Description

Brief Backdrop of the broader Investment Opportunity:

Unlike several global markets which have been in a raging bull market, the Indian small and mid caps have been in a proper bear market for the past 24 months. While they have traded cheaper than present on an absolute basis in 2008 and 2013, the valuation divergence with large caps has been the highest it’s ever been. 

Indian small and mid caps are as cheap as 2008 or 2013 when you adjust for the fact that inflation and interest rates are far lower currently than in the previous episodes. In terms of absolute drawdowns, Indian small caps are down over 60% which makes it as bad as the 2008 global financial crisis. There has been a humongous polarization in the market with a few quality/ growth consumer stocks in a raging bull market of valuation expansion and several other cyclicals that are extremely cheap. 

There are several factors for this divergence such as the small cap bubble of 2017, new regulatory constraints for Indian mutual funds in small caps, global quality premium, ETF flows, momentum investing, formalization of the Indian economy, credit squeeze, governance issues, promoter leverage etc. While I don’t know if the entire basket is cheap enough to play through a broad buying strategy, it is clear to me that there are several attractive bottom-up opportunities emerging for a stock picker. 

As someone who considers Indian small & mid caps as my primary home hunting ground, I am seeing it very fertile to deploy capital compared with other opportunities globally. Hence, I have been spending most of the last 6 months in India, scouting for asymmetric bets. I believe the best opportunities are currently present in the special situation categories of spin-offs, demergers, catalyst based SOTP discounts and rights issues. There have been at least six good demergers/ spin off opportunities in the Indian market over the last year that I have underwritten with very attractive risk-reward. While a lot of these special situation ideas can’t be disclosed for liquidity concerns or timing issues or continuous accumulation by our fund etc, I believe Birlasoft is an executable investment for the members of this forum.  

Birlasoft - A simple Investment Thesis:

Elevator Pitch: A recently demerged Indian IT services business with a good team, cash rich balance sheet along with strong revenue growth and margin expansion opportunity is trading at an attractive <4X EV/ EBIT valuation. Recent deal wins and a successful integration of the merged entity are key catalysts for this special sit. 

Industry Background:

The global IT services is a growth industry as companies worldover continue to invest in their digital and other tech capabilities to not just grow but also to just stay in the game. A lot of the IT spend is no more discretionary in nature. Within the IT services market, the Indian IT firms continue to grow their market share every year. The biggest advantage for India in the IT services market continues to be its attractive labour pool. India continues to produce software engineers at a massive scale and that has resulted in continuous deflation in entry level programmer salaries over the last 15 years. The real wages have de-grown by over 40% in the last decade.The labour price arbitrage for Indian IT companies continues to widen every year. 

A lot of the Indian companies have now peneterated well in different segments of the global markets and continue to win marquee clients. They have also adapted well to various things such as new visa process globally, shift from time & material contracts to fixed contracts, change in large orders to smaller but frequent digital orders etc. Most of the Indian IT companies have strong governance practices and generate solid cash flows. Since they benefit from rupee depreciation, they are good counter cyclical bets for Indian investors during a downturn. The IT services businesses can only be differentiated in terms of the segments or geographies they target and the team’s strategy to land and expand customers. The winning companies are the ones with a good team and strong execution capability. 

Demerger and merger background:

Birlasoft, a CK Birla company, is a newly formed IT services company formed by the

merger of Birlasoft and the IT services division of KPIT Technologies. As a brief history, Birlasoft was initially formed as a GE outsourcing shop and KPIT technologies as an outsourcing shop for Cummins limited. While KPIT diversified in the early 2000’s, Birlasoft continued to generate over 50% of revenues from GE until 2014. 

The new management team at Birlasoft consciously diversified away from GE and added new clients and capabilities. In 2017-18, GE’s business was sold to Genpact on a slump-sale basis. Currently GE contributes ~ 2-3% of overall revenues. Even though the overall revenues didn’t grow at a fast clip, the non-GE business grew at 18% CAGR. 

Both Birlasoft and KPIT were listed companies trading in the Indian exchanges. The erstwhile KPIT technologies had two divisions, an IT services business focused on enterprises, primarily on ERP implementation and maintenance and an IT services/ products business that focused purely on automobile industry. The management focused a lot more on the automobile business as the market gave them a higher value for the same. Hence, the non-auto ERP business was never given the attention it required. 

In this transaction, the erstwhile KPIT was demerged into auto and non-auto businesses and the former has now been separately listed as KPIT technologies. The non-auto IT services business was merged with Birlasoft’s IT services business. So, the current entity that we are looking at is a product of this demerger and merger exercise. At the time of the merger, the revenue contribution to the merged entity was as follows: Birlasoft - 145 Million USD and KPIT’s non-auto business - 330 Million USD. 

Even though KPIT’s non-auto business was the larger segment, it was the management team of Birlasoft that runs the merged entity and they now have a much bigger platform to scale up their IT services business. The current KPIT Technologies is a pure play automobile IT services business and the erstwhile promoters of KPIT have used this demerger exercise to increase their shareholding in the auto business and continue to run it. We have a position in that business and I think that stock is attractively positioned as well. 

As with several other spin offs, a lot of the shareholders of the erstwhile KPIT technologies were present for its auto business as they had a unique story to say to the market. It helps automobile companies ride over massive disruptions such as EV, connected cars, digitization of cars etc. Hence, it trades at a much higher valuation than Birlasoft and continues to grow revenues at a faster clip. The erstwhile shareholders of KPIT don’t have much interest in holding onto a mid tier IT services firm that doesn’t have any strong moat or a clear focus segment. Hence, I believe that there has been forced selling of the Birlasoft shares and this could be one of the main reasons as to why this investment opportunity exists now. 

Business Overview:

Birlasoft is promoted by the CK Birla group. It is a growing US $2.3 billion conglomerate that has spun off and created value for shareholders in several of their other listed businesses in the country. Their balance sheets are clean and they have treated minority shareholders fairly. The group has 25,000 employees, 41 manufacturing facilities and 21 service delivery locations, operating in three industry clusters: technology & automotive, home & building, and healthcare & education. They own around 41% of Birlasoft and continue to run it professionally with a properly incentivized management team. 

The erstwhile Birlasoft had strengths in the non-ERP digital businesses like CRM, BI & Data analytics, Application development, while KPIT IT services had core strengths in enterprise software solutions like Oracle, JD Edwards, SAP etc and capabilities in digital transformation services. Since the integrated business has much more scale, it’s ability to get larger clients and attract a better employee base improves significantly. Birlasoft has the highest percentage of business coming from core enterprise systems and has the highest level of partnership with SAP, Oracle as well as with Salesforce, a position unmatched by any other company of similar size. 

With over 500 Million USD revenues, the current Birlasoft platform has the necessary scale to penetrate into larger accounts if they execute their advisory led sales model well. The company also has around 67 Million USD in net cash which can be used for tuck in acquisitions to build capabilities and provide entry into good niches. The current business is broadly diversified on the following lines:

Geographic Revenues Split: Americas (78.5%), Europe (11%) and Rest of world (10.5%)

Industries Revenues Split: Discrete Manufacturing (19.8%), BFSI (19.9%), Energy & Utilities (17.8%), Retail (11.6%), Life Sciences (16.9%) and Automotive (14.1%). 

Service Offerings Split: Integrated Enterprise Solutions (32.5%), SAP (16.8%), Digital Transformation (28.4%), Custom Application Development (13%) and Others (9.3%)

Customer Concentration Split: Top 5 (27.1%), Top 10 (37.1%) and Top 20 (49%).

The IT services business is more of an execution business and hence a good team is very important to the thesis. The current CEO was the COO of the firm when the merger was done and was a key player in the growth of non-GE business at Birlasoft. He has led the integration well and is cost conscious. He has beefed up the sales and delivery teams by bringing in new talent from other firms. The hard part of integration, strategy and team building is done and now they need to put their heads down and execute on the plan. 

The company has 5 clients who give them 10 Million $+ business and 86 clients who give them 1 Million $+ business. The strategy would be to scale up a lot of these 1 Million USD customers into the 5 or 10 Million+ basket. The company has taken a conscious decision to prune its long tail and focus on accounts which can scale up. The new team seems to be focused on sales and delivery to grow the business. 

There are a lot of cross-sell opportunities as the two merged companies had very different strengths and customer profiles. These businesses have historically generated around 13% EBITDA margins and I believe that once the integration process is completed and cost synergies are realized, we would see much better margins from the current 11%. The revenue synergies and accelerated growth might probably take a bit longer to fructify and if they execute well on client cross-sell, the management believes that they can take margins to around 15% over the next few quarters. 

The new team is well in place and since most of the integration work is complete, they have started to focus on adding new clients. The pipeline looks healthy and they have had a few good order wins of late. They recently won a 240 Million USD transformational deal from Invacare Corporation and this deal is the biggest in Birlasoft’s history. It’s a multi‐year agreement wherein Birlasoft will deliver IT‐as‐a‐ Service to Invacare. Birlasoft will accelerate Invacare’s business transformation by modernizing systems, taking responsibility for the provision of service desk, applications, server, network and telephony support. Birlasoft will build  a new analytics platform and move the Invacare data center to the cloud. As a part of the IT transformation, Birlasoft will implement a new Product Lifecycle Management system and Invacare customers will benefit from a new ecommerce portal to access products, spares and supplies. Birlasoft will support Invacare in global implementation of SAP S/4HANA and associated SAP solutions, harmonizing business processes and information flows worldwide. These kind of large deal wins can significantly change the financial trajectory for the firm. 

Valuation & Conclusion:

Birlasoft has the potential to create value for shareholders in all 3 forms - revenue growth, margin expansion and valuation re-rating. The current market cap of the firm is around 250 Million USD. Net cash on the balance sheet is around 67 Million USD. Hence, the current enterprise value is around 183 Million USD. The firm has been doing a quarterly EBITDA of 12 Million USD. Hence the stock is trading at less than <4X EBITDA for a business that is still growing and has a good management team to scale up the business. 

Similar sized IT services businesses in India trade at anywhere between 8 to 12X EBITDA and hence there is a case to be built even on relative valuation metrics. The risk in the investment thesis is if they use the cash on the balance sheet to do value destructive acquisitions or if the team disintegrates and loses a lot of key client relationships. Since the revenues are dollar based, there is no currency risk for global investors in Birlasoft. 

Catalyst

Succesfful integration & large deal wins