Description

Despite all the current negative sentiment around Chinese US listed companies (some of it we agree is deserved), we believe HSFT presents a compelling LONG opportunity currently trading at 1.3x EV/Sales, 13.5x non-gaap P/E, and 10x P/E ex. $4.00/share of cash (~30% of market cap) on 2012 estimates. Note this is for a 40% top-line grower and with one of the best management teams in the space in our view. The stock is currently down 48% YTD and up about 55% from its IPO in July 2010. Some of the YTD performance is understandable/attributable to (1) bad debt provision equal to 2-3% of revs, (2) lowering of margin guidance by 150bps in early March, (3) the Japan earthquake which mgmt expects to have a potential negative 2% revenue impact in 2011. Two out of the three we ascribe to the nature of the services business/bad luck. While having three missteps in a row (counting the earthquake) after a secondary is not a good recipe for a stock, the economic impact from the above items is fairly minimal and more than discounted.  The recent sentiment shift against Chinese US listed companies/fraud concerns at LFT have led to further weakness in HSFT and its peers and why believe there is an attractive long opportunity here with 50-100% upside from current levels.

It took 3-6months post Satyam's (SAY) blow-up in India for legitimate players like INFY and CTSH to recover. We believe the situation here will be somewhat analogous as fundamentals begin to matter again and confidence returns.

Apart from the recovery in sentiment, we believe HSFT presents an attractive and undervalued secular growth story. The drivers being (1) the under-representation of Chinese IT providers in the US market, (2) low IT penetration with China domestic companies, (3) strong govt. support to develop the industry, and (4) vast pool of qualified engineering/IT talent.  As to the potential opportunity, the simple observation is that the cumulative market cap of China IT Services is currently < $5B vs. the Big 4 in India currently over $100B. The pitch here is not necessarily about taking share from India, but more pointing out that we believe we are in the early innings for China IT services and on a trajectory that so far has been fairly similar to how Indian IT evolved in the early 2000-2003 timeframe.

Brief Business Description

HSFT is a China-based provider of IT services (consulting/package implementation + App development/testing) and R&D services. In the latest quarter the split between ITS and R&D was 57% and 43%, respectively. Roughly, 17% of revenue now comes from China HQ'd companies and 83% coming from US/Japan/Europe based corporates. Relative to other outsourcing companies in China, HSFT has the biggest non-China mix (i.e., export business similar to INFY/CTSH in India) though domestic China is the fastest growing geography given the lower base. As of 3/31, HSFT had roughly 6K employees.

Just to get this out of the way:

• HSFT is NOT a reverse merger/RTO
• HSFT does not use any outside staffing agencies
• It's important to emphasize that the majority of HSFT's customers are multinationals (not domestic Chinese companies)
• HSFT filed their 20-F without incident in early April
• HSFT is audited by Deloitte Touche Tohmatsu in Beijing. This is a different office than LFT and CCME (see CCME discussion for more details on auditors) and the same one used by VIT and ISS who we believe are also legitimate players in the space.
• Details on cash accounts have been disclosed by the company

What happened / Sequence of Events

• July 2010 - IPO at $10. Underwriters were DB, Citi, UBS.
• August 2010 - first beat and raise quarter
• November 2010 - second beat and raise quarter
• December 2010 - completes secondary at $26.00/share
• February 2011 - On 2/23, HSFT proactively announced a bad debt provision of $3.5M (roughly 2% of revs) of a Japanese systems integrator that they do business with because they noticed that the balance sheet of that customer was over-levered (though the customer was still current on payments). While the disclosure was appropriate, the communication of it was poor. A press release was issued 15mins before the market open with no conference call and management inaccessible that evening. Since this was the first announcement after the secondary, the news was not received well. Stock sold off 17%.
• March 2011 - On 3/1 (a week later), the company announced earnings, beat top-line with better than expected 2011 guidance, but guided down margins by 100-200 bps for the year to 14% because of additional reinvestment in S&M to drive top-line...stock sold off another 17%. Again, management gets a C in communication and could have telegraphed this better given the bad debt call just one week earlier.
• March 2011 - On 3/12, Japan earthquake hit (23% of revs from Japanese domiciled companies)...stock off 13% the next month.
• April 2011 - On 4/6, HSFT gives preliminary view on Japan earthquake impact. No project cancels were noted but mgmt took opportunity to factor in for potential delays. Revenue estimate was cut by 2% and EPS by 10% (due to some one time costs)...stock was up 16% because guide down was not as bad as expected.
• April 2011 - On 4/26, Citron released a report on LFT (see Razor99's writeup). HSFT has traded down another 25% since Citron wrote up LFT.
• After all of this, 2011 and 2012 revenue estimates are actually higher than before they announced the write-down...EPS estimates are down by 10-15%, due in part to one-time Japan costs and re-investment.

From the fact pattern above, on one hand it's encouraging to see a Chinese company pro-actively disclose a bad debt provision, but clearly the communication effort was poor and the timing not ideal post a secondary. Furthermore, the communication/credibility was further damaged when the company decided to invest for top-line growth which in our view has merits from a long-term growth perspective, but was a change from prior communication and not telegraphed well. Lastly, the recent doubts about Chinese frauds has cast a shadow on the entire space and essentially carried HSFT out with the LFT bathwater.

Importantly, HSFT this past week took its first step towards differentiating itself by disclosing all of its bank accounts to help address any concerns from the LFT situation. http://www.hisoft.com/news-center/164-hisoft-issues-corporate-deposit-account-list-and-cash-flow-statements

While the sentiment recovery in itself provides for significant upside, we believe there is an attractive secular growth story here as well with 30-40% annual revenue and earnings growth over the next few years:

Salient points of the thesis:

• IT outsourcing in China has secular tailwinds
  • The government has made IT services and technology a focus in their most recent 5-year plan - this was a big driver of the industry in India and we believe will be as important if not more in China via subsidies, favorable tax treatment, hiring incentives, etc
  • There are strong parallels between China's nascent outsourcing industry and India's in the early 2000's - the drivers are different (i.e., Y2K) but many similar characteristics with strong engineering base, lower cost labor, govt support, etc
  • As multi-nationals continue to expand into China, it will be important to have local IT outsourcing support available and to diversify away from India
    • 39% of revenues are either from multi-nationals who outsource their IT and R&D to HSFT for their Chinese subsidiaries or Chinese indigenous companie
  • IT outsourcing a relatively new concept for most Chinese domestic companies - only 17% of HSFT's revenues currently come from Chinese companies (up from 6% a year ago), but as outsourcing is becoming more prevalent in China as, HSFT stands to benefit.
  • India is currently the most common IT outsourcing destination (INFY, WIT, etc.)
    • China offers a lower cost alternative to IT outsourcing vs. India (~20% cheaper)
  • Industry is growing 25% and HSFT is growing well north of that with 40% growth in 1H.
  • Barriers to entry from outside players is high - Indians to date have largely been unsuccessful. Given the government in China, there is natural protection from outside competition.
• Strong Management - despite the recent communication issues, the HSFT management team in our view is solid and internal reference checks have come back positive. Most of the team has western experience with large multinationals. Tiak Koon-Loh is the CEO and has been with the company since 2006. Before that he was with HP's china business along with Cheng Yaw who is the Chairman. Cheng Yaw's reputation in China is highly respected and he was responsible for growing HP's business from 1000 to over 100K employees. The CFO is a US certified CPA and has a strong background in US GAAP accounting. The Board is also balanced with independent members (Granite Global Ventures) unlike many other Chinese companies (e.g., LFT). Management owns about 11% of the company and the majority of CEO's net worth is tied up in HSFT stock.
• Best DSOs in the industry
  • Currently, DSOs are around 91 days vs. peers anywhere from 120-160 days
  • DSOs for companies with customers in domestic china run high given longer payment terms and dealing with SOEs in China
  • As HSFT's china business grows, DSOs will increase some but management feels comfortable to hold DSOs under 100 even as their China business grows to over 20% of total.
• Fortune 500 customer base - brand recognition
  • Currently has GE, MSFT, Sony, UBS, Nomura, AIG, CTXS and a host of other large multi-national corporations as clients. 36 of the F500 are customers.
  • Domestically, Huawei is a customer along with ZTE, Baidu, Tencent, Agricultural Bank of China.
  • HSFT is a preferred vendor at HP, MSFT, CTXS and others
  • GE known as one of the pioneers in outsourcing in India and China invested in only one outsourcing company in China...HSFT
• Street numbers seem conservative
  • The company set out goals to reach 20% of sales from domestic China by the end of 2011...actual reported was 17% after Q1. Goal for 2012 is to be 40%.
  • HSFT has beat top-line estimates every quarter by 3-7%
  • 2H11 estimates only require 28% growth to meet street estimates vs. 39% projected in 1H (assuming mgmt guidance for Q2).
  • 2-yr stacked comp suggests acceleration in the business
  • Limited analyst coverage - still generally an underfollowed group in terms of street coverage
• Attractive risk-reward
  • Risk/Reward > 1:5
  • We think the downside is mitigated with almost 30% of HSFT's market cap in cash. $128M in cash as of 3/31/11.
  • Upside - 20x our EPS estimate for $1.15 in 2012 = $22.50 or +50%. Note that both VIT and ISS currently trade for 25-28x 2011 estimates despite the negative sentiment. We think those multiples are not out of bounds and the group was trading north of 30x before. A 25x multiple would point to almost a double from the current price.
  • Downside - this is trickier given it's a services business (no hard asset support) and sentiment can overshoot in these names, but 10x street numbers (ex interest income) for 2011 plus cash of $4/share suggests 15-20% potential downside (also ~1x EV/sales). I'm not sure why 10x is the right multiple for a 35-40% top-line grower unless structural concerns in the industry arise or the china fraud concerns become even more prevalent than they are today.

Risks:

1. Wage inflation - a hot topic these days and most companies in the space note wage inflation levels around 5-10%. HSFT has been able to offset much of this by moving delivery to tier 2 and 3 cities (i.e., Wuxi) and by pricing.
2. Fraud sentiment in China
3. IP concerns - Large customers that we have spoken to haven't reported any issues but this has been a broad concern for China for some time now. As part of the 5-year plan, the govt is making this a priority.
4. Japan - No project cancellations as of yet...only delays, though cancellations could be a plausible concern. Management's latest commentary is that we should see flat to slightly down sequentially in Q2 with resumption of sequential growth in Q3/Q4.
5. FX - every 100bps of RMB appreciation impacts GMs by ~30bps. Partial mitigant is via other levers like utilization, pricing, and move to tier-2 cities.
6. General economic slowdown

Catalyst