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Equity Research: Birlasoft Ltd
Birlasoft, a small-cap IT company, has an upside potential of 35%. The company’s repeated demonstration of ‘walking the talk’ makes us believe that it is on track to achieve its stated target of USD1bn revenue by FY25E.
Birlasoft is a part of CK Birla Group, and was incorporated in 1995. The unlisted entity Birlasoft, in January 2019, was merged with KPIT Technologies post which the engineering business was demerged and the IT service vertical then became Birlasoft Limited. Birlasoft has strong presence in ERP and digital space and has lately expanded to partnerships with hyperscalers managing the migration deals. The company is expanding capabilities and is effectively competing with larger players and elevating its positioning. The company by its ERP capabilities, core IT systems, ADMS, IMS, functional, non-functional, product, UX/UI, and digital tools provides effective, end-to-end quality service.
Birlasoft, a small-cap IT company, with a fair value of Rs480, an upside potential of 35%. The company’s repeated demonstration of ‘walking the talk’ makes us believe that it is on track to achieve its stated target of USD1bn revenue by FY25E. Its investment in capabilities across digital, cloud and ERP (its ‘bread and butter’) and its long-standing partnership with platform providers puts Birlasoft in an advantageous position. Its competence in core backend charts a higher degree of customer confidence in Birlasoft’s ability to consult and execute integrated transformation projects, enabling it to ride the accelerating digital transformation wave. Its wide range of offerings, growth visibility and healthy financials further build our conviction in its long term prospects.
Ready to go: Birlasoft devised and perfectly executed a slew of strategies to re-position offerings, approach the market with strengthened base as well as an improved Go-to-Market strategy post-merger/ demerger with KPIT Technologies and fasten the pace of growth. Key strategies adopted by Birlasoft (i) micro-vertical approach to fight the biggies, (ii) trimming tail accounts, (iii) mining select key large accounts, and (iv) increasing annuity income. Impeccable execution of these initiatives led to improved TCV wins for Birlasoft (driving strong growth visibility) and enhanced the margin profile (15.5% in FY22 vs 12% in FY19). The ability to consistently meet set targets leads us to believe that the company could meet its target of USD1bn revenue with EBIT of 16% by FY25 through a combination of organic growth and acquisitions.
Enhancing digital and cloud capabilities: Birlasoft built digital and cloud capabilities thereby transforming into an enterprise digital company; positioning as a business & customer centric organisation from a technology centric business. Partnerships with hyperscalers and platform providers and early investments enabled Birlasoft build key digital and cloud capabilities and align with current demand trends. Its ERP expertise on the backend and ability to consult on full stack digitization enabled Birlasoft to be better placed to capture opportunities in high-growth digital services, evidenced by increasing revenue trend from its digital and cloud endeavour, which grew by 25.5% over the last 8 quarters.
ERP - Shift in industry dynamics: Birlasoft modified its ERP strategy and carved out separate growth engine by way of dedicated channel sales for the entire ERP vertical rather than being merely channel partners to platform providers, thereby ordaining the onus on the team to generate growth. This change in approach coupled with shift in market dynamics had a positive impact on growth in this segment. Over the years, Birlasoft has built strong partnerships with major platform providers and we believe change in strategy coupled with tailwinds in the ERP market (resurgence of demand) should help it drive ERP vertical’s growth.
Outlook: Given the company's core ERP and digital capabilities, as well as its long- standing relationships with platform providers and hyperscalers, we ascribe a 20x P/E multiple on FY24 EPS, arriving at a fair value of Rs480. Considering the company's core competency on the backend, we believe it is in a sweet spot to consult clients on desired digital capabilities and handhold clients through their digital transformation journey in a cost-effective manner. A modest downside risk from current price to bear case value (Rs330) and a high score on corporate governance are effective buffers.
Birlasoft, in order to accelerate growth pace has devised a slew of strategies to re-position its bouquet of offerings, strengthen foundation and improve Go-to-Market strategies post-merger/ demerger with KPIT Technologies, thereby improving TCV wins, growth visibility and margin profile of the company. Key strategies adopted by Birlasoft that enable it to take longer strides include:
i) Micro-vertical approach to fight biggies
ii) Trimming tail accounts
iii) Mining select key large accounts
iv) Increasing annuity revenues
The ability to meet set targets leads us to believe that the company’s vision of USD1bn revenue with EBIT of 16% by FY25E could be realistic. The management is expected to achieve this target through a combination of organic growth (80-85%) and acquisitions.
With the endeavour to build domain capabilities and differentiate itself, Birlasoft consolidated its focus on 4 key verticals i.e. Manufacturing, BFSI, Energy & Utilities and Life sciences; deep diving in select verticals rather than going thin across segments. Post-merger with KPIT, Birlasoft’s presence in 2 verticals (BFSI and Manufacturing) widened into more sectors such as Life Sciences, Hi-tech and Energy & Utilities which were later consolidated into 4 by merging Discrete manufacturing, Hi-tech, CPG, Retail, Process manufacturing and Automotive into a single manufacturing vertical.
The company has focused on sharpening its capabilities in select verticals (vs. trying to spread across verticals) and also bifurcated leadership vertically so as to drive its value proposition wherein it could leverage domain expertise and its ability to understand industry level technicalities.
Trimming tail accounts
Tail account reduction was driven by Birlasoft with the agenda to (i) reduce effort on non- strategic accounts, (ii) prioritise key clients and create deeper relations, and (iii) drive resource appropriation. The decision to cut an account is based on multiple criteria including its strategic importance to Birlasoft, scope on incremental projects from the client and significance of revenue and profitability for the company. Number of active clients have significantly reduced from 401 in FY19 to 296 in FY22 and the management is expected to continue with this strategy to prioritise resources towards developing deeper relations with preferred clients. As a result of this effort, revenue per client significantly increased over FY19-22 (from USD0.3mn in FY20 to USD0.5mn in FY22). At the time when the merger/de- merger sailed through, Birlasoft's initial active client list comprised of 400 clients (more than half were KPIT Tech’s clientele) of which more than 40% were only consuming single services, which hindered resources and cost optimisation.
Mining strategic key accounts
The activity of trimming tail accounts enabled Birlasoft to refocus management bandwidth to gold and platinum clients (larger accounts) from smaller accounts leading to higher revenue from these select clients where relationship could be established. The company is focussed on account mining and cross selling to select accounts and these activities have been rewarding as evidenced by increasing revenue per client.
Increasing annuity revenue
The company is now focussing on higher annuity revenue (which has been improving gradually every quarter) for enhanced growth visibility and cushion against unprompted deal loss. The management aims to inch towards 75% annuity revenue which it believes should be sustainable.
These initiatives by Birlasoft have resulted in increased TCV wins; in FY22 total TCV wins amounted to USD696mn, of which USD444mn is from new business vs USD427mn in FY21 deals. Repositioning of offerings has enabled higher new wins ~15% in FY22vs 3% in FY21. These initiatives have positively impacted margins, where significant expansion has been witnessed over the quarters.
Birlasoft focused on enhancing digital and cloud capabilities:
Birlasoft with its capabilities has transformed to an enterprise and digital company thereby evolving to a business and customer centric company from a technology centric business. Instead of exclusively depending on ERP knowledge, it has built capabilities around digital and cloud to reposition offerings in line with customers demand.
It invested in strengthening of cloud and digital capabilities, partnered with hyperscalers and platform providers such as Microsoft, Google, Salesforce.com, etc., with the aim to build capabilities for short and long term needs of clients so as to be well placed to capture opportunities aided by growing demand for digitization expedited by Covid-19. To effectively harness the growing digitization demand, Birlasoft relied on its backend (ERP) expertise coupled with its ability to consult on full stack digitization. Further, Birlasoft collaborates with organizations in its micro-verticals enabling them to transform their operational processes, improve customer and employee experience and help clients discover new business models to effectively compete via its bouquet of digital offerings such as data analytics, connected products, intelligent automation, customer experience, cloud and blockchain. The company is poised to leverage industry tailwinds to grow its digital services contribution to revenues, which is currently contributing ~58% of revenue combined. The business transformation service line grew by 21% YoY in FY22 and cloud services grew by 29% YoY.
The company’s focus on partnering and building relationships with digital software/ platform vendors is enabling it to negotiate and structure transformational and multiservice/ long-term deals. The company has partnered with best-in-class hyperscalers and platform providers such as Salesforce, ServcieNow, Microsoft and Amazon, with initiatives aimed at providing clients with best suite of services as per their requirement (it aims to derive USD100mn revenue from solely Microsoft partnership).
Pandemic - Accelerated digital transformation, IT spends on the rise
With technology emerging as a bedrock for growth, the IT industry has evolved from merely supporting operations to participating in business growth. Furthermore, the pandemic has forced businesses towards early adoption of technology, causing them to recalibrate their digital strategy and emphasize on enhancing, extending and transforming company’s value proposition. Dramatic increase in digital customer interactions led to the realisation that adoption of advanced technology can help with business differentiation. Emphasis on customer experience and brand building is playing a vital role in increased dependence on quality assurance as we witness shorter delivery cycles and reduced costs. All of this is leading to increased spends on technology as overall IT spend is expected to grow at 5.5% to USD4.6tn driven by a shift in the technology industry to a growth enabler (according to Gartner).
Despite robust growth in 2021, IT spends are still on the cards as 72% CXOs expect 2022 to be another growth year driven by digital demand and higher investments in R&D; Resilience and Agility integrated in the industry business model leads to over 70% CXOs believing that FY23 is poised to be another growth year for the industry (as per Nasscom survey).
In the digital gamut, cloud data, cyber security and AI are top priorities while smaller deals for differentiated niche products seems to be the theme. The Indian IT industry has set itself a target of USD300-350bn by 2025, almost 55-60% will be digital (excluding hardware). The allocation of digital spends vs. revenue has been on the rise as companies intend to fasten technology enabled products and services to market and achieve efficiencies. The industry dynamics have changed and 72% executives believe they need to radically transform operations in next 2 years in order to effectively compete.
Cloud to be the center piece of digital strategy:
Cloud plays a crucial role in digital strategies for companies as they would be unable to fully execute digital goals without use of cloud. Global public cloud total addressable market (only for hyperscalers and not IT spends) is expected to reach USD2tn in base case scenario from USD157bn during a longer-term time frame (10-20 year) from 2022 onwards as per IoT Analytics (with bull case reaching to USD10tn and bear case to USD0.6tn). Cloud transformation is expected to be below the 40% mark currently (according to IoT Analytics and many industry veterans), thereby indicating low possibility of muted demand in medium term coupled with the fact that companies which transformed to cloud in the 2014-era are going through the modernization process (owing to inability to keep up with cloud advancements) as they try to achieve a more efficient and lean architecture.
Hyperscalers are expected to continue their accelerated growth path as seen in exhibit 19 (albeit some effect of the higher base comes into play) and also expected to ramp up capex on next generation servers and architectures with focus on AI/ML.
It is believed that Birlasoft given its partnership with key hyperscalers, ability to consult on end to end transformation, targeted Go-to-Market strategy and accelerator capabilities is well placed to capture these opportunities.
Increase In the demand of ERP :
Post-merger with KPIT Tech, Birlasoft gained material scale in enterprise solutions business of leading software vendors including Oracle, SAP, Infor, PTC, etc. widening its reach from its organic strong presence in Microsoft and Salesforce practice. Post-merger, SAP practice was key for Birlasoft, however, the company witnessed material decline in the SAP practice revenues as these were project based deals- completion of which would lead to revenue loss + lack of on-premise implementation demand as we witnessed rising traction of cloud products and/or pandemic led challenges.
To address the problem, Birlasoft changed its ERP strategy and carved out separate growth engines to focus on channel sales on the whole ERP vertical from being only channel partners to platform provider, thereby citing more onus on the team to drive growth in ERP vertical. This change in approach coupled with shift in market dynamics led to positive effect on growth in this segment, which contributes ~43% to revenues. Birlasoft, within its SAP and Oracle practice, provides packaged implementation service, cloud solutions/migration, up-gradation as well as maintenance.
Effective from Q1FY22, the company reclassified its SAP and other ERP practices to enterprise solutions service line, which now includes software package around SAP, Oracle, Infor, PTC, JD Edwards, across on premise and cloud with domain focus on CRM, manufacturing execution systems (MES), PLM, SCM, IT transformation, AMS, testing and IMS and cloud management. Prior to reclassification, some part of these services were bucketed under the digital transformation service line. Cloud offerings related to SAP and Oracle continue to form a part of enterprise solution.
Organization’s larger digital journey would be incomplete (missing material efficiency) if their ERP is not integrated or transformed. Deals to transform, improve or upgrade the enterprise solution has started to increase so that clients can implement digital layer on top of existing infrastructure. The ERP market is expected to grow at 10.7% CAGR to USD123.4bn from USD54.7bn during 2022- 30E owing to need for operational efficiency, reliance on data for decision making, and rising demand for cloud and mobile adoption as per Grand View Research. Gartner expects that initiated or concluded ERP initiatives that may have halted during the pandemic to pick up as hybrid work environments have become the new norm.
The onset of the pandemic compelled organizations to re-engineer their legacy systems and shift to newer, more agile, prompt systems in order to better prepare for pandemic related disruptions. This has also resulted in a shift to smaller deals as the introduction of cloud infrastructure has broken down ERP deals into smaller fragments separating backend, frontend and middle-end from a larger monolithic deal, thereby enabling the company to choose the best platform providers for their needs. The importance placed on supply chain and customer experience during Covid-19 also fueled ERP demand. Companies also preferred a partner to consult them for growth rather than just a provider, they do not want to lift and shift for short term benefit, and require capabilities to transform underlying core business processes.
This benefits System integrators such as Birlasoft, as client’s reliance on them is based on the foundation of a stable backend providing them with ‘foot in the door’ thereby helping them trickle down/ cross sell to customers and handhold clients through their transformation journey. We believe, Birlasoft, driven by its long withstanding partnerships with platform providers is aptly placed to capture buoyancy in this segment.
Tightening of the monetary policy by central banks across the world is expected to weigh-in on the IT sector coupled expected margin pressure and low probability of positive earnings surprise as robust consensus estimates are built in. However, we believe the demand for digital services and the structural change in perception and positioning of the industry should also aid in sustaining multiples higher than historic mean. In our analysis of companies across market-caps in the IT space to understand multiple expansion during high growth periods, we saw that there exists correlation between revenue/PAT growth and valuation expansion, providing us the comfort on current valuation.
Birlasoft, over the years, has witnessed significant improvement across financial metrics. Its margin profile is on the lower band among the peer group, however the company has been focusing on improving the same with the vision to reach 16% EBIT margin by FY25E. Despite strong commentary on margin expansion, we have been conservative in building our estimates owing to the supply pressure. In the IT space, among the small-cap peers, Birlasoft is attractively placed and we believe it is a strong contender for growth and thereby valuation expansion. The company's financials, compared to the likes of any Mid-cap/ Small-cap peer, showcase the strength across all domains, however, we believe that the valuations do not reflect the same.
Expected revenue CAGR of 16.4% over FY22-24E for Birlasoft based on strong TCVs, focussed approach on niche capabilities and domain expertise coupled with industry tailwinds and robust demand for digital and cloud services with revival of ERP industry.
It is expected that EBITDA margin will expand driven by initiatives such as (i) increasing utilisation, (ii) higher offshoring, (iii) constant effort to reduce subcontracting cost, (iv) improving efficiency of SG&A, and (v) initiatives to trim long tail accounts (lower margin profile). It is believed that high attrition coupled with revival of travel could negatively impact margins in the shorter term, however increased offshoring, higher fresher intake and initiative to optimise resource cost could cushion the impact.
PAT to grow in line with EBITDA; PAT has grown significantly over FY19-22 at 25.3% CAGR, however, we expect the same to moderate over FY22-24E to 18.1% with PAT margins in the range of ~11% as significant EBITDA expansion is behind us; however, room for improvement exists owing to strong operating leverage and benefits from the new tax scheme.