Description
Thesis
Ness Technologies Inc. (Nasdaq: NSTC) is a high-quality growth company trading at a cheap price.
- 20% organic growth
- increasing margins due to favorable mix change
- 31% after-tax ROIC
- consolidating industry
- under-levered and acknowledged by management as such
- favorable tax rate
- recurring revenue and diverse customer base
- 13.4x and 10.8x 2006/2007 EPS
I also believe the downside in NSTC shares is limited given that Mr. Market isn’t requiring a growth multiple to buy this business. Further, a favorable mix shift towards higher margin business segments should accelerate earnings growth to exceed top-line growth.
So let’s take this new VIC formatting for a test drive with a table:
(in 000’s)
|
FD Shares |
36,709 |
|
Price |
$11.18 |
|
Market Value |
$410,402 |
|
|
|
|
Net Debt (cash) |
(3,829) |
|
Enterprise Value |
$406,573 |
|
|
|
|
|
|
|
EV / 2006 EBIT |
11.5x |
|
EV / 2007 EBIT |
9.4x |
|
|
|
|
P / 2006 EPS |
13.4x |
|
P / 2007 EPS |
10.8x |
Business Description
Israel based Ness Technology (“Ness”, or the “Company”) is a global IT consulting services provider. Currently, Ness does business in 15 countries, has over 500 customers and over 7,000 employees. Their services include outsourcing, system integration and application development, software and consulting, and quality assurance and training. By focusing on select verticals such as high-tech, life science, defense/homeland security, financial services, and independent software vendors (“ISV”), Ness has developed industry specific “know-how” which acts as a competitive advantage.
The revenue stream is diverse and recurring: (i) no customer accounts for more than 5% of revenue, (ii) 85% of revenue is from existing customers, and (iii) 40-50% of revenue comes from multi-year contracts. The company also has a large backlog ( > 1x sales) – about half of which is considered short-term.
In 1999, over 90% of Ness’s business was from Israeli clients. Today, it is less than 50% - mostly because of expansion into new markets. The Israeli business has operating margins around 6% vs. the Eastern Europe, India, and Defense segments, which have operating margins in the low to mid-teens. Ness is committed to keeping their #1 share in Israel and hence management believes it will be difficult for them to raise these margins above current levels without sacrificing revenue.
Ness entered Eastern Europe through acquisition in 2002 to address local markets which have economies going through modernizations, privatizations, etc, and hence have high demands for IT projects. A large part of the Eastern European business is from Western European clients, as they prefer to outsource to Eastern Europe rather than India.
The company’s 2006 acquisition in India almost doubled their staff from 1,400 to 2,200. India continues to have more demand than supply for IT services. The biggest constraint to growth is hiring enough engineers. The competition for resources has had a negative impact on both wages and attrition for everyone in the industry, although Ness estimates that 70-80% of wage increase can be passed through.
In the India focused business segment, Ness operates a unique business model by offering what they call a “Managed Lab”. This is essentially an outsourced Software R&D group for Independent Software Vendors – giving clients all the benefits of outsourcing to India while still having an option to own the business. The Managed Lab business tends to be more sophisticated than the more commoditized IT outsourcing projects typically pursued by India based providers. With the Managed Lab, the ISV has an option to buy the Lab after 36 months. The Company believes this offering differentiates them and has allowed them to win business over larger competitors.
Revenue by client’s region is approximately: 49% Israel, 26% US, 20% Europe, and 5% Other.
Ness’s 7,000 employees are located: 45% Israel, 31% India, 7% US, 11% Europe, 5% Asia Pacific.
Brief History
Ness was founded in 1999 and focused exclusively on Israeli customers, where they quickly became the #1 provider of IT services by market share. In 2001, Ness expanded into other markets where they could leverage their niche focus on select verticals and use off-shore as a means of being competitive. From 2002-2005, Ness achieved a 30% CAGR (20% of which is from organic growth, the remainder through acquisition). Ness was listed on Nasdaq in October 2004 in a Lehman / Merrill led IPO which raised $70 million.
After going public, Ness share traded as high as $15/share but came down to $8/share last summer after the company gave disappointing EPS guidance, due to the delay of three contract wins (a matter of timing). My understanding is that the company went public without an experienced CFO, who was replaced in Q2 2005 with Ytzhak Edelman. Edelman has a significant amount of experience as he was the former CFO of Cellcom, Israel’s largest cellular operator.
Warburg Pincus, the private equity group that funded the original rollup has recently distributed 1,000,000 of their 6,000,000 shares. They hold their shares in 3 separate funds. According to Ness IR: (i) The shares that were distributed were from a fund that has reached its maturity, and (ii) Warburg has said they have no immediate plans to distribute the remaining 5,000,000 shares. I believe the market could therefore be incorrectly seeing the Warburg distribution as a negative sign.
Acquisitions
Ness has made a number of acquisitions. Acquisitions in this industry are typically about acquiring personnel as a quick entry into a new market and to a lesser extent to acquire revenue or industry expertise. I typically look skeptically at serial acquirers, however, it appears that Ness has done a relatively good job at paying reasonable prices (structured with earn-outs) and integrating them. On the most recent earnings call, the new CFO made a point of noting there shouldn’t be any new acquisitions in the next 12 to 18 months.
Following is the acquisition history:
April 1999 Founders acquired Israel based, Compro Software (170 employees)
April 1999 Israel based Gilad Software (340 employees)
May 1999 Acquired Contahal, a publicly traded IT services company (310 employees)
Aug 1999 Acquired Advanced Technology, a public Israeli IT Services company (650 employees)
Nov 1999 Acquired IPEX, an Israeli system integrator (350 employees)
Nov 1999 Acquired IPEX ISI, an Israeli software development company (43 employees)
2000-2001 Consolidated all six companies / major reorganization.
Nov 2001 Acquired Blueflame out of Chapter 11. (120 employees and $18mm in revenue)
Sept 2002 Acquired APP, a Czech / Slovakia based IT services firm. (Sept 2002)
June 2003 Acquired Apar Holding Corp., a US-Indian IT services company. (1,200 employees)
Q4 2005 Acquired three privately held IT service providers in Eastern Europe: (i) Radix Company in Romania, (ii) Delta Electronic Services in Slovakia, and (iii) Efcon in the Czech Republic.
2/28/2006 Acquired Innova, a provider of IT services and solutions based in the US and India for $25 million ($15mm + $10mm earn-out).
Summary Financials
Quarterly (inclusive of acquisitions)
|
Quarter |
Revenue |
Seq. Growth |
y/y
Growth |
Op.
Margin |
|
Mar-03 |
$47,574 |
0.3% |
18.1% |
5.3% |
|
Jun-03 |
$44,788 |
(5.9%) |
12.6% |
(0.1%) |
|
Sep-03 |
$64,327 |
43.6% |
64.7% |
3.0% |
|
Dec-03 |
$69,079 |
7.4% |
45.6% |
2.2% |
|
Mar-04 |
$71,146 |
3.0% |
49.5% |
7.4% |
|
Jun-04 |
$73,879 |
3.8% |
65.0% |
5.9% |
|
Sep-04 |
$77,152 |
4.4% |
19.9% |
7.0% |
|
Dec-04 |
$82,348 |
6.7% |
19.2% |
7.2% |
|
Mar-05 |
$88,405 |
7.4% |
24.3% |
6.6% |
|
Jun-05 |
$94,218 |
6.6% |
27.5% |
5.2% |
|
Sep-05 |
$97,719 |
3.7% |
26.7% |
7.8% |
|
Dec-05 |
$105,094 |
7.5% |
27.6% |
7.4% |
|
Mar-06 |
$107,042 |
1.9% |
21.1% |
7.3% |
|
|
|
|
|
2003 |
2004 |
2005 |
2005 Adj |
2006 P |
2007 P |
|
Revenue |
|
$225,768 |
$304,525 |
$385,436 |
$385,436 |
$471,330 |
$565,727 |
|
|
Growth |
|
|
35% |
27% |
27% |
22% |
20% |
|
|
|
|
|
|
|
|
|
|
|
|
Operating Profit |
|
5,945 |
20,961 |
26,206 |
28,206 |
35,244 |
43,381 |
|
|
Margin |
|
2.6% |
6.9% |
6.8% |
7.3% |
7.5% |
7.7% |
|
|
|
|
|
|
|
|
|
|
|
|
Net Income |
|
4,559 |
14,377 |
21,691 |
23,291 |
30,587 |
37,880 |
|
|
Margin |
|
2.0% |
4.7% |
5.6% |
6.0% |
6.5% |
6.7% |
|
|
Growth |
|
|
215% |
51% |
62% |
31% |
24% |
|
|
|
|
|
|
|
|
|
|
|
|
EPS |
|
|
|
|
$0.59 |
$0.63 |
$0.83 |
$1.03 |
|
|
Growth |
|
|
|
|
|
32% |
24% |
As of 3/31/2006 the backlog was $527 million. Revenue is recognized as services are performed. All of the backlog is “won” business, half of which is expected to be performed within 12 months.
Projections
Current guidance for 2006 is $470-485 million in revenue. If the Innova acquisition was included for the whole year, 2006 would be $5-$10 million higher. I’ve assumed the middle of management guidance with 7.5% operating margins for my 2006E of operating income. In 2007, I’ve assumed 20% growth and some credit for the margin expansion based on growing the individual business segments at their respective rates (with a healthy does of skepticism) – i.e. the Israeli business will continue to be flattish, while the Eastern European and India businesses experience strong growth. Further, 2005’s margins were impacted by public offering expenses, Sarbox, and merger expenses that were largely one-time in nature, which have been adjusted in “2005 Adj.”
Management believes they can achieve long-term operating margins above 10%, and feel that they can improve from current levels by 100-200 bps per year.
Margins
The margin enhancement story is several fold:
(i) Mix - higher margin segments are growing rapidly.
(ii) Cost savings
a. Ness is spending ahead of growth on infrastructure which is having a negative impact on margins.
b. Ness is hiring more “freshers”. In the past, Ness hired more experienced workers which have both higher salaries and higher attrition rates. These workers bill at higher rates but no enough to make them the same margin percentage as freshers.
c. Brand Recognition – Attrition in India is also influenced by the brand recognition of the employer they work for. As Ness grows to become a more recognized name in India, they should enjoy some of these benefits as well.
(iii) Operating leverage - As the percentage of “billable employees” continues to increase margins will expand.
(iv) Selling IP – Ness intends on packaging their IP and selling it as technology to collect royalty streams.
Ness competes with all the India based outsourcers such as: INFY, WIT, and SAY. These companies have much higher EBIT margins than the Company, mainly due to their scale and higher use of freshers. Ness also competes with the US based outsourcers such as CTSH and SYNT as well as big consulting firms such as EDS, HP, Accenture, and Keane. Additionally, there’s competition from companies engaging in their own off-shoring.
Catalyst
Margin improvement
New segment disclosure highlights operating margins of segments
Continued sequential growth and cash generation