), higher promoter
dominance (Infosys), related party transactions which do not appear to be at
arms length prices (MCX and FTech), less-than-adequate risk control measures
(MCX) and a peculiar pattern of representing the future outlook to investors
(Infosys).
6. Weaker disclosure norms: Relatively weak financial and event disclosures lead
to investor decision-making based on inadequate information. Educomp, FTech
and Tech Mahindra appear to fall in this category.
Tech Mahindras RoE sensitivity to
IFRS accounting
` mn
Current
(Pooling of
interest
method)
Purchase
method
(estimated)
FY13 FY14E FY13 FY14E
Adjusted net
income
21,157 27,674 13,694 20,211
Adjusted Equity 68,530 97,484 99,168 120,659
Adjusted RoE 36.3% 33.3% 14.8% 18.4%
Source: Ambit Capital research

Technology


We present case studies on the following companies:
The Ugly
1. Geodesic: Are the revenues real?
2. Educomp Solutions: The accounts appear to be window dressed
3. Financial Technologies (FTech): Suspicious subsidiary accounts; corporate
governance concerns
The bad
4. Rolta India: Tricky accounting practices
5. MCX: Suspicious related party deals and seemingly artificial volumes
The not so good
6. Tech Mahindra/Satyam: Weaker disclosure norms; accounting not up to
international standards; flags on corporate governance
7. Infosys: Letting down its own governance standards?
8. KPIT Technologies: Magnified margins

Technology


Part 1: The Ugly
Geodesic
Are the revenues real?
Geodesics receivable days have increased to 300 days in FY12 (from 120 days in
FY12), whilst the doubtful debt provisioning has increased to 11.9% of debtors (9.8%
of revenues in FY12). Cash yields remain at astonishingly low levels. All these raise
concerns whether the earlier years revenues were indeed real. Cash conversion
though improved over the last three years, the increase in current liabilities has been
a significant factor pushing up the cash conversion.

Educomp Solutions
Accounts window dressing
Educomps creation of a special purpose vehicle to transfer its receivables and then
securitise it was an attempt to improve its cash conversion and make its balance
sheet look lighter. Its change in revenue recognition policy was also intriguing. These
coupled with instances of poor disclosures make it an interesting case study.

Financial Technologies (FTech)
Suspicious subsidiary accounts; corporate governance concerns
From a stockmarket darling, riding on success in MCX and similar expectations from
the other exchange ventures, Financial Technologies is now struggling to retain
ownership of these exchanges on the back of the NSEL fiasco, bringing down
expectations from its other exchange ventures. Besides the corporate governance
issues (for not curbing the illegitimate activities at NSEL), our analysis also indicates
suspicious manipulation of subsidiary accounts to present a better picture at
standalone business. FTech does not publish consolidated quarterly results (despite
~40% revenues from subsidiaries), and hence, presenting good-looking standalone
numbers makes sense.

Technology


Geodesic
Are the revenues real?
Geodesic offers an interesting case study that shows several signs of revenue and
cash conversion manipulations. With a glorious historical track record (104% FY04-09
revenue CAGR and ~55% EBITDA margins), Geodesic was viewed as an internet and
mobile software company with exciting B2C products in instant messaging, cheaper
SMS, VoIP calling, mobile TV and several products in a fast-growing market. Although
its products were exciting, most of them failed to get commercial scale before they
commoditised. The quality of revenue growth was always under question given
significantly higher receivable days and low yield on investments (indicating
possibilities of fictitious revenue booking).
Whilst this remained unnoticed till the time the company was growing in triple digits,
the problems intensified FY10 onwards, when the companys revenues declined for
the first time in FY10, with a consequent decline in margins. Geodesics receivable
days have increased to 300 days in FY12 (from 120 days in FY12), whilst the doubtful
debt provisioning has increased to 11.9% of debtors (9.8% of revenues in FY12).
Cash yields remain at astonishingly low levels. All these raise concerns whether the
earlier years revenues were indeed real. Cash conversion, though improved over the
last three years, increase in current liabilities has been a significant factor pushing up
the cash conversion.
Geodesic unsurprisingly finds itself in a greater mess now, with its auditor (Borkar
and Muzumdar) raising qualifications on revenue and expense accounting, default on
FCCBs, and forex hedging losses. The company has not yet published the
consolidated FY13 accounts, is yet to pay the final dividend for FY12 and is
functioning with just three directors all executive (all of the independent directors
have resigned). This reflects in the market capitalisation which is down from `6.9bn
at the beginning of 2009 to `284mn.
Cashless revenues
We find at least three evidences raising concerns on Geodesics revenue recognition:
1. High receivable days and increasing doubtful debt provisions: Although
revenue growth recovered in FY11 and FY12, it came on the back of significant
increase in receivable days (see Exhibit 1 below). Receivable days increased from
120 days in FY10 to 174 in FY11 and further to 300 in FY12. This, coupled with
high bad debt provisioning in FY12, raises concerns on the quality of revenues
booked in earlier years.
Exhibit 1: Suspicious revenue accounting
` mn FY08 FY09 FY10 FY11 FY12
Revenues 3,164 6,530 6,374 8,732 11,627
Revenue growth 92% 106% -2% 37% 33%
Receivable days 120 168 120 174 300
Bad debts (P&L) as % of debtors 0.2% 1.8% 0.2% 0.8% 11.9%
Bad debts (P&L) as % of revenues 0.1% 0.8% 0.1% 0.4% 9.8%
Source: Company, Ambit Capital research
2. Low yield on cash and cash equivalents: The average yield on cash and
investments was moderate 1.5% during FY10-12, which also raises concerns over
fictitious revenue booking (see Exhibit 2). The proportion of cash in the current
accounts was not material enough to result in such low yields.
Exhibit 2: Fictitious revenue booking?
Interest and dividend income 118 206 75 183 212
Average Cash and investments 3,898 6,862 7,991 10,878 12,163
Yield on average cash and investments 3.0% 3.0% 0.9% 1.7% 1.7%

Five-year share price
performance

Source: Bloomberg

Financials
` mn FY11 FY12 FY13*
Revenues 8,732 11,627 NA
PAT 2,737 2,600 NA
FCF 4,707 1,363 NA
Note: * FY13 annual report is not yet
published

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Technology


3. Revenue reversals and auditor qualifications: Furthermore, as disclosed by
the company in its filing to the BSE, auditors raised qualifications on inability to
verify the correctness of write-off of `2,778mn on licence sales. This also raises
suspicion on the quality of revenues booked in earlier years. The auditors also
raised qualifications on lower doubtful debt provisioning to the extent of
`3,675mn.
Playing with current liabilities to shield cash conversion?
Whilst Geodesic reported better cash conversion in FY10, thanks to a 48 day YoY
decline in receivable days, FY11 and FY12 were marked by an unusually high
contribution from the current liabilities to offset the impact of the increase in
receivable days.
Exhibit 3: Cash conversion improved but was driven by current liabilities
CFO/EBITDA 57% 31% 125% 134% 92%
CFO 1,172 1,122 4,188 5,413 3,893
CFO before working capital changes 1,978 3,601 3,531 4,294 4,115
Increase in debtors -413 -1,959 905 -2,074 -5,396
Change in loans and advances -584 -663 -727 1,344 -2,230
Change in current liabilities 264 290 563 1,956 9,696
Others -74 -149 -84 -107 -2,292
Underestimation of expenses
Besides lower provisioning of expenses, as discussed above, auditors also raised
concerns over correctness of write-back of `4,370mn in respect of software licence
returned to the supplier. Furthermore, auditors also qualified on non-provisioning
for depletion of the companys investment in Geodesic Technologies Solutions Limited
(GTSL) amounting to `616mn.

Corporate governance concerns
1. Lack of Board independence: Whilst Geodesic had more than 50%
independent directors on the board as on March 2012, all these independent
directors have resigned since then and the Board now comprises just three
directors, all of them executive. Departure of all the independent directors and
inability of the company to bring in new independent directors to replace them
further accentuates our concerns.
2. Non-payment of dividends: Furthermore, despite the cash crunch arising from
FCCB maturity in FY13, Geodesic proposed a dividend of `2/share in 2012,
which still remains unpaid.

Technology


Educomp Solutions
Accounts window-dressing
Educomps creation of a special purpose vehicle to transfer its receivables and then
securitise it was an attempt to improve its cash conversion and make its balance
sheet look lighter. Its revenue change in revenue recognition policy was also
intriguing. These coupled with instances of poor disclosures make it an interesting
case study.
SPV structure allowed accelerated revenues, better CFO and lower leverage
In FY10, Educomp changed its revenue recognition policy for the Smart_Class
business. It created an SPV (named Edu Smart) for this purpose. It created a model
whereby the Smart_Class receivables were securitised through Edu Smart. Rather
than following the earlier BOOT (Build, Own, Operate and Transfer) model, Educomp
sold the hardware and content as a package to Edu Smart (whom it called a third
party vendor), which then securitised the receivables with banks. This securitisation
process helped Educomp to window dress its accounts in three ways:
1. Accelerated revenue recognition: In the earlier BOOT model, Educomp
recognised contract revenues over a five-year period (i.e. only 20% of TCV was
recognised in any quarter). However, under the new securitisation model,
Educomp booked 75% of revenues for the total signed classrooms during the
quarter in two tranches, whilst 25% was passed on to the vendor (Edu Smart).
Out of the 75% revenues, 52.5% was recognised upfront during the particular
quarter whilst 22.5% was booked in the successive year same quarter. Since
Educomp had an economic obligation to provide content updates, Educomp
decided to recognise the content revenues over a two-year period. This
accelerated the revenue recognition as well as profitability.
2. Cash flow from securitisation boosted Educomps cash flows: Whilst the
proceeds from securitisation are ideally in the nature of borrowing, the SPV
structure allowed Educomp to account it as cash flow from operations. This
artificially improved Educomps cash conversion ratio.
3. Off balance sheet liabilities: The structure allowed recognition of liabilities on
the SPVs balance sheet. However, Educomp had given corporate guarantees for
Edu Smarts securitisation arrangement. (Given that Edu Smart was a new entity,
it would have been difficult for it to raise funds on its own.) This made it liable to
banks in the event of default by Edu Smart or any breach in the securitisation
covenants. However, the SPV structure allowed Educomp to keep its balance
sheet light, so that it can raise funds for its evolving K-12 business.
In FY10, Educomp disclosed Corporate guarantee to banks for secured loans
to third party of `6,650mn in the notes to accounts of the Annual Report. A
cross check with Edu Smarts return filing at the Ministry of Corporate Affairs
(MCA) confirms that this was the guarantee given by Educomp to Edu Smart.
Through the SPV structure, Educomp managed to under-report the leverage
(Debt/Equity) by 39%. The actual reported leverage was 0.64x, whilst the
real leverage accounting for the liabilities on SPVs balance sheet would
have been 1.04x. The extent of contingent liabilities and true leverage kept
rising significantly till this SPV was made redundant in FY13.
However, in the 3QFY13 results, the management announced the move back to the
BOOT model, feeling pressure from the institutional shareholders.

performance

Source: Bloomberg

Financials
` mn FY11 FY12 FY13
Revenues 13,509 14,913 12,109
PAT 3,354 1,355 -1,328
FCF -5,267 -2,281 -3,585

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Technology


Less-than-ideal disclosures
We also observed some disclosure lapses by Educomp, worth highlighting:
1. Promoter allotted warrants: Educomp increased the stake in Educomp
Infrastructure and School Management Ltd (EISML) from 69.4% to 78.2% at
`4.89bn in 2009. This gave EISML an implied valuation of `16.42bn. However,
the promoter (MD of Educomp) was awarded 800K warrants at the same
valuation as Educomp, over six months after Educomps equity infusion according
to filings to the Ministry of Corporate Affairs. We find the lack of disclosure on this
front unsettling although we recognise that the law might not require Educomp to
make such a disclosure.
2. Undisclosed JV with an existing school: Educomp established a JV with an
existing school called the Ambika Modern School in Jalandhar that has been
rebranded as Millennium Jalandhar. We find it intriguing that the management
did not disclose this explicitly.

Technology


Financial Technologies (FTech)
Suspicious subsidiary accounts; corporate governance
concerns
From a stockmarket darling, riding on the success in MCX and similar expectations
from the other exchange ventures, Financial Technologies is now struggling to retain
ownership of these exchanges on the back of the NSEL fiasco, bringing down
expectations from its other exchange ventures. Besides the corporate governance
issues (for not curbing the illegitimate activities at NSEL), our analysis also indicates
suspicious manipulation of subsidiary accounts to present a better picture at the
standalone business. FTech does not publish consolidated quarterly results (despite
~40% revenues from subsidiaries), and hence presenting good-looking standalone
numbers makes sense.
Significant related party transactions standalone numbers appear
artificially attractive
FTech derives more that 40% of its revenue from subsidiaries (its investments in
several exchanges and related businesses), which make them an important part of
the overall financials. We have observed that FTech has allocated a higher proportion
of its expenses to subsidiaries. For example, it allocates all the advertisement and
promotion expenses and more than half of its other expenses to subsidiaries. Given
that FTech reports only standalone results in its quarterly filing (despite subsidiaries
accounting for >40% of revenue), charging of significantly higher expenses to
subsidiaries raise concerns on accounting manipulations in company financials,
making the standalone financials look better.
Exhibit 4: Consolidated vs standalone
` mn FY10 FY11 FY12 FY13
Revenue

Consolidated (a) 3,292 4,079 5,012 7,519
Standalone (b) 3,286 3,577 4,255 4,509
a - b 6 502 757 3,010
Add: Sales by Standalone to Subsidiaries 1,519 1,434 1,785 1,176
Estimated Subsidiary revenue 1,525 1,936 2,542 4,186
Employee benefit expenses

Consolidated (a) 2,151 2,638 2,469 2,501
Standalone (b) 900 1,154 1,125 1,241
% of Standalone revenue 27% 32% 26% 28%
a - b 1,251 1,484 1,344 1,260
% of Subsidiary revenue 82% 77% 53% 30%
Other expenses

Consolidated (a) 2,430 2,572 2,607 3,053
Standalone (b) 1,004 1,089 1,019 651
a - b 1,425 1,484 1,588 2,402
Advertisement and business promotion expenses

Consolidated (a) 129 204 319 337
Standalone (b) 0 0 0 0
a - b 129 204 319 337
PAT

Consolidated (a) 1,401 -1,368 2,641 2,274
Standalone (b) 3,444 919 4,780 3,229
a - b -2,043 -2,287 -2,140 -954

performance

Source: Bloomberg

Financials
` mn FY11 FY12 FY13
Revenues 4,079 5,012 7,519
PAT -1,368 2,641 2,274
FCF -5,371 2,107 756

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Technology


NSEL fiasco Corporate governance issue
National Spot Exchange (100% subsidiary of FTech) was promoted as a delivery
based market place for the purchase and sale of commodities. However, as it
eventually turned out, NSEL became an unregulated repo market for agricultural
commodities as collateral
1
. Contracts were rolled over without mark to market (MTM)
adjustments, there was no physical transfer of commodities (indeed the underlying
commodities and warehouses did not exist in many cases) and there were also short
selling. The pair trades in various commodities were offered in forward contracts of
T+2 to T+25 (sometimes even T + 35) payment terms (bought and sold at the same
time), whilst the maximum allowed settlement period was T+11. Such pair trades
offered an arbitrage opportunity of about 12-15% return per annum.
The Ministry of Corporate Affairs took exception to this and appointed the Forward
Market Commission (FMC) to investigate. The Minister for Consumer Affairs, KV
Thomas, and the FMC sent a circular to NSEL to stop launching new forward
contracts and make deliveries on existing contracts to curb speculation
2
. Given that
delivery never happened in the earlier scheme of things, sudden termination of
contracts in the absence of collaterals led to defaults by the borrowers.
The company is now looking to sell some of its assets. For example, Financial
Technologies sold its stake in Singapore Mercantile Exchange to the Singapore unit of
Intercontinental Exchange Group for US$150mn in November 2013. It also sold its
warehousing subsidiary (National Bulk Housing Corp) for ~US$40mn
3
.
Financial Technologies now struggles to maintain ownership of its most profitable
venture, MCX and its other Indian exchange holdings such as MCX-SX, given
questions raised by regulators SEBI (regulating stock exchanges) and FMC
(regulating commodity exchanges) over its fit and proper status to be a
shareholder in commodity and stock exchanges
4

5
.

1
http://articles.economictimes.indiatimes.com/2013-0802/news/41008403 _1_national -spot exchange -
nsel-contracts

2
http://www.livemint.com/Money/N0hCBdRIbDKuOcD4o4ZW6M/NSEL-suspends-trading-of-all-contracts-
except-eSeries.html

3
http://www.moneycontrol.com/news/business/ftil-sells-nbhc-for-rs-242-crore_1054257.html

4
http://www.business-standard.com/article/markets/all-eyes-on-sebi-after-fmc-s-decision-on-ft-
113121800892_1.html

5
http://www.moneylife.in/article/sebi-rules-fintech-not-fit-and-proper-to-hold-stake-in-any-stock-
exchange/36774.html

Technology


Part 2: The Bad
Rolta India
Tricky accounting practices
An analysis of the financial statements of Rolta India indicates a couple of grey areas.
Its recent revaluation of land just coinciding with the change in depreciation policy (to
bring the depreciation rates to the industry norms) seems to be an accounting trick to
manage the net worth, whilst at the same time not hurting the future profitability (as
land is not subject to depreciation). Roltas capital employed turnover has also been
quite low (0.5x on an average over FY11-13). A deeper look indicates that despite
moderate revenue growth (6% USD revenue CAGR over FY10-13), the capital
expenditure has remained surprisingly high (average 46% of revenues over FY11-13).
This creates suspicion on expense manipulation (through capitalisation).
Furthermore, Rolta has an uneven accounting history with the SEBI probe on over-
reporting of revenues through booking of inter-divisional transfer of self-
assembled/integrated capital equipment as sales. Though Rolta has abandoned this
practice post the SEBI order in 2004, the other observations raise concerns on the
sanity of accounting practices.

Multi Commodity Exchange (MCX)
Suspicious related party deals and seemingly artificial volumes
Whilst MCX has been a success story and the only publicly listed commodity bourse in
India with ~77% market share, it does not have a clean accounting and operational
track record. The reported volumes seem to be overstated (evident from unnaturally
higher Average Daily Volume to Open Interest ratio), whilst transactions with
promoter entity do not seem to be at arms length. Lower margin to open interest
also reflect imprudent risk control, presumably in pursuit of higher volumes.

Technology


Rolta India
Tricky accounting practices
An analysis of the financial statements of Rolta India indicates a couple of grey areas.
Its recent revaluation of land just coinciding with the change in depreciation policy (to
bring the depreciation rates to the industry norms) seems to be an accounting trick to
manage the net worth, whilst at the same time not hurting the future profitability (as
land is not subject to depreciation). Roltas capital employed turnover has also been
quite low (0.5x on an average over FY11-13). A deeper look indicates that despite
moderate revenue growth (6% USD revenue CAGR over FY10-13), the capital
expenditure has remained surprisingly high (average 46% of revenues over FY11-13).
This creates suspicion on expense manipulation (through capitalisation).
Furthermore, Rolta has an uneven accounting history with the SEBI probe on over-
reporting of revenues through booking of inter-divisional transfer of self-
assembled/integrated capital equipment as sales. Though Rolta has abandoned this
practice post the SEBI order in 2004, the other observations raise concerns on sanity
of accounting practices.
Accounting gimmicks to protect net worth
During the fourth quarter of FY13, Rolta changed its depreciation policy (by reducing
the estimated useful life of the assets) and at the same time re-valued land on the
balance sheet.
The management highlighted that as a matter of prudence and to align depreciation
policy with the current replacement cycle taking into consideration various factors
such as technology up-gradation and industry best practices, the Company has
revised estimated useful life of all assets. Consequently, Rolta India reduced the
estimated useful life of Computer Systems to 2-6 years against 4-10 years earlier,
Other Equipment at 10 years against 20 years earlier, Furniture & Fixtures at 10
years against 15 years earlier and Vehicles at 5 years against 10 years earlier.
Consequent to the above, it booked an additional charge for depreciation during the
quarter, amounting to `11,537mn as an exceptional item. Interestingly, the
management simultaneously revalued the freehold and leasehold land during the
quarter, booking the revaluation gains of `10,571mn directly in the reserves, with an
eventual impact of just `966mn on the net worth.
Had the company not revalued land, the depreciation estimate revision could have
eroded the net worth by 57%. Given ~2x Debt/Equity ratio, 57% erosion in net worth
could have a serious implication on Rolta, both in terms of re-financing the existing
debt at the same or better borrowing cost as well as raising additional funds. More
importantly, revaluation of land will also not impact the future profits and land is not
subject to depreciation. This clearly seems to be an accounting trick to manage
the net worth without hurting the future profitability at the same time.
Low capital employed turnover and high capitalisation raise concerns over
expense manipulation
Roltas asset turnover (sales/average capital employed) has been significantly below
the peer average over the last three years (0.5x vs tier-2 peer average of 1.6x). A
deeper look into the causes shows that capitalisation as a percentage of revenues has
been extraordinarily high (~46% on an average over FY11-13 vs tier-2 peers
average of 6%). More surprisingly, this comes at a time when Roltas revenues have
grown at a moderate 12.3% CAGR over FY10-13 (6.6% in USD terms).
Given such a moderate growth rate, disproportionately high levels of capex
create suspicion regarding expense manipulation (through capitalisation).

performance

Source: Bloomberg

Financials
` mn FY11 FY12 FY13
Revenues 18,056 18,288 21,788
PAT 3,519 -959 -8,674
FCF -1,345 -4,418 -4,696
Capex -8,393 -13,932 -16,069

20
70
120
170
220
270
10,000
15,000
20,000
25,000
Mar-
09
Jun-
10
Aug-
11
Nov-
12
Jan-
14
Sensex Rolta

Technology


Exhibit 5: Low asset turnover coupled with high capitalisation raises concerns on expense manipulation
Company\Metric
Asset turnover
(sales/average net capital
employed)
Capitalised R&D (mentioned by
company) as % of revenue
Intangibles (Ex Goodwill) addition
as % of revenue
Overall capex as % of revenues
FY11 FY12 FY13 Average FY11 FY12 FY13 Average FY11 FY12 FY13 Average FY11 FY12 FY13 Average
Rolta 0.6 0.5 0.4 0.5 2.7% 4.0% 5.4% 4.0% 9.7% 8.3% 4.3% 7.4% 18.7% 49.4% 68.9% 45.7%
Tier 2 peers

eClerx 1.6 1.6 1.7 1.6 NA NA NA NA 0.7% 0.3% 0.5% 0.5% 7.0% 5.3% 16.4% 9.6%
Persistent Systems 1.1 1.3 1.3 1.2 0.1% 0.1% 0.0% 0.1% 6.9% 4.1% 2.7% 4.6% 12.5% 15.1% 8.8% 12.1%
Hexaware 1.1 1.5 1.7 1.4 NA NA NA NA 0.2% 0.2% 0.4% 0.3% 3.2% 4.4% 3.8% 3.8%
Infotech Enterprises 1.2 1.4 1.5 1.3 NA NA NA NA 0.4% 1.1% 1.7% 1.1% 9.0% 5.3% 4.9% 6.4%
KPIT 1.6 1.7 1.9 1.7 1.5% NA NA 1.5% 2.5% 1.2% 0.8% 1.5% 4.3% 4.1% 3.1% 3.8%
NIIT Tech 1.8 1.8 1.9 1.8 NA NA NA NA 0.7% 1.1% 1.5% 1.1% 4.1% 5.9% 4.6% 4.9%
Mindtree 2.0 2.1 2.0 2.1 NA NA NA NA 0.4% 0.0% 0.0% 0.1% 5.6% 2.5% 4.5% 4.2%
Polaris 1.7 1.7 1.6 1.7 NA NA NA NA 0.4% 0.3% 0.5% 0.4% 7.1% 7.2% 2.5% 5.6%
Tech Mahindra 1.0 1.0 1.1 1.0 NA NA NA NA 0.0% 0.3% 1.0% 0.4% 3.0% 5.4% 2.6% 3.7%
Tier 2 peers average 1.5 1.6 1.6 1.6 0.8% 0.1% 0.0% 0.8% 1.3% 1.0% 1.0% 1.1% 6.2% 6.1% 5.7% 6.0%

Uneven accounting history - Inter-divisional transfers booked as revenues!
Rolta followed a practice of booking the self-assembled/integrated capital
equipment transfer (including the fixed assets and estimated labour and overhead
costs) from its CAD/CAM division to internet and export divisions as revenues from
1996-2003. It booked the cost of these assets as expenses and then capitalised the
overall cost of the capital equipment. Whilst this did not impact the bottom-line of the
company, the revenues were overstated to the extent of these transfers. Furthermore,
~50% of these capital equipment costs comprised overheads which were based on
management certification rather than an external audit. This left scope for significant
revenue manipulation.
Rolta was following this accounting practice for seven years (since 1996) and had
claimed that given the accounting treatment is EPS neutral, it should not impact
investor decision-making. However, post the SEBI order in July 2004
6
, Rolta India
abandoned reporting these inter-divisional capital equipment transfers as sales.

6
http://www.sebi.gov.in/cmorder/roltaorder.html

Technology


Multi Commodity Exchange (MCX)
Suspicious related party deals and seemingly artificial
volumes
Whilst MCX has been a success story and the only publicly listed commodity bourse in
India with ~77% market share, it does not have clean accounting and operational
track record. The reported volumes seem to be overstated (evident from unnaturally
higher Average Daily Volume to Open Interest ratio), whilst transactions with
promoter entity do not seem to be at arms length. Lower margin to open interest
also reflect imprudent risk control, presumably in pursuit of higher volumes.
Creating volumes in thin air?
The ratio of Average Daily Volume traded (ADV) to Open Interest (OI or the positions
kept open overnight) is often used to measure market depth. Given below is the
comparison of ADV (average daily volume) to OI (Open Interest) for the past three
years for Futures contracts on MCX as compared to NCDEX, CME and NSE Nifty
Futures (see Exhibit 6). This is the best measure of depth and hedging interest in an
exchange and separates speculative/artificial volumes from sustainable volumes
(lower the better). MCXs ADV/OI has historically been significantly higher that of
NCDEX, NSE and CME.
Exhibit 6: Ratio of ADV to Open Interest
2011 2012 2013 Jan-14 Feb-14
MCX 7.48 4.79 4.13 3.65 3.29
NCDEX 3.78 1.49 0.84 0.81 0.64
NSE 1.17 1.56 1.37 1.63 1.47
CME 0.44 0.40 0.39 0.35 NA
CME - Metals and Energy 0.13 0.12 0.13 0.13 NA
Source: Company, Bloomberg, FMC, Ambit Capital research
Besides this, certain media reports
7
also claim that a special audit report by PwC has
found the Indian Bullion Markets Association, a firm related to MCX, indulged in
volume rigging on the commodity exchange. The report claims the value of the
transactions to be `400bn. This corroborates our analysis of significantly higher ADV
to OI as compared to other exchanges.
Related party transactions are these at arms length?
FT, the promoter entity of MCX, provides it the software and business support
technology. MCXs technology charges (as a percentage of revenues) appear to be
too high relative to the other global bourses, which raises concerns whether these
technology service payments are at arms length.
Exhibit 7: Comparison of technology charges
As % of revenues FY10 FY11 FY12 FY13 FY14
MCX 20% 21% 16% 18% NA
CME 5% 4% 4% 5% 5%
SGX 8% 10% 10% 9% NA
ICE 4% 4% 4% 3% NA
Hong Kong Exchange 4% 4% 4% 5% 7%
Bursa Malaysia 5% 5% 7% 8% 8%

7
http://www.moneycontrol.com/news/business/pwc-audit-finds-ibma-rigged-
tradesmcx-sources_1046667.html

performance

Source: Bloomberg

Financials
` mn FY11 FY12 FY13
Revenues 3,689 5,451 5,240
PAT 1,763 2,867 2,992
FCF 2,387 3,305 68

0
500
1000
1500
2000
10,000
15,000
20,000
25,000
Mar-12 Dec-12 Oct-13
Sensex MCX

Technology


Indeed, according to media reports
8
, interim findings of a special audit by PwC flag
several related issues regarding related party transactions:
1. No documented policy was in place for buying services from group firms and
related parties, while certain contracts with the parent company Financial
Technologies were not discussed and approved in the exchange board
and directors' committee.
2. MCX paid a mark-up of up to 32% on procurement of hardware by FTIL
and signed contracts with it that had "unprecedented long tenure" of 33-50 years
with a provision of automatic renewal for another 33 years.
3. Several other suspicious transactions have been highlighted in the report. (Click
here for the news release disclosing these transactions.)
Although these revelations are still preliminary and not publicly available, our
analysis of astonishingly high technology charges to FT certainly raises concerns.

Declining margins Are the default risks managed well?
MCX collects margins from its members to deal with price volatility. This reduces
systemic risk of defaults in periods of high volatility. The growth in MCX's Open
Interest and Margin Money (as reported on the Balance Sheet) is shown in Exhibit 8
below. The percentage of margin money has declined from 12.7% in FY08 to 2.2% in
FY13. This indicates either of the below three possibilities:
1. The exchange is collecting lower margins per contract than before that indicates
rising systemic risk from defaults in case of high price volatility.
2. Increasing trades by some members that do not stump up margins.
3. Possibility of accepting off balance sheet collateral or assets in lieu of margin such
as liens on FDs or liquid investments. This still may not make such a big shortfall.
Moreover, brokers may accept this and this does not seem prudent practice for an
exchange.
Exhibit 8: Declining margin of safety
In ` mn Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13
Margin money disclosed in current liabilities 3,205 5,449 4,082 5,283 6,096 4,324
Total Open Interest Amount 28,780 50,562 74,017 138,430 155,868 192,935
Margin to OI 12.7% 10.8% 5.5% 3.8% 3.9% 2.2%
Source: Company, FMC, Ambit Capital research

8
http://articles.economictimes.indiatimes.com/2014-0224/news/47635734_1_
shreekant -javalgekar- year-mcx-ftil-group

Technology


Part 3: The not so good
Tech Mahindra
Weaker disclosure norms; accounting not up to international standards; flags
on governance
Whilst many see Tech Mahindra as the next tier-1 Indian IT service company, its
quality of disclosure lags that of other tier-2 companies such as Mindtree. TechM
does not publish quarterly cash flow and balance sheet statements and it provides no
service-line break-up.
Secondly, whilst all the tier-1 firms publish IFRS financial statements, along with the
Indian GAAP accounts (with the exception of HCL Tech that reports under US GAAP),
Tech Mahindra reports financials only under Indian GAAP. This makes comparisons
with peers less meaningful due to differences in accounting methods.
Finally, lack of adequate independent director representation on the Satyam Board at
the time when the swap ratio between Satyam and TechM was finalised raises
concerns on corporate governance.

Infosys
Letting down its own governance standards?
Ever since its IPO in 1993, Infosys has been regarded as a paradigm of corporate
governance in India. Whilst this image earned Infosys goodwill from investors, clients
and employees, there are signs that these high corporate governance standards are
fraying. NRN Murthys entry into Infosys in an executive capacity (even after Infosys
well-articulated policy of executives retiring at the age of 60), bringing with him his
son as executive assistant, higher promoter representation at the Board and peculiar
guidance pattern resulting in high volatility in the share price none of this gels with
Infosys image of a leader when it comes to corporate governance.

KPIT Technologies
Magnified margins
KPIT Technologies margins appear to be overstated given the accounting policies
and estimates that are different from its peers. Its accounting policy of excluding re-
imbursements both from income and cost (contrary to accounting policy followed by
companies such as Infosys, TCS and Persistent Systems) benefits its margins by
~50bps according to our calculations. Furthermore, its actuarial assumption of salary
increase for retirement benefit obligations is significantly below that of peers (5% vs
peer average of 7%).

Technology


Tech Mahindra
Weaker disclosure norms; accounting not up to
international standards; flags on governance
Whilst many claim Tech Mahindra is the next tier-1 Indian IT services company, its
quality of disclosure still lags that of several tier-2 companies such as Mindtree.
TechM does not publish quarterly cash flow and balance sheet statements and it
provides no service-line break-up. Secondly, whilst all the tier-1 firms publish IFRS
financial statements, along with the Indian GAAP accounts (with the exception of HCL
Tech that reports under US GAAP), Tech Mahindra reports financials only under
Indian GAAP. This makes the comparison less meaningful due to differences in
accounting methods. Finally, lack of adequate independent director representation
on the Satyam Board at the time when the merger swap ratio with TechM was
finalised raises concerns on corporate governance.
Weaker disclosure norms
Tech Mahindras disclosures (in the quarterly financials) still lag that of tier-1 Indian
firms and even the tier-2 firms such as Mindtree and Persistent Systems. Tech
Mahindra does not report the quarterly balance sheet and cash flow statements.
Given cash flow (and working capital intensity) is the most widely tracked metric for
an IT service company, this creates information asymmetry. Furthermore, absence of
a service-line breakup makes the analysis of underlying revenue growth drivers
difficult.
Cash flow and cash conversion are amongst the most keenly tracked financial metrics
for IT companies. Non-reporting of quarterly balance sheet and cash-flow statements
makes this analysis very difficult. Our back calculation of cash flow from operations
using changes in net debt, capex and other expenses indicate that cash conversion
has remained weak for Tech Mahindra in 9MFY14 (even weaker than 57% cash
conversion in FY13).
Furthermore, there was no satisfactory explanation for the US$22mn stamp duty
payment for the Tech Mahindra and Satyam merger by the company management. It
was neither mentioned in the notes to the accounts although we understand that this
payment was made during 3QFY14.
Exhibit 9: Unexplained weakness in cash conversion*
` mn FY13 1QFY14 2QFY14 3QFY14 9MFY14
Net debt 24993 29,081 29,376 31,177 31,177
Net change in cash

4,088 295 1,801 6,184
Capex

2333 1497 1316 5,146
Adjustment for stamp duty payment (US$22mn)

0 0 1320 1,320
Adjustment for final dividend (incl dividend tax) for FY13
(assumed to be paid in 2QFY14)
0 750 0 750
CFO 16382 6,421 2,542 4,437 13,400
EBITDA (Adjusted for BT deferred revenues) 28627 8092 10557 10810 29,459
Revenues (Adjusted for BT deferred revenues) 141315 40479 47162 48432 136,073
CFO/EBITDA 57% 79% 24% 41% 45%
CFO/Revenues 12% 16% 5% 9% 10%
Receivable days 96 97 102 100 100
Source: Company, Ambit Capital research *Our estimates as company does not disclose quarterly cashflow statement
Accounting systems though legitimate, not comparable with tier-1 peers
Whilst all the tier-1 firms publish IFRS financial statements, along with the Indian
GAAP accounts (with the exception of HCL Tech that reports under US GAAP), Tech
Mahindra reports financials only under Indian GAAP. This makes an apple-to-apple
comparison difficult, particularly in the areas where Indian GAAP provisions differ
significantly with those of international accounting standards.

performance

Source: Bloomberg

Financials
` mn FY11 FY12 FY13
Revenues 102,852 117,024 143,320
PAT 5,965 18,431 19,556
FCF -121 2,474 6,132

200
700
1200
1700
10,000
15,000
20,000
25,000
Mar-
09
Jun-
10
Aug-
11
Nov-
12
Jan-
14
Sensex Tech Mahindra

Technology


One such area of difference is merger accounting. Indian GAAP allows the use of
two methods for merger accounting:
1. Pooling of interest method: In this method no goodwill is recognised and all
the assets and liabilities are accounted at book value. The applicability criteria
are: (a) all assets and liabilities should be transferred, (b) the consideration
should be through share swap, and (c) at least 90% of the shareholders of the
acquired company should become the shareholders of the acquirer.
2. Purchase method: If the merger fails the conditions for Pooling of interest
method, Purchase method applies. Here, the assets and liabilities are recorded
at fair value and hence goodwill is recognised.
On the other hand, US GAAP and IFRS prohibit the use of Pooling of interest
method. Hence in the event of a merger, the merged entity needs to account for all
the assets and liabilities at fair value. Consequently, goodwill is recognised in
mergers in US GAAP and IFRS.
The method of accounting for merger has a significant bearing on the RoE post-merger.
If the assets and liabilities of the acquired company are accounted at fair value
(Purchase method - the general internationally accepted norm) and the consideration
is greater than the book value, a goodwill is recognised (which is then amortised over
five years unless a longer period is justified) that inflates the equity base and
eventually results in relatively lower RoE for the merged entity. Indeed, in laymans
language, the goodwill is effectively written-off against equity in the Pooling
of the interest method, whilst it is routed through P&L in Purchase method.
Given the Satyam merger met the Pooling of interest methods criteria under Indian
GAAP, Tech Mahindra recorded the merger under Pooling of interest method. The
use of Indian GAAP has helped it maintain high RoEs. Had the transaction
been recorded under the internationally accepted Purchase method, the
RoEs would have been significantly lower. Our back-of-the-envelope
calculations suggest that FY13/FY14E RoE could have been 14.8%/18.4% under
the purchase method (with Goodwill recognition) vs the estimated RoEs of
36.3%/33.3% under the currently followed Pooling of interest method (see
Exhibit 10 below).
Exhibit 10: RoEs could be significantly lower under the purchase method of merger accounting
In ` mn
Pooling of interest method
(currently followed by TechM)
Purchase method (estimated)
FY12 FY13 FY14E FY12 FY13 FY14E
Adjusted net income 18,062 21,157 27,674 18,062 21,157 27,674
Goodwill amortization 0 0 0 -11,306 -11,306 -11,306
Tax benefit on above (@33.99%) 0 0 0 3,843 3,843 3,843
Proforma net income 18,062 21,157 27,674 10,599 13,694 20,211
Equity at TechM's share price as on the appointed dated of merger* 48,158 68,530 97,484 86,259 99,168 120,659
RoE

36.3% 33.3%

14.8% 18.4%
Source: Ambit Capital research; Note: * Appointed date of the merger was 1 April 2011
Please reach out to us for greater details on the calculations and underlying
assumptions.
Questionable attendance on Satyams Board whilst deciding the merger ratio
From 19 September 2011 to 23 January 2012, the Board comprised less than 50% of
independent directors. This was the period when Satyams merger ratio was decided
(announced in March 2012). Also, the merger ratio was announced shortly after two
new independent directors (Mr Ashok Kacker and M Rajyalakshmi Rao) were
appointed (Jan and Feb 2012) who presumably had limited understanding of the firm
to push for a fairer ratio for minority shareholders. The swap ratio seems relatively
unfair to Satyams minority shareholders. Although there have been departures in
independent directors, board meeting attendance has been appalling, particularly in

Technology


FY11 and FY12, which was also the period when the merger ratio was accepted by
the board.
Exhibit 11: Satyam independent directors poor attendance track-record during the
time merger ratio was finalised
Name/Attendance FY10 FY10 FY11 FY12
Deepak Parekh (Independent) 12/13 5/10
Keeran Karnik (Independent) 13/13 7/10
Vineet Nayyar 5/10 6/6 8/8
CP Gurnani 3/10 6/6 7/8
C Achuthan (Independent) 13/13 9/10 4/6 1/8
Tarun Das (Independent) 10/13 5/10
TN Mahoharan (Independent) 11/13 8/10 6/6 6/8
SB Mainak (Independent) 12/13 7/10
M Damodaran (Independent) 1/10 2/6 4/8
Ashok Kacker (Independent) 1/8
M Rajyalakshmi Rao (Independent) 1/8
Sanjay Kalra 5/10 3/6
Gautam S Kaji (Independent) 1/6
Ulhas N Yargop 5/10 6/6 5/8
Ravindra Kulkarni (Independent) NA
Source: Company, Ambit Capital research Note: Independent directors in Grey shade
Similarly, the independent directors participation in the Board meetings was not
particularly strong at the time Tech Mahindra was bidding for Satyam in FY09-10 (see
Exhibit 12 below).

Exhibit 12: Tech Mahindra independent directors poor attendance track-record at
the time of bidding for Satyam
Name/Attendance FY09 FY10
Anand G Mahindra 5/6 8/8
Akash Paul (Independent) 4/6 4/8
Al-Noor Ramji 2/6 1/8
Anupam Puri (Independent) 3/6 6/8
Arun Seth 4/6 4/8
Bharat N Doshi 6/6 8/8
B H Wani (Independent) 8/8
Clibe Goodwin 4/6 2/8
CP Gurnani NA
M Damodaran (Independent) 2/6 4/8
Nigel Stagg * NA
Paul Zuckerman (Independent) 4/6 4/8
Dr Raj Reddy (Independent) 4/6 4/8
Nigel Stagg 1/8
Ravindra Kulkarni (Independent) 8/8
Richard Cameron* 1/8
Vineet Nayyar 5/6 5/8
Ulhas N Yargop 6/6 8/8
Source: Company, Ambit Capital research Note: Independent directors in Grey shade

Technology


Infosys
Letting down its own governance standards?
Ever since its IPO in 1993, Infosys has been regarded as a paradigm of corporate
governance in India. Whilst this image has earned Infosys goodwill from investors,
clients and employees, there are signs that these high corporate governance
standards are fraying. NRN Murthys entry into Infosys in an executive capacity (even
after the firms well-articulated policy of executives retiring at the age of 60), bringing
with him his son as an executive assistant, higher promoter representation at the
Board and peculiar guidance pattern resulting in high volatility in share price none
of this gels well with Infosys image of a leader in corporate governance.
Breach of corporate policies
Infosys has historically followed a well-articulated policy of executive retirement at the
age of 60, with Mr NRN Murthy himself being a strong proponent of the policy.
Similarly, all the founders have time and again mentioned about not letting family
manage the business. More surprising was Rohan Murthys entry into Infosys as Mr
NRN Murthys Executive Assistant. Whilst this is a position of power but not of control,
the manner in which Rohan Murthy was brought in raised eyebrows to put it mildly.
High promoter representation on the board
The promoters Board representation is significantly higher relative to their
shareholding in the company. Whilst NRN Murthy, S Shibulal and Kris
Gopalakrishnan collectively hold ~10% stake in the company, they represent 23% of
the voting rights on the Board. With the highest promoter representation and the
lowest proportion of independent directors on the Board, Infosys Board
independence appears to be the weakest among the tier-1 firms.
Exhibit 13: Infosys ownership structure
Promoter representation on the board 23.08%
Promoter ownership 15.94%
Active promoters

NRN Murthy 4.47%
S Shibulal 2.20%
Kris Gopalakrishnan 3.41%
Combined shareholding of active promoters 10.08%
Source: NSE, Ambit Capital research
Exhibit 14: Measuring the board independence
Company Promoter shareholding
Promoter representation
on the Board
Non-independent
directors on the Board
Infosys 15.9% 23.1% 46.2%
TCS 73.9% 9.1% 45.5%
Wipro 73.5% 7.7% 23.1%
HCL Tech 61.8% 20.0% 20.0%
Source: Company, NSE, Ambit Capital research
Peculiar guidance pattern leading to extreme volatility
There has been a pattern in Infosys guidance and outlook over the last three years. It
sets a lower expectation in the fourth quarter of the year and over-delivers in the
following quarters, causing extreme volatility in the share price. Indeed, Infosys has
repeated this pattern yet again by indicating on 12 March 2014 that it will settle at
the lower end of the guidance for FY14 and giving a weaker outlook for 1HFY15.

performance

Source: Bloomberg

Financials
` mn FY11 FY12 FY13
Revenues 275,010 337,340 403,520
PAT 68,230 83,210 94,210
FCF 46,070 66,800 86,510

1000
1500
2000
2500
3000
3500
4000
10,000
15,000
20,000
25,000
Mar-
09
Jun-
10
Aug-
11
Nov-
12
Jan-
14
Sensex Infosys Tech.

Technology


Exhibit 15: Playing with investors expectations?

Source: Company, Bloomberg, Ambit Capital research; Note: Infosys abandoned the quarterly guidance from 1QFY13 * Infosys management announced in an
Investment Banking Conference that it will meet the lower end of the FY14 revenue guidance (11.5-12%)

-25%
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
-6%
-4%
-2%
0%
2%
4%
6%
8%
1
Q
F
Y
1
0
2
Q
F
Y
1
0
3
Q
F
Y
1
0
4
Q
F
Y
1
0
1
Q
F
Y
1
1
2
Q
F
Y
1
1
3
Q
F
Y
1
1
4
Q
F
Y
1
1
1
Q
F
Y
1
2
2
Q
F
Y
1
2
3
Q
F
Y
1
2
4
Q
F
Y
1
2
1
Q
F
Y
1
3
2
Q
F
Y
1
3
3
Q
F
Y
1
3
4
Q
F
Y
1
3
1
Q
F
Y
1
4
2
Q
F
Y
1
4
3
Q
F
Y
1
4
M
a
r
-
2
0
1
4
*
Actual vs guidance (mid-point) -
LHS
Change in next year guidance
(mid-point of guidance) - LHS
Share price performance on the
day of results - RHS
Absolute volatility range (RHS)
Setting lower expectation
in 4Q

Technology


KPIT Technologies
Magnified margins
KPIT Technologies margins appear to be overstated given the accounting policies
and estimates that are different from its peers. Its accounting policy of excluding re-
imbursements both from income and cost (contrary to accounting policy followed by
companies such as Infosys, TCS and Persistent Systems) benefits its margins by
~50bps according to our calculations. Furthermore, its actuarial assumption of salary
increase for retirement benefit obligations is significantly below that of peers (5% vs
peer average of 7%).
Margin management through change in accounting policy
During FY12, KPIT Technologies changed its policy of booking re-imbursement
expenses. KPIT mentioned in its FY12 annual report that the reimbursement expense
billing has been netted off against the actual expenses whilst previously the
reimbursement billing was accounted as income in revenues and as expense in the
costs. The third-party license sale amount now appear in revenues only to the tune of
the margins on such sale (earlier the full sale amount used to appear as revenue and
the cost of the license as direct cost).
The new policy is not consistent with that followed by Infosys, TCS and Persistent (the
other companies do not mention the accounting policy in this regard). These
companies follow the policy of booking the third-party licence sales under revenue as
well as costs (these companies book it under third-party items, Equipment and
software cost and Purchase of software license and support services, respectively).
This change in policy makes the operating margins appear artificially better than the
historical margins and that of competitors, because operating margin is now
calculated by dividing the operating profit by a lower denominator (revenues).
Indeed, our calculations suggest that just because of this change in accounting
policy, FY11 EBITDA margins were overstated by 50bps.
Exhibit 16: Margin impact from change in re-imbursement accounting policy
` mn Earlier policy New policy
FY11 Revenue 10,230* 9,870**
FY11 EBITDA 1,484 1,484
EBITDA margins 14.5% 15.0%
Source: Company, Ambit Capital research *reported revenue in FY11 annual report ** restated FY11 revenue in
FY12 annual report
We have assumed that all the restatement in FY11 revenues is due to change in
accounting policy of excluding the re-imbursement from the revenues and costs.
Given this change in accounting policy is margin neutral (reimbursements are
removed from both revenue and costs), we have used re-stated FY11 EBITDA (from
FY12 annual report) for margin calculations.
Lower salary increase estimate for retirement benefit accounting
The retirement benefit obligations of a firm depend to a large extent on the
underlying variables such as discount rate (to calculate present value of future
obligations), long-term salary increase rates, attrition, demographics, return on plan
assets etc. Manipulation of any of these variables could materially impact the
eventually calculated liability.
Whilst KPIT Technologies discount rate estimates are conservative as compared to
the industry average (8.5% vs industry average of ~8%), its salary increase estimate
of 5% appears to be too low relative to the industry average of ~7% (see Exhibit 17).
Furthermore, KPITs retirement benefit obligations are unfunded (i.e. there are no
plan assets).

performance

Source: Bloomberg

Financials
` mn FY11 FY12 FY13
Revenues 1,484 2,166 3,214
PAT 946 1,454 1,990
FCF 221 396 503

20
120
220
320
420
520
10,000
15,000
20,000
25,000
Mar-
09
Jun-
10
Aug-
11
Nov-
12
Jan-
14
Sensex KPIT

Technology


Exhibit 17: Retirement benefit actuarial assumptions
Company
Discount rate Salary increase
FY11 FY12 FY13 FY11 FY12 FY13
KPIT 8.3% 8.5% 8.5% 5.0% 5.0% 5.0%
Tier 2 peers

Mindtree 8.0% 8.5% 8.0% 10-12% 6.0% 6.0%
Hexaware 8.0% 8.6% NA
10% for first year and
7.5% thereafter
7.5% thereafter
NA
Tech Mahindra 7.7% 8.6%
8.6% for funded and
8% for non-funded
8% thereafter
9% thereafter
9% for non-funded
and 7.5% for
funded
Infotech Enterprises 8.0% 8.5% 8.0% 7.5% to 10% 7.5% to 10% 6% to 8%
NIIT Tech 8.1% 8.6% NA 9.15% to 9.4% 9.15% to 9.4% NA
eClerx 8.0% 8.5% 8.0% 4.0% 4.0% 5.0%
Persistent Systems 8.5% 8.7% 8.3% 7.0% 7.0% 7.0%
Tier 1 peers

TCS 8.0% 8.25% to 8.5% 8.0% 4% to 12% 4% to 9% 4% to 7%
Infosys 8.0% 8.6% 8.0% 7.3% 7.3% 7.3%
HCL Tech 8.4% 8.1% 7.5% 6% to 10% 7.0% 7.0%
Wipro 8.0% 8.4% 7.8% 5.0% 5.0% 5.0%
Poor cash flow generation at subsidiaries
KPIT Technologies cash conversion has been materially weaker than the peers,
largely due to poor cash generation at the subsidiaries. As shown in Exhibit 18 below,
KPIT has infused significant amounts of cash into the subsidiaries with weak cash
generation profile.
Exhibit 18: Burning cash at subsidiaries
` mn FY11 FY12 FY13
CFO 645 1,005 1,203
Capex -422 -609 -701
Investment in equity shares of subsidiaries -463 -2,088 -1,255
Investment in equity shares of associates 0 -98 0
Investment in preference shares of associates 0 -278 0
Cash & Cash Equivalent from acquisition of subsidiaries 37 146 0
FCF 222 396 503
FCF including acquisitions and investments in subsidiaries
and associates
-203 -1,922 -753
Cash conversion

KPIT (Consolidated) 43% 46% 37%
KPIT (Standalone) 46% 100% 70%
KPIT (Subsidiaries) 41% 4% 3%

Higher use of subcontractors
KPIT uses subcontractors to a significantly larger extent as compared to its tier-2
peers. This artificially inflates the revenue per employee (given sub-contractors are
not included in the reported headcount) and gives a prima facie impression of better
employee productivity.

Technology


Exhibit 19: Higher subcontractors use artificially inflates the employee productivity
Company/Metric
Subcontracting cost as % of
Revenue
Subcontracting cost as
% of Operating Cost
Subcontracting cost as % of
Total Cost
Revenue per employee
(INR mn)
FY11 FY12 FY13 FY11 FY12 FY13 FY11 FY12 FY13 FY11 FY12 FY13
KPIT (Consolidated) 14.5% 17.2% 17.7% 46.5% 50.5% 52.0% 17.1% 20.1% 20.7% 1.5 1.9 2.7
KPIT Standalone 2.8% 2.2% 3.3% 13.5% 9.6% 12.4% 3.3% 2.7% 4.2% NA NA NA
KPIT (Subsidiaries) 28.0% 27.6% 24.5% 65.1% 66.5% 64.9% 33.8% 31.9% 27.3% NA NA NA
Tier 2 peers

eClerx NA NA NA NA NA NA NA NA NA 0.9 1.1 1.1
Persistent Systems 4.0% 4.2% 4.1% 22.6% 23.6% 19.7% 5.0% 5.4% 5.4% 1.2 1.5 1.9
Hexaware 7.2% 7.7% 8.9% 26.3% 30.3% 36.0% 7.9% 9.4% 11.3% 1.6 1.7 2.1
Infotech Enterprises 2.6% 2.2% 3.9% 11.7% 11.1% 18.8% 3.1% 2.7% 4.8% 1.4 1.7 1.8
NIIT Tech NA NA NA NA NA NA NA NA NA 2.1 2.1 2.5
Mindtree 3.0% 3.5% 3.6% 13.2% 16.7% 17.9% 3.4% 4.1% 4.5% 1.6 1.7 2.0
Polaris 6.5% 5.8% 5.9% 40.6% 37.3% 40.3% 7.5% 6.8% 6.7% 1.5 1.6 1.7
Tech Mahindra 9.6% 10.6% 9.6% 28.7% 52.2% 59.3% 12.0% 12.7% 11.9% 1.3 1.3 1.4
Tier 2 peer average 5.5% 5.7% 6.0% 23.9% 28.5% 32.0% 6.5% 6.8% 7.4% 1.5 1.6 1.8

Technology


Institutional Equities Team
Saurabh Mukherjea, CFA CEO, Institutional Equities (022) 30433174 saurabhmukherjea@ambitcapital.com
Research
Analysts Industry Sectors Desk-Phone E-mail
Aadesh Mehta Banking & Financial Services (022) 30433239 aadeshmehta@ambitcapital.com
Achint Bhagat Cement / Infrastructure (022) 30433178 achintbhagat@ambitcapital.com
Aditya Khemka Healthcare (022) 30433272 adityakhemka@ambitcapital.com
Akshay Wadhwa Banking & Financial Services (022) 30433005 akshaywadhwa@ambitcapital.com
Ankur Rudra, CFA Technology / Telecom / Media (022) 30433211 ankurrudra@ambitcapital.com
Ashvin Shetty, CFA Automobile (022) 30433285 ashvinshetty@ambitcapital.com
Bhargav Buddhadev Power / Capital Goods (022) 30433252 bhargavbuddhadev@ambitcapital.com
Dayanand Mittal, CFA Oil & Gas / Metals & Mining (022) 30433202 dayanandmittal@ambitcapital.com
Deepesh Agarwal Power / Capital Goods (022) 30433275 deepeshagarwal@ambitcapital.com
Gaurav Mehta, CFA Strategy / Derivatives Research (022) 30433255 gauravmehta@ambitcapital.com
Karan Khanna Strategy (022) 30433251 karankhanna@ambitcapital.com
Krishnan ASV Banking & Financial Services (022) 30433205 vkrishnan@ambitcapital.com
Nitin Bhasin E&C / Infrastructure / Cement (022) 30433241 nitinbhasin@ambitcapital.com
Nitin Jain Technology (022) 30433291 nitinjain@ambitcapital.com
Pankaj Agarwal, CFA Banking & Financial Services (022) 30433206 pankajagarwal@ambitcapital.com
Pratik Singhania Real Estate / Retail (022) 30433264 pratiksinghania@ambitcapital.com
Parita Ashar Metals & Mining / Oil & Gas (022) 30433223 paritaashar@ambitcapital.com
Rakshit Ranjan, CFA Consumer / Real Estate / Retail (022) 30433201 rakshitranjan@ambitcapital.com
Ravi Singh Banking & Financial Services (022) 30433181 ravisingh@ambitcapital.com
Ritika Mankar Mukherjee, CFA Economy / Strategy (022) 30433175 ritikamankar@ambitcapital.com
Ritu Modi Automobile (022) 30433292 ritumodi@ambitcapital.com
Tanuj Mukhija, CFA E&C / Infrastructure (022) 30433203 tanujmukhija@ambitcapital.com
Sales
Name Regions Desk-Phone E-mail
Deepak Sawhney India / Asia (022) 30433295 deepaksawhney@ambitcapital.com
Dharmen Shah India / Asia (022) 30433289 dharmenshah@ambitcapital.com
Dipti Mehta India / USA (022) 30433053 diptimehta@ambitcapital.com
Nityam Shah, CFA USA / Europe (022) 30433259 nityamshah@ambitcapital.com
Parees Purohit, CFA UK / USA (022) 30433169 pareespurohit@ambitcapital.com
Praveena Pattabiraman India / Asia (022) 30433268 praveenapattabiraman@ambitcapital.com
Sarojini Ramachandran UK +44 (0) 20 7614 8374 sarojini@panmure.com
Production
Sajid Merchant Production (022) 30433247 sajidmerchant@ambitcapital.com
Sharoz G Hussain Production (022) 30433183 sharozghussain@ambitcapital.com
Joel Pereira Editor (022) 30433284 joelpereira@ambitcapital.com
Nikhil Pillai Database (022) 30433265 nikhilpillai@ambitcapital.com
E&C = Engineering & Construction

Technology


Explanation of Investment Rating

Investment Rating Expected return
(over 12-month period from date of initial rating)
Buy >5%
Sell <5%

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