iGATE ("IGTE") has been on a near vertical ascent in recent months and I think it represents a  great short opportunity as its recent revenue and margin expansion are unsustainable in my view and the company's earnings are likely to fall considerably in the coming 12-18 months as a tax holiday expires. 

 

Insiders have been aggressively unloading their stock, including a large underwritten offering at a price 40% below current levels.  While earnings are difficult to precisely predict (due to customer concentration that I will describe below), I believe the company's earnings are more likely to fall between $0.45 and $0.55 compared to Street consensus of almost double that level.  Assuming a full multiple of 15x for this competitive business with massive customer concentration issues, the stock would trade between $7 and $8 - about 60% below current levels. 

 

IGTE plays in the very competitive space of outsourced IT and business processing services such as systems installations and maintenance.  Currently 36% of the company's revenues come from Royal Bank of Canada ("RBC").  As you can see in the chart below, RBC has increased its spend significantly in the past two quarters.  When compared to the soft Q1 and Q2 in 2009 (when spending was constrained due to the economic climate), the growth looks particularly strong resulting in a company that showed 30-40% revenue growth in 1H of 2010.  This has caught the attention of many momentum investors.

 

 

However, outside of RBC, the business has been basically flat the past few years.  Growth in 1H 2010 in non-RBC business appears to be nothing more than a bounce off the bottom in 1H 2009 due to the soft economic environment.  While unfortunately I do not have much insight into RBC's IT budget, I can say that they likely had some big catch up after the soft 2008 and 2009 that affected the budgets of all financial services companies.  In any event, I view revenue bumps from large single customers as very low quality.  Clearly RBC knows their spending bump has made many people at IGTE rich in recent months and they will have tremendous negotiating power with IGTE to push rates lower (hurting margins and revenues) given the incredible power they wield in this equation.

 

Furthermore, EBIT margin has expanded from around 10% historically to around 18% in the past several quarters.  I believe at least half of that increase is unsustainable.  About 2% of margin expansion came from the fact that most of the costs for IGTE are outside the US (such as India) and a strong US dollar has helped the company's bottom line.  Additionally, 2% of margin expansion came from the fact that the company has fully depreciated some of its PP&E and therefore, D&A as a % of sales has declined to extremely low levels.  Capex has begun to pick up again as I believe the company may have underspent the past few years and therefore, D&A should move higher and put future pressure on operating income.  (Additionally, as I mentioned above, I would expect RBC to negotiate hard for rates given the profits they have generated for IGTE).

 

If we assume that RBC revenues are going to be $60-70 million per year (well above the past few years, but below the current run-rate) and non-RBC revenues grow a bit from here to $180-190 million, then the company will be doing $240-260 million of revenues.  At a 13-15% operating margin (well above historical levels but below the extremely high levels of the past few quarters), the operating income of this company will be roughly between $30 to $40 million or 30-50% below 2011 consensus.

 

If that isn't enough, analysts seem to have missed the fact that the company's tax holiday from earnings out of India will expire in March 2011.  The past several years, IGTE has barely paid any taxes (effective rate has been 2%).  We believe that number could approach 25-30% after the tax holiday expires.  The Street appears to be modeling in around 12%. 

 

At a 25-30% tax rate, my operating income numbers above will translate into $25 to $30 million of net income (assuming the company continues to generate $3 million in interest income).  This would equate to around $0.45 to $0.55 per share vs. consensus of $0.95.  If I am even close to right here, this business will no longer trade like a high flying tech stock but much closer to a level reflecting the real risks of a competitive, low growth business with massive customer concentration issues (GE is also around 20% of the business).  I believe this business is inferior to other IT consulting firms that tend to be higher value-add, higher growth and much more diversified in their customer base (Infosys, Cognizant, etc.) and as a result, IGTE should trade at a considerable discount.  At 15x earnings (which could prove generous if earnings start declining), the stock would be at $7 to $8 or around 60% lower than today's levels.

 

In summary, a questionable revenue bump, unsustainably high margins, massive insider selling, an expiration of a tax credit and an extremely high valuation all make for a highly compelling short.