Polaris: Deal or not, switch to other counters

Given the volatile products business and sluggish services revenue growth, analysts remain bearish on the scrip

Recently, there were reports Tech Mahindra was considering acquiring FT Sourcing, the information technology (IT) services business of mid-sized IT company Polaris Financial Technology. In the past, too, it was reported L&T Infotech and other companies were interested in acquiring this division. Then, analysts had estimated the deal price at $450-500 million, valuing FT Sourcing at 1.4-1.5 times 2012-13 sales.

However, the Polaris stock hasn’t reacted much. Since the beginning of this year, it has been range-bound, rising just 3.4 per cent to Rs 118, against the Sensex’s 2.2 per cent gain. This isn’t surprising, given the core products and services business isn’t faring well. Therefore, analysts are bearish on the stock, despite inexpensive values (a price-to-earnings ratio of 5.05 times the 2013-14 estimated earnings); they recommend shifting to other IT companies with better earnings visibility. Most analysts polled by Bloomberg since April have a ‘sell’ or ‘neutral’ rating on the stock, with an average target price of Rs 119.

Considering the possibility of the sale of the services division, analysts feel large IT players might not be keen to buy it, given its relatively small size (revenues of $324 million in 2012-13) and the fact that FT Sourcing caters to large clients in the financial services space, a domain in which large Indian players already have a strong foothold. However, as Polaris has a strong relationship with its marquee clients in the banking and financial services (BFSI) space, mid-sized companies looking to scale up in this segment may show interest. The highly skilled and experienced employee base of Polaris (average experience of 6.5 years, against 3-3.5 years for its peers) is another significant asset.

Tech Mahindra derives just 10 per cent of its business from the BFSI vertical and this acquisition would enable it to further diversify from the telecom vertical (which accounts for about half its consolidated revenue). Ankita Somani, IT analyst at Angel Broking, says, “The Polaris acquisition will be positive for Tech Mahindra, as its exposure to the BFSI space will increase after this deal. Given BFSI is one of the largest revenue generators for the IT sector, this acquisition makes sense for Tech Mahindra.”

However, potential acquirers would have to deal with a key aspect—Citigroup holds 20 per cent stake in Polaris and accounts for 35 per cent of its revenues. Any acquirer would have to convince this client, as well as others, to continue with Polaris, which would ensure revenue visibility for the company.

In a filing to the exchanges in May, the Polaris management had stated it was restructuring its businesses into separate services and products divisions. In an interview with Business Standard in January, Arun Jain, founder, chairman and chief executive of Polaris, had said the company was considering separating the products and services businesses on the recommendations of global management consulting firm BCG.

In sync with the weak demand environment, Polaris has been struggling to grow its services business (which accounts for 76 per cent of its total revenues). Also, competition from peers and rising pricing pressures have hit it hard. Since the quarter ended June 2012, its services business has contracted 2.7 per cent, while growth in the products business has been volatile.

Therefore, most analysts remain bearish on the stock. “With continuing vendor consolidation and uncertainty in deal closures in the products business, we remain cautious on Polaris’s FY14 performance. Discontinuation of formal annual revenue and EPS (earnings per share) guidance also confirms the uncertainty faced by the business,” says Ankur Rudra, IT analyst at Ambit Capital. He has a ‘sell’ recommendation on the stock, with a target price of Rs 113. While two separate divisions would mean better business focus and, hopefully, an improvement in the stock valuations, immediate gains are ruled out.