Technology

CONTENTS
The underbelly of Indian IT the ugly, the bad and the not so good... 4 THE UGLY. 6 Geodesic 7 Educomp.9 Financial Technologies (FTech)11 THE BAD. 13 Rolta..14 MCX.. 16 THE NOT SO GOOD 18 Tech Mahindra 19 Infosys...22 KPIT Technologies.. 24

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Technology
THEMATIC March 24, 2014
Case studies in this note
The ugly Geodesic Educomp Solutions Revenue and cash flow manipulation; corporate governance concerns Accounts window dressing

The underbelly of Indian IT

The Indian IT sector is oft praised for its good corporate governance and accounting excellence. However, our history of covering the sector over the last four years indicates that this blanket assumption is misleading. We present case studies of companies (classified as ugly, bad and not so good) that underperform on accounting and corporate governance standards. Whilst some of these companies (such as FTech, Educomp and Geodesic) are already understood by the market for what they are, others (such as Rolta, MCX, Infosys, Tech Mahindra and KPIT) are yet to be discounted appropriately by investors. Misconceptions about the quality of Indian IT sector Five years since the Satyam fraud, the IT Index is up over 300%, implying that the Indian IT sector is still assumed to be a safe haven of relatively cleaner promoters, strong and neat accounts, and sound corporate governance practices. However, our analysis and experience of the sector suggests this is probably the easiest sector to fudge accounts, particularly given its largely services-led nature and given that it relies on B2B transactions that do not lend themselves to the sanity checks that one can do in industrial sectors. Range of tricks to window-dress accounts Indian IT firms have used a variety of tricks to window dress their accounts, ranging from recognising cashless revenues (Geodesic), recognising seemingly non-existent revenues (Geodesic, Rolta and MCX), accelerated revenue recognition (Educomp), margin management (Geodesic, Rolta and KPIT Technologies), inflated balance sheet (Rolta) to cash flow management (Rolta and Geodesic). Furthermore, we also highlight how choice of accounting policies can sugar-coat the accounts (Tech Mahindra and KPIT). Not the cleanest on corporate governance either Significant related party transactions at MCX (not appearing to be arms length), the NSEL fiasco at FTech, questionably low independent director involvement at TechM and Satyam when the merger ratio was finalised, relatively high promoter Board representation and peculiar guidance pattern creating stock price volatility at Infosys are some examples of corporate governance loopholes. Furthermore, less-than-adequate disclosures at Tech Mahindra, Educomp and seemingly weak risk management at MCX are also concerns. Traces of suspicion in MCX and Rolta Whilst cases such as Satyam (with its artificially inflated bank balances) can be difficult to detect in advance, other cases such as Geodesic, Educomp and FTech had similar financial characteristics, which could have been spotted by investors who were willing to dig deep into their accounts. We find somewhat similar issues in the annual reports of MCX and Rolta India. On the other hand, Tech Mahindra, Infosys and KPIT present less than desirable standards of accounting and corporate governance. For firms rated as richly as these three, this should weigh on their valuation multiples. We reiterate our SELL stance on Infosys and Tech Mahindra . We do not cover the other IT companies mentioned in this note.

Suspicious subsidiary accounts; Financial corporate governance Technologies concerns The bad Rolta India MCX The not so good Tech Mahindra/ Satyam Infosys Weaker disclosure norms; accounting not up to international standards; flags on governance Letting down its own governance standards? Tricky accounting practices Suspicious related party deals and seemingly artificial volumes

KPIT Magnified margins Technologies Source: Ambit Capital research

Key Recommendations
HCL Tech
Target Price:1,614 BUY Upside :13% BUY Upside : 11% SELL Downside : 19% SELL Downside : 11%

TCS
Target Price:2,351

Tech Mahindra
Target Price:1,471

Infosys
Target Price: 2,945

Analyst Details
Ankur Rudra, CFA +91 22 3043 3211 ankurrudra@ambitcapital.com Nitin Jain +91 22 3043 3291 nitinjain@ambitcapital.com

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

Technology

The underbelly of Indian IT

Five years on from the Satyam fraud, the Indian IT sector is still assumed to be a safe haven of relatively clean promoters, strong accounting and sound corporate governance practices. This has been historically reflected in the lower discount rates applied to the sector, leading to higher P/E multiples. However, our analysis and experience of the sector suggests this is probably one of the easiest sectors to fudge accounts for three reasons: (1) its largely services-led nature (i.e. there is no tangible output that can be observed), (2) it is centred around B2B transactions that do not lend themselves to typical sanity checks that one can do in industrial sectors (limited capability to do ground level surveys), and (3) there is a declining linear relationship in this sector between revenues and headcount. (Given that employee cost is the single-largest input cost, a declining correlation with revenues offers greater scope for manipulation.) Based on our observations over the past four years, we present case studies of eight IT companies, highlighting their accounting and corporate governance issues and challenging the notion that Indian IT firms have high-quality accounts and strong corporate governance. This is not an exhaustive study and is based on the standout cases we have come across. Other firms may have similar or even greater issues. We classify the accounting and governance issues in this sector into six broad categories: 1. Revenue manipulation: This can be done by either booking cashless revenues (with a corresponding increase in receivables), fictitious revenue booking (through classification of other income as revenues) or accelerated revenue booking through creative accounting methods. We find evidences of revenue manipulation by firms such as Geodesic, Rolta, Educomp and MCX. 2. Margin management: This can be done through capitalising expenditures, lower provisioning for doubtful debts or through creative accounting (such as not accounting for client re-imbursements in revenues and costs). Geodesic, Rolta and KPIT seem to follow such practices. 3. Accounting method/system not comparable to peers: The most apt example is Tech Mahindra. It uses Indian GAAP, whilst most of its peers have already migrated to US GAAP/IFRS many years ago. Use of Indian GAAP allowed it to adopt the Pooling of interest method (that records all balance sheet items at book value) for merger accounting of Satyam. The use of Indian GAAP has helped it maintain high RoEs. Had the transaction been recorded under internationally accepted Purchase method, the RoEs would have been significantly lower. Our back-of-the-envelope calculations suggest that FY13 /FY14E RoE could have been 14.8%/18.4% under the purchase method (with Goodwill recognition) vs the RoEs of 36.3%/33.3% under the currently followed Pooling of interest method (see pages 19-20). 4. Balance sheet and cash flow management: This can be done by removing the borrowings from the balance-sheet through a separate Special Purpose Vehicle (SPV) and accelerating cash flow receipts through factoring using this SPV (example Educomp) or through the use of creative accounting (Rolta revaluation of land to offset additional depreciation charges). 5. Corporate misgovernance: This can be done through under-representation of independent directors (Tech Mahindra and Satyam), higher promoter dominance (Infosys), related party transactions which do not appear to be at arms length prices (MCX and FTech), less-than-adequate risk control measures (MCX) and a peculiar pattern of representing the future outlook to investors (Infosys). 6. Weaker disclosure norms: Relatively weak financial and event disclosures lead to investor decision-making based on inadequate information. Educomp, FTech and Tech Mahindra appear to fall in this category.
Tech Mahindras RoE sensitivity to IFRS accounting
Current (Pooling of interest method) FY13 Adjusted net income Adjusted Equity Adjusted RoE FY14E Purchase method (estimated) FY13 FY14E

` mn

21,157 27,674 13,694 20,211 68,530 97,484 99,168 120,659 36.3% 33.3% 14.8% 18.4%

Source: Ambit Capital research

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Technology We present case studies on the following companies:

The Ugly
1. Geodesic: Are the revenues real? 2. Educomp Solutions: The accounts appear to be window dressed 3. Financial Technologies (FTech): Suspicious subsidiary accounts; corporate governance concerns

The bad
4. Rolta India: Tricky accounting practices 5. MCX: Suspicious related party deals and seemingly artificial volumes

The not so good

6. Tech Mahindra/Satyam: Weaker disclosure norms; accounting not up to international standards; flags on corporate governance 7. Infosys: Letting down its own governance standards? 8. KPIT Technologies: Magnified margins

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Part 1: The Ugly

Geodesic
Are the revenues real? Geodesics receivable days have increased to 300 days in FY12 (from 120 days in FY12), whilst the doubtful debt provisioning has increased to 11.9% of debtors (9.8% of revenues in FY12). Cash yields remain at astonishingly low levels. All these raise concerns whether the earlier years revenues were indeed real. Cash conversion though improved over the last three years, the increase in current liabilities has been a significant factor pushing up the cash conversion.

Educomp Solutions
Accounts window dressing Educomps creation of a special purpose vehicle to transfer its receivables and then securitise it was an attempt to improve its cash conversion and make its balance sheet look lighter. Its change in revenue recognition policy was also intriguing. These coupled with instances of poor disclosures make it an interesting case study.

Financial Technologies (FTech)

Suspicious subsidiary accounts; corporate governance concerns From a stockmarket darling, riding on success in MCX and similar expectations from the other exchange ventures, Financial Technologies is now struggling to retain ownership of these exchanges on the back of the NSEL fiasco, bringing down expectations from its other exchange ventures. Besides the corporate governance issues (for not curbing the illegitimate activities at NSEL), our analysis also indicates suspicious manipulation of subsidiary accounts to present a better picture at standalone business. FTech does not publish consolidated quarterly results (despite ~40% revenues from subsidiaries), and hence, presenting good-looking standalone numbers makes sense.

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Geodesic
Are the revenues real?
Geodesic offers an interesting case study that shows several signs of revenue and cash conversion manipulations. With a glorious historical track record (104% FY04-09 revenue CAGR and ~55% EBITDA margins), Geodesic was viewed as an internet and mobile software company with exciting B2C products in instant messaging, cheaper SMS, VoIP calling, mobile TV and several products in a fast-growing market. Although its products were exciting, most of them failed to get commercial scale before they commoditised. The quality of revenue growth was always under question given significantly higher receivable days and low yield on investments (indicating possibilities of fictitious revenue booking). Whilst this remained unnoticed till the time the company was growing in triple digits, the problems intensified FY10 onwards, when the companys revenues declined for the first time in FY10, with a consequent decline in margins. Geodesics receivable days have increased to 300 days in FY12 (from 120 days in FY12), whilst the doubtful debt provisioning has increased to 11.9% of debtors (9.8% of revenues in FY12). Cash yields remain at astonishingly low levels. All these raise concerns whether the earlier years revenues were indeed real. Cash conversion, though improved over the last three years, increase in current liabilities has been a significant factor pushing up the cash conversion. Geodesic unsurprisingly finds itself in a greater mess now, with its auditor (Borkar and Muzumdar) raising qualifications on revenue and expense accounting, default on FCCBs, and forex hedging losses. The company has not yet published the consolidated FY13 accounts, is yet to pay the final dividend for FY12 and is functioning with just three directors all executive (all of the independent directors have resigned). This reflects in the market capitalisation which is down from `6.9bn at the beginning of 2009 to `284mn. Cashless revenues We find at least three evidences raising concerns on Geodesics revenue recognition: 1. High receivable days and increasing doubtful debt provisions: Although revenue growth recovered in FY11 and FY12, it came on the back of significant increase in receivable days (see Exhibit 1 below). Receivable days increased from 120 days in FY10 to 174 in FY11 and further to 300 in FY12. This, coupled with high bad debt provisioning in FY12, raises concerns on the quality of revenues booked in earlier years.
Exhibit 1: Suspicious revenue accounting
` mn Revenues Revenue growth Receivable days Bad debts (P&L) as % of debtors Bad debts (P&L) as % of revenues Source: Company, Ambit Capital research FY08 3,164 92% 120 0.2% 0.1% FY09 6,530 106% 168 1.8% 0.8% FY10 6,374 -2% 120 0.2% 0.1% FY11 8,732 37% 174 0.8% 0.4% FY12 11,627 33% 300 11.9% 9.8%

Five-year performance
25,000 20,000 15,000 10,000

share

price

150 100 50 0 Mar- Jun- Aug- Nov- Jan09 10 11 12 14 Sensex Geodesic

Source: Bloomberg

Financials
` mn Revenues PAT FCF FY11 8,732 2,737 4,707 FY12 11,627 2,600 1,363 FY13* NA NA NA

Source: Company, Ambit Capital research Note: * FY13 annual report is not yet published

2. Low yield on cash and cash equivalents: The average yield on cash and investments was moderate 1.5% during FY10-12, which also raises concerns over fictitious revenue booking (see Exhibit 2). The proportion of cash in the current accounts was not material enough to result in such low yields.
Exhibit 2: Fictitious revenue booking?
` mn Interest and dividend income Average Cash and investments Yield on average cash and investments Source: Company, Ambit Capital research FY08 118 3,898 3.0% FY09 206 6,862 3.0% FY10 75 7,991 0.9% FY11 183 10,878 1.7% FY12 212 12,163 1.7%

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Technology 3. Revenue reversals and auditor qualifications: Furthermore, as disclosed by the company in its filing to the BSE, auditors raised qualifications on inability to verify the correctness of write-off of `2,778mn on licence sales. This also raises suspicion on the quality of revenues booked in earlier years. The auditors also raised qualifications on lower doubtful debt provisioning to the extent of `3,675mn. Playing with current liabilities to shield cash conversion? Whilst Geodesic reported better cash conversion in FY10, thanks to a 48 day YoY decline in receivable days, FY11 and FY12 were marked by an unusually high contribution from the current liabilities to offset the impact of the increase in receivable days.
Exhibit 3: Cash conversion improved but was driven by current liabilities
` mn CFO/EBITDA CFO CFO before working capital changes Increase in debtors Change in loans and advances Change in current liabilities Others Source: Company, Ambit Capital research FY08 57% 1,172 1,978 -413 -584 264 -74 FY09 31% 1,122 3,601 -1,959 -663 290 -149 FY10 125% 4,188 3,531 905 -727 563 -84 FY11 134% 5,413 4,294 -2,074 1,344 1,956 -107 FY12 92% 3,893 4,115 -5,396 -2,230 9,696 -2,292

Underestimation of expenses Besides lower provisioning of expenses, as discussed above, auditors also raised concerns over correctness of write-back of `4,370mn in respect of software licence returned to the supplier. Furthermore, auditors also qualified on non-provisioning for depletion of the companys investment in Geodesic Technologies Solutions Limited (GTSL) amounting to `616mn. Corporate governance concerns 1. Lack of Board independence: Whilst Geodesic had more than 50% independent directors on the board as on March 2012, all these independent directors have resigned since then and the Board now comprises just three directors, all of them executive. Departure of all the independent directors and inability of the company to bring in new independent directors to replace them further accentuates our concerns. 2. Non-payment of dividends: Furthermore, despite the cash crunch arising from FCCB maturity in FY13, Geodesic proposed a dividend of `2/share in 2012, which still remains unpaid.

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Educomp Solutions
Accounts window-dressing
Educomps creation of a special purpose vehicle to transfer its receivables and then securitise it was an attempt to improve its cash conversion and make its balance sheet look lighter. Its revenue change in revenue recognition policy was also intriguing. These coupled with instances of poor disclosures make it an interesting case study. SPV structure allowed accelerated revenues, better CFO and lower leverage In FY10, Educomp changed its revenue recognition policy for the Smart_Class business. It created an SPV (named Edu Smart) for this purpose. It created a model whereby the Smart_Class receivables were securitised through Edu Smart. Rather than following the earlier BOOT (Build, Own, Operate and Transfer) model, Educomp sold the hardware and content as a package to Edu Smart ( whom it called a third party vendor), which then securitised the receivables with banks. This securitisation process helped Educomp to window dress its accounts in three ways: 1. Accelerated revenue recognition: In the earlier BOOT model, Educomp recognised contract revenues over a five-year period (i.e. only 20% of TCV was recognised in any quarter). However, under the new securitisation model, Educomp booked 75% of revenues for the total signed classrooms during the quarter in two tranches, whilst 25% was passed on to the vendor (Edu Smart). Out of the 75% revenues, 52.5% was recognised upfront during the particular quarter whilst 22.5% was booked in the successive year same quarter. Since Educomp had an economic obligation to provide content updates, Educomp decided to recognise the content revenues over a two-year period. This accelerated the revenue recognition as well as profitability. 2. Cash flow from securitisation boosted Educomps cash flows: Whilst the proceeds from securitisation are ideally in the nature of borrowing, the SPV structure allowed Educomp to account it as cash flow from operations . This artificially improved Educomps cash conversion ratio. 3. Off balance sheet liabilities: The structure allowed recognition of liabilities on the SPVs balance sheet. However, Educomp had given corporate guarantees for Edu Smarts securitisation arrangement. (Given that Edu Smart was a new entity, it would have been difficult for it to raise funds on its own.) This made it liable to banks in the event of default by Edu Smart or any breach in the securitisation covenants. However, the SPV structure allowed Educomp to keep its balance sheet light, so that it can raise funds for its evolving K-12 business. In FY10, Educomp disclosed Corporate guarantee to banks for secured loans to third party of `6,650mn in the notes to accounts of the Annual Report. A cross check with Edu Smarts return filing at the Ministry of Corporate Affairs (MCA) confirms that this was the guarantee given by Educomp to Edu Smart. Through the SPV structure, Educomp managed to under-report the leverage (Debt/Equity) by 39%. The actual reported leverage was 0.64x, whilst the real leverage accounting for the liabilities on SPVs balance sheet would have been 1.04x. The extent of contingent liabilities and true leverage kept rising significantly till this SPV was made redundant in FY13. However, in the 3QFY13 results, the management announced the move back to the BOOT model, feeling pressure from the institutional shareholders.

Five-year performance
25,000 20,000 15,000 10,000 5,000

share

price

1000 800 600 400 200 0 Mar- Jun- Aug- Nov- Jan09 10 11 12 14 Sensex Educomp

Source: Bloomberg

Financials
` mn Revenues PAT FCF FY11 13,509 3,354 -5,267 FY12 14,913 1,355 -2,281 FY13 12,109 -1,328 -3,585

Source: Company, Ambit Capital research

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Technology Less-than-ideal disclosures We also observed some disclosure lapses by Educomp, worth highlighting: 1. Promoter allotted warrants: Educomp increased the stake in Educomp Infrastructure and School Management Ltd (EISML) from 69.4% to 78.2% at `4.89bn in 2009. This gave EISML an implied valuation of `16.42bn. However, the promoter (MD of Educomp) was awarded 800K warrants at the same valuation as Educomp, over six months after Educomps equity infusion according to filings to the Ministry of Corporate Affairs. We find the lack of disclosure on this front unsettling although we recognise that the law might not require Educomp to make such a disclosure. 2. Undisclosed JV with an existing school: Educomp established a JV with an existing school called the Ambika Modern School in Jalandhar that has been rebranded as Millennium Jalandhar. We find it intriguing that the management did not disclose this explicitly.

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Financial Technologies (FTech)

Suspicious subsidiary accounts; corporate governance concerns
From a stockmarket darling, riding on the success in MCX and similar expectations from the other exchange ventures, Financial Technologies is now struggling to retain ownership of these exchanges on the back of the NSEL fiasco, bringing down expectations from its other exchange ventures. Besides the corporate governance issues (for not curbing the illegitimate activities at NSEL), our analysis also indicates suspicious manipulation of subsidiary accounts to present a better picture at the standalone business. FTech does not publish consolidated quarterly results (despite ~40% revenues from subsidiaries), and hence presenting good-looking standalone numbers makes sense. Significant related party artificially attractive transactions standalone numbers appear
Five-year performance
25,000 20,000 15,000 10,000 Mar- Jun- Aug- Nov- Jan09 10 11 12 14 Sensex FTECH

share

price

1500 1000 500 0

Source: Bloomberg

Financials
` mn Revenues PAT FCF FY11 4,079 -1,368 -5,371 FY12 5,012 2,641 2,107 FY13 7,519 2,274 756

FTech derives more that 40% of its revenue from subsidiaries (its investments in several exchanges and related businesses), which make them an important part of the overall financials. We have observed that FTech has allocated a higher proportion of its expenses to subsidiaries. For example, it allocates all the advertisement and promotion expenses and more than half of its other expenses to subsidiaries. Given that FTech reports only standalone results in its quarterly filing (despite subsidiaries accounting for >40% of revenue), charging of significantly higher expenses to subsidiaries raise concerns on accounting manipulations in company financials, making the standalone financials look better.
Exhibit 4: Consolidated vs standalone
` mn Revenue Consolidated (a) Standalone (b) a-b Add: Sales by Standalone to Subsidiaries Estimated Subsidiary revenue Employee benefit expenses Consolidated (a) Standalone (b) % of Standalone revenue a-b % of Subsidiary revenue Other expenses Consolidated (a) Standalone (b) % of Standalone revenue a-b % of Subsidiary revenue Advertisement and business promotion expenses Consolidated (a) Standalone (b) % of Standalone revenue a-b % of Subsidiary revenue PAT Consolidated (a) Standalone (b) a-b Source: Company, Ambit Capital research FY10 3,292 3,286 6 1,519 1,525 2,151 900 27% 1,251 82% 2,430 1,004 31% 1,425 93% 129 0 0% 129 8% 1,401 3,444 -2,043 FY11 4,079 3,577 502 1,434 1,936 2,638 1,154 32% 1,484 77% 2,572 1,089 30% 1,484 77% 204 0 0% 204 11% -1,368 919 -2,287 FY12 5,012 4,255 757 1,785 2,542 2,469 1,125 26% 1,344 53% 2,607 1,019 24% 1,588 62% 319 0 0% 319 13% 2,641 4,780 -2,140 FY13 7,519 4,509 3,010 1,176 4,186 2,501 1,241 28% 1,260 30% 3,053 651 14% 2,402 57% 337 0 0% 337 8% 2,274 3,229 -954

Source: Company, Ambit Capital research

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Technology NSEL fiasco Corporate governance issue National Spot Exchange (100% subsidiary of FTech) was promoted as a delivery based market place for the purchase and sale of commodities. However, as it eventually turned out, NSEL became an unregulated repo market for agricultural commodities as collateral1. Contracts were rolled over without mark to market (MTM) adjustments, there was no physical transfer of commodities (indeed the underlying commodities and warehouses did not exist in many cases) and there were also short selling. The pair trades in various commodities were offered in forward contracts of T+2 to T+25 (sometimes even T + 35) payment terms (bought and sold at the same time), whilst the maximum allowed settlement period was T+11. Such pair trades offered an arbitrage opportunity of about 12-15% return per annum. The Ministry of Corporate Affairs took exception to this and appointed the Forward Market Commission (FMC) to investigate. The Minister for Consumer Affairs, KV Thomas, and the FMC sent a circular to NSEL to stop launching new forward contracts and make deliveries on existing contracts to curb speculation 2. Given that delivery never happened in the earlier scheme of things, sudden termination of contracts in the absence of collaterals led to defaults by the borrowers. The company is now looking to sell some of its assets. For example, Financial Technologies sold its stake in Singapore Mercantile Exchange to the Singapore unit of Intercontinental Exchange Group for US$150mn in November 2013. It also sold its warehousing subsidiary (National Bulk Housing Corp) for ~US$40mn3. Financial Technologies now struggles to maintain ownership of its most profitable venture, MCX and its other Indian exchange holdings such as MCX-SX, given questions raised by regulators SEBI (regulating stock exchanges) and FMC (regulating commodity exchanges) over its fit and proper status to be a shareholder in commodity and stock exchanges4 5.

http://articles.economictimes.indiatimes.com/2013-0802/news/41008403 _1_national -spot exchange nsel-contracts

2

http://www.livemint.com/Money/N0hCBdRIbDKuOcD4o4ZW6M/NSEL-suspends-trading-of-all-contractsexcept-eSeries.html
3

http://www.moneycontrol.com/news/business/ftil-sells-nbhc-for-rs-242-crore_1054257.html

http://www.business-standard.com/article/markets/all-eyes-on-sebi-after-fmc-s-decision-on-ft113121800892_1.html
5

http://www.moneylife.in/article/sebi-rules-fintech-not-fit-and-proper-to-hold-stake-in-any-stockexchange/36774.html

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Part 2: The Bad

Rolta India
Tricky accounting practices An analysis of the financial statements of Rolta India indicates a couple of grey areas. Its recent revaluation of land just coinciding with the change in depreciation policy (to bring the depreciation rates to the industry norms) seems to be an accounting trick to manage the net worth, whilst at the same time not hurting the future profitability (as land is not subject to depreciation). Roltas capital employed turnover has also been quite low (0.5x on an average over FY11-13). A deeper look indicates that despite moderate revenue growth (6% USD revenue CAGR over FY10-13), the capital expenditure has remained surprisingly high (average 46% of revenues over FY11-13). This creates suspicion on expense manipulation (through capitalisation). Furthermore, Rolta has an uneven accounting history with the SEBI probe on overreporting of revenues through booking of inter-divisional transfer of selfassembled/integrated capital equipment as sales. Though Rolta has abandoned this practice post the SEBI order in 2004, the other observations raise concerns on the sanity of accounting practices.

Multi Commodity Exchange (MCX)

Suspicious related party deals and seemingly artificial volumes Whilst MCX has been a success story and the only publicly listed commodity bourse in India with ~77% market share, it does not have a clean accounting and operational track record. The reported volumes seem to be overstated (evident from unnaturally higher Average Daily Volume to Open Interest ratio), whilst transactions with promoter entity do not seem to be at arms length. Lower margin to open interest also reflect imprudent risk control, presumably in pursuit of higher volumes.

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Rolta India
Tricky accounting practices
An analysis of the financial statements of Rolta India indicates a couple of grey areas. Its recent revaluation of land just coinciding with the change in depreciation policy (to bring the depreciation rates to the industry norms) seems to be an accounting trick to manage the net worth, whilst at the same time not hurting the future profitability (as land is not subject to depreciation). Roltas capital employed turnover has also been quite low (0.5x on an average over FY11-13). A deeper look indicates that despite moderate revenue growth (6% USD revenue CAGR over FY10-13), the capital expenditure has remained surprisingly high (average 46% of revenues over FY11-13). This creates suspicion on expense manipulation (through capitalisation). Furthermore, Rolta has an uneven accounting history with the SEBI probe on overreporting of revenues through booking of inter-divisional transfer of selfassembled/integrated capital equipment as sales. Though Rolta has abandoned this practice post the SEBI order in 2004, the other observations raise concerns on sanity of accounting practices. Accounting gimmicks to protect net worth During the fourth quarter of FY13, Rolta changed its depreciation policy (by reducing the estimated useful life of the assets) and at the same time re-valued land on the balance sheet. The management highlighted that as a matter of prudence and to align depreciation policy with the current replacement cycle taking into consideration various factors such as technology up-gradation and industry best practices, the Company has revised estimated useful life of all assets. Consequently, Rolta India reduced the estimated useful life of Computer Systems to 2-6 years against 4-10 years earlier, Other Equipment at 10 years against 20 years earlier, Furniture & Fixtures at 10 years against 15 years earlier and Vehicles at 5 years against 10 years earlier. Consequent to the above, it booked an additional charge for depreciation during the quarter, amounting to `11,537mn as an exceptional item. Interestingly, the management simultaneously revalued the freehold and leasehold land during the quarter, booking the revaluation gains of `10,571mn directly in the reserves, with an eventual impact of just `966mn on the net worth. Had the company not revalued land, the depreciation estimate revision could have eroded the net worth by 57%. Given ~2x Debt/Equity ratio, 57% erosion in net worth could have a serious implication on Rolta, both in terms of re-financing the existing debt at the same or better borrowing cost as well as raising additional funds. More importantly, revaluation of land will also not impact the future profits and land is not subject to depreciation. This clearly seems to be an accounting trick to manage the net worth without hurting the future profitability at the same time. Low capital employed turnover and high capitalisation raise concerns over expense manipulation Roltas asset turnover (sales/average capital employed) has been significantly below the peer average over the last three years (0.5x vs tier-2 peer average of 1.6x). A deeper look into the causes shows that capitalisation as a percentage of revenues has been extraordinarily high (~46% on an average over FY11-13 vs tier-2 peers average of 6%). More surprisingly, this comes at a time when Roltas revenues have grown at a moderate 12.3% CAGR over FY10-13 (6.6% in USD terms). Given such a moderate growth rate, disproportionately high levels of capex create suspicion regarding expense manipulation (through capitalisation).
Five-year performance
25,000 20,000 15,000 10,000 Mar- Jun- Aug- Nov- Jan09 10 11 12 14 Sensex Rolta

share

price

270 220 170 120 70 20

Source: Bloomberg

Financials
` mn Revenues PAT FCF Capex FY11 18,056 3,519 -1,345 FY12 18,288 -959 -4,418 FY13 21,788 -8,674 -4,696

-8,393 -13,932 -16,069

Source: Company, Ambit Capital research

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Exhibit 5: Low asset turnover coupled with high capitalisation raises concerns on expense manipulation
Company\Metric Asset turnover (sales/average net capital employed) FY11 Rolta Tier 2 peers eClerx Persistent Systems Hexaware Infotech Enterprises KPIT NIIT Tech Mindtree Polaris Tech Mahindra Tier 2 peers average 1.6 1.1 1.1 1.2 1.6 1.8 2.0 1.7 1.0 1.5 1.6 1.3 1.5 1.4 1.7 1.8 2.1 1.7 1.0 1.6 1.7 1.3 1.7 1.5 1.9 1.9 2.0 1.6 1.1 1.6 1.6 1.2 1.4 1.3 1.7 1.8 2.1 1.7 1.0 1.6 NA 0.1% NA NA 1.5% NA NA NA NA 0.8% NA 0.1% NA NA NA NA NA NA NA 0.1% NA 0.0% NA NA NA NA NA NA NA 0.0% NA 0.1% NA NA 1.5% NA NA NA NA 0.8% 0.7% 6.9% 0.2% 0.4% 2.5% 0.7% 0.4% 0.4% 0.0% 1.3% 0.3% 4.1% 0.2% 1.1% 1.2% 1.1% 0.0% 0.3% 0.3% 1.0% 0.5% 2.7% 0.4% 1.7% 0.8% 1.5% 0.0% 0.5% 1.0% 1.0% 0.5% 7.0% 5.3% 16.4% 8.8% 3.8% 4.9% 3.1% 4.6% 4.5% 2.5% 2.6% 5.7% 9.6% 12.1% 3.8% 6.4% 3.8% 4.9% 4.2% 5.6% 3.7% 6.0% 0.6 FY12 FY13 Average 0.5 0.4 0.5 Capitalised R&D (mentioned by company) as % of revenue FY11 2.7% FY12 4.0% FY13 Average 5.4% 4.0% Intangibles (Ex Goodwill) addition as % of revenue FY11 9.7% FY12 8.3% FY13 Average 4.3% Overall capex as % of revenues FY11 FY12 FY13 Average 45.7%

7.4% 18.7% 49.4% 68.9%

4.6% 12.5% 15.1% 0.3% 1.1% 1.5% 1.1% 0.1% 0.4% 0.4% 1.1% 3.2% 9.0% 4.3% 4.1% 5.6% 7.1% 3.0% 6.2% 4.4% 5.3% 4.1% 5.9% 2.5% 7.2% 5.4% 6.1%

Source: Company, Ambit Capital research

Uneven accounting history - Inter-divisional transfers booked as revenues! Rolta followed a practice of booking the self-assembled/integrated capital equipment transfer (including the fixed assets and estimated labour and overhead costs) from its CAD/CAM division to internet and export divisions as revenues from 1996-2003. It booked the cost of these assets as expenses and then capitalised the overall cost of the capital equipment. Whilst this did not impact the bottom-line of the company, the revenues were overstated to the extent of these transfers. Furthermore, ~50% of these capital equipment costs comprised overheads which were based on management certification rather than an external audit. This left scope for significant revenue manipulation. Rolta was following this accounting practice for seven years (since 1996) and had claimed that given the accounting treatment is EPS neutral, it should not impact investor decision-making. However, post the SEBI order in July 20046, Rolta India abandoned reporting these inter-divisional capital equipment transfers as sales.

http://www.sebi.gov.in/cmorder/roltaorder.html

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Multi Commodity Exchange (MCX)

Suspicious related party deals and seemingly artificial volumes
Whilst MCX has been a success story and the only publicly listed commodity bourse in India with ~77% market share, it does not have clean accounting and operational track record. The reported volumes seem to be overstated (evident from unnaturally higher Average Daily Volume to Open Interest ratio), whilst transactions with promoter entity do not seem to be at arms length. Lower margin to open interest also reflect imprudent risk control, presumably in pursuit of higher volumes. Creating volumes in thin air? The ratio of Average Daily Volume traded (ADV) to Open Interest (OI or the positions kept open overnight) is often used to measure market depth. Given below is the comparison of ADV (average daily volume) to OI (Open Interest) for the past three years for Futures contracts on MCX as compared to NCDEX, CME and NSE Nifty Futures (see Exhibit 6). This is the best measure of depth and hedging interest in an exchange and separates speculative/artificial volumes from sustainable volumes (lower the better). MCXs ADV/OI has historically been significantly higher that of NCDEX, NSE and CME.
Exhibit 6: Ratio of ADV to Open Interest
2011 MCX NCDEX NSE CME CME - Metals and Energy 7.48 3.78 1.17 0.44 0.13 2012 4.79 1.49 1.56 0.40 0.12 2013 4.13 0.84 1.37 0.39 0.13 Jan-14 3.65 0.81 1.63 0.35 0.13 Feb-14 3.29 0.64 1.47 NA NA

Five-year performance
25,000 20,000 15,000 10,000 Mar-12

share

price

2000 1500 1000 500 0 Dec-12 Oct-13 MCX

Sensex

Source: Bloomberg

Financials
` mn Revenues PAT FCF FY11 3,689 1,763 2,387 FY12 5,451 2,867 3,305 FY13 5,240 2,992 68

Source: Company, Ambit Capital research

Source: Company, Bloomberg, FMC, Ambit Capital research

Besides this, certain media reports7 also claim that a special audit report by PwC has found the Indian Bullion Markets Association, a firm related to MCX, indulged in volume rigging on the commodity exchange. The report claims the value of the transactions to be `400bn. This corroborates our analysis of significantly higher ADV to OI as compared to other exchanges. Related party transactions are these at arms length? FT, the promoter entity of MCX, provides it the software and business support technology. MCXs technology charges (as a percentage of revenues) appear to be too high relative to the other global bourses, which raises concerns whether these technology service payments are at arms length.
Exhibit 7: Comparison of technology charges
As % of revenues MCX CME SGX ICE Hong Kong Exchange Bursa Malaysia Source: Company, Ambit Capital research FY10 20% 5% 8% 4% 4% 5% FY11 21% 4% 10% 4% 4% 5% FY12 16% 4% 10% 4% 4% 7% FY13 18% 5% 9% 3% 5% 8% FY14 NA 5% NA NA 7% 8%

http://www.moneycontrol.com/news/business/pwc-audit-finds-ibma-riggedtradesmcx-sources_1046667.html

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Technology Indeed, according to media reports8, interim findings of a special audit by PwC flag several related issues regarding related party transactions: 1. No documented policy was in place for buying services from group firms and related parties, while certain contracts with the parent company Financial Technologies were not discussed and approved in the exchange board and directors' committee. 2. MCX paid a mark-up of up to 32% on procurement of hardware by FTIL and signed contracts with it that had "unprecedented long tenure" of 33-50 years with a provision of automatic renewal for another 33 years. 3. Several other suspicious transactions have been highlighted in the report. (Click here for the news release disclosing these transactions.) Although these revelations are still preliminary and not publicly available, our analysis of astonishingly high technology charges to FT certainly raises concerns. Declining margins Are the default risks managed well? MCX collects margins from its members to deal with price volatility. This reduces systemic risk of defaults in periods of high volatility. The growth in MCX's Open Interest and Margin Money (as reported on the Balance Sheet) is shown in Exhibit 8 below. The percentage of margin money has declined from 12.7% in FY08 to 2.2% in FY13. This indicates either of the below three possibilities: 1. The exchange is collecting lower margins per contract than before that indicates rising systemic risk from defaults in case of high price volatility. 2. Increasing trades by some members that do not stump up margins. 3. Possibility of accepting off balance sheet collateral or assets in lieu of margin such as liens on FDs or liquid investments. This still may not make such a big shortfall. Moreover, brokers may accept this and this does not seem prudent practice for an exchange.
Exhibit 8: Declining margin of safety
In ` mn Margin money disclosed in current liabilities Total Open Interest Amount Margin to OI Source: Company, FMC, Ambit Capital research Mar-08 3,205 28,780 12.7% Mar-09 5,449 50,562 10.8% Mar-10 4,082 74,017 5.5% Mar-11 5,283 138,430 3.8% Mar-12 6,096 155,868 3.9% Mar-13 4,324 192,935 2.2%

http://articles.economictimes.indiatimes.com/2014-0224/news/47635734_1_ shreekant -javalgekar- year-mcx-ftil-group

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Technology

Part 3: The not so good

Tech Mahindra
Weaker disclosure norms; accounting not up to international standards; flags on governance Whilst many see Tech Mahindra as the next tier-1 Indian IT service company, its quality of disclosure lags that of other tier-2 companies such as Mindtree. TechM does not publish quarterly cash flow and balance sheet statements and it provides no service-line break-up. Secondly, whilst all the tier-1 firms publish IFRS financial statements, along with the Indian GAAP accounts (with the exception of HCL Tech that reports under US GAAP), Tech Mahindra reports financials only under Indian GAAP. This makes comparisons with peers less meaningful due to differences in accounting methods. Finally, lack of adequate independent director representation on the Satyam Board at the time when the swap ratio between Satyam and TechM was finalised raises concerns on corporate governance.

Infosys
Letting down its own governance standards? Ever since its IPO in 1993, Infosys has been regarded as a paradigm of corporate governance in India. Whilst this image earned Infosys goodwill from investors, clients and employees, there are signs that these high corporate governance standards are fraying. NRN Murthys entry into Infosys in an executive capacity (even after Infosys well-articulated policy of executives retiring at the age of 60), bringing with him his son as executive assistant, higher promoter representation at the Board and peculiar guidance pattern resulting in high volatility in the share price none of this gels with Infosys image of a leader when it comes to corporate governance.

KPIT Technologies
Magnified margins KPIT Technologies margins appear to be overstated given the accounting policies and estimates that are different from its peers. Its accounting policy of excluding reimbursements both from income and cost (contrary to accounting policy followed by companies such as Infosys, TCS and Persistent Systems) benefits its margins by ~50bps according to our calculations. Furthermore, its actuarial assumption of salary increase for retirement benefit obligations is significantly below that of peers (5% vs peer average of 7%).

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Technology

Tech Mahindra
Weaker disclosure norms; accounting not up to international standards; flags on governance
Whilst many claim Tech Mahindra is the next tier-1 Indian IT services company, its quality of disclosure still lags that of several tier-2 companies such as Mindtree. TechM does not publish quarterly cash flow and balance sheet statements and it provides no service-line break-up. Secondly, whilst all the tier-1 firms publish IFRS financial statements, along with the Indian GAAP accounts (with the exception of HCL Tech that reports under US GAAP), Tech Mahindra reports financials only under Indian GAAP. This makes the comparison less meaningful due to differences in accounting methods. Finally, lack of adequate independent director representation on the Satyam Board at the time when the merger swap ratio with TechM was finalised raises concerns on corporate governance. Weaker disclosure norms Tech Mahindras disclosures (in the quarterly financials) still lag that of tier -1 Indian firms and even the tier-2 firms such as Mindtree and Persistent Systems. Tech Mahindra does not report the quarterly balance sheet and cash flow statements. Given cash flow (and working capital intensity) is the most widely tracked metric for an IT service company, this creates information asymmetry. Furthermore, absence of a service-line breakup makes the analysis of underlying revenue growth drivers difficult. Cash flow and cash conversion are amongst the most keenly tracked financial metrics for IT companies. Non-reporting of quarterly balance sheet and cash-flow statements makes this analysis very difficult. Our back calculation of cash flow from operations using changes in net debt, capex and other expenses indicate that cash conversion has remained weak for Tech Mahindra in 9MFY14 (even weaker than 57% cash conversion in FY13). Furthermore, there was no satisfactory explanation for the US$22mn stamp duty payment for the Tech Mahindra and Satyam merger by the company management. It was neither mentioned in the notes to the accounts although we understand that this payment was made during 3QFY14.
Exhibit 9: Unexplained weakness in cash conversion*
` mn Net debt Net change in cash Capex Adjustment for stamp duty payment (US$22mn) Adjustment for final dividend (incl dividend tax) for FY13 (assumed to be paid in 2QFY14) CFO EBITDA (Adjusted for BT deferred revenues) Revenues (Adjusted for BT deferred revenues) CFO/EBITDA CFO/Revenues Receivable days FY13 24993 1QFY14 29,081 4,088 2333 0 0 16382 28627 141315 57% 12% 96 6,421 8092 40479 79% 16% 97 2QFY14 29,376 295 1497 0 750 2,542 10557 47162 24% 5% 102 3QFY14 31,177 1,801 1316 1320 0 4,437 10810 48432 41% 9% 100 9MFY14 31,177 6,184 5,146 1,320 750 13,400 29,459 136,073 45% 10% 100

Five-year performance
25,000 20,000 15,000 10,000

share

price

1700 1200 700 200 Mar- Jun- Aug- Nov- Jan09 10 11 12 14 Sensex Tech Mahindra

Source: Bloomberg

Financials
` mn PAT FCF FY11 5,965 -121 FY12 18,431 2,474 FY13 19,556 6,132 Revenues 102,852 117,024 143,320

Source: Company, Ambit Capital research

Source: Company, Ambit Capital research *Our estimates as company does not disclose quarterly cashflow statement

Accounting systems though legitimate, not comparable with tier-1 peers Whilst all the tier-1 firms publish IFRS financial statements, along with the Indian GAAP accounts (with the exception of HCL Tech that reports under US GAAP), Tech Mahindra reports financials only under Indian GAAP. This makes an apple-to-apple comparison difficult, particularly in the areas where Indian GAAP provisions differ significantly with those of international accounting standards.

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Technology One such area of difference is merger accounting. Indian GAAP allows the use of two methods for merger accounting: 1. Pooling of interest method: In this method no goodwill is recognised and all the assets and liabilities are accounted at book value. The applicability criteria are: (a) all assets and liabilities should be transferred, (b) the consideration should be through share swap, and (c) at least 90% of the shareholders of the acquired company should become the shareholders of the acquirer. 2. Purchase method: If the merger fails the conditions for Pooling of interest method, Purchase method applies. Here, the assets and liabilities are recorded at fair value and hence goodwill is recognised. On the other hand, US GAAP and IFRS prohibit the use of Pooling of interest method. Hence in the event of a merger, the merged entity needs to account for all the assets and liabilities at fair value. Consequently, goodwill is recognised in mergers in US GAAP and IFRS. The method of accounting for merger has a significant bearing on the RoE post-merger. If the assets and liabilities of the acquired company are accounted at fair value (Purchase method - the general internationally accepted norm) and the consideration is greater than the book value, a goodwill is recognised (which is then amortised over five years unless a longer period is justified) that inflates the equity base and eventually results in relatively lower RoE for the merged entity . Indeed, in laymans language, the goodwill is effectively written-off against equity in the Pooling of the interest method, whilst it is routed through P&L in Purchase method. Given the Satyam merger met the Pooling of interest methods criteria under Indian GAAP, Tech Mahindra recorded the merger under Pooling of interest method. The use of Indian GAAP has helped it maintain high RoEs. Had the transaction been recorded under the internationally accepted Purchase method, the RoEs would have been significantly lower. Our back-of-the-envelope calculations suggest that FY13/FY14E RoE could have been 14.8%/18.4% under the purchase method (with Goodwill recognition) vs the estimated RoEs of 36.3%/33.3% under the currently followed Pooling of interest method (see Exhibit 10 below).
Exhibit 10: RoEs could be significantly lower under the purchase method of merger accounting
In ` mn Adjusted net income Goodwill amortization Tax benefit on above (@33.99%) Proforma net income Equity at TechM's share price as on the appointed dated of merger* RoE Source: Ambit Capital research; Note: * Appointed date of the merger was 1 April 2011 Pooling of interest method (currently followed by TechM) FY12 18,062 0 0 18,062 48,158 FY13 21,157 0 0 21,157 68,530 36.3% FY14E 27,674 0 27,674 97,484 33.3% Purchase method (estimated) FY12 18,062 3,843 10,599 86,259 FY13 21,157 -11,306 3,843 13,694 99,168 14.8% FY14E 27,674 -11,306 3,843 20,211 120,659 18.4%

0 -11,306

Please reach out to us for greater details on the calculations and underlying assumptions. Questionable attendance on Satyams Board whilst deciding the merger ratio From 19 September 2011 to 23 January 2012, the Board comprised less than 50% of independent directors. This was the period when Satyams merger ratio was decided (announced in March 2012). Also, the merger ratio was announced shortly after two new independent directors (Mr Ashok Kacker and M Rajyalakshmi Rao) were appointed (Jan and Feb 2012) who presumably had limited understanding of the firm to push for a fairer ratio for minority shareholders. The swap ratio seems relatively unfair to Satyams minority shareholders. Although there have been departures in independent directors, board meeting attendance has been appalling, particularly in

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Technology FY11 and FY12, which was also the period when the merger ratio was accepted by the board.
Exhibit 11: Satyam independent directors poor attendance track-record during the time merger ratio was finalised
Name/Attendance Deepak Parekh (Independent) Keeran Karnik (Independent) Vineet Nayyar CP Gurnani C Achuthan (Independent) Tarun Das (Independent) TN Mahoharan (Independent) SB Mainak (Independent) M Damodaran (Independent) Ashok Kacker (Independent) M Rajyalakshmi Rao (Independent) Sanjay Kalra Gautam S Kaji (Independent) Ulhas N Yargop Ravindra Kulkarni (Independent) Source: Company, Ambit Capital research Note: Independent directors in Grey shade 5/10 5/10 3/6 1/6 6/6 5/8 NA 13/13 10/13 11/13 12/13 FY10 12/13 13/13 FY10 5/10 7/10 5/10 3/10 9/10 5/10 8/10 7/10 1/10 2/6 4/8 1/8 1/8 6/6 6/8 6/6 6/6 4/6 8/8 7/8 1/8 FY11 FY12

Similarly, the independent directors participation in the Board meetings was not particularly strong at the time Tech Mahindra was bidding for Satyam in FY09-10 (see Exhibit 12 below).
Exhibit 12: Tech Mahindra independent directors poor attendance track-record at the time of bidding for Satyam
Name/Attendance Anand G Mahindra Akash Paul (Independent) Al-Noor Ramji Anupam Puri (Independent) Arun Seth Bharat N Doshi B H Wani (Independent) Clibe Goodwin CP Gurnani M Damodaran (Independent) Nigel Stagg * Paul Zuckerman (Independent) Dr Raj Reddy (Independent) Nigel Stagg Ravindra Kulkarni (Independent) Richard Cameron* Vineet Nayyar Ulhas N Yargop Source: Company, Ambit Capital research Note: Independent directors in Grey shade 5/6 6/6 4/6 4/6 2/6 4/6 FY09 5/6 4/6 2/6 3/6 4/6 6/6 FY10 8/8 4/8 1/8 6/8 4/8 8/8 8/8 2/8 NA 4/8 NA 4/8 4/8 1/8 8/8 1/8 5/8 8/8

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Infosys
Letting down its own governance standards?
Ever since its IPO in 1993, Infosys has been regarded as a paradigm of corporate governance in India. Whilst this image has earned Infosys goodwill from investors, clients and employees, there are signs that these high corporate governance standards are fraying. NRN Murthys entry into Infosys in an executive capacity (even after the firms well-articulated policy of executives retiring at the age of 60), bringing with him his son as an executive assistant, higher promoter representation at the Board and peculiar guidance pattern resulting in high volatility in share price none of this gels well with Infosys image of a leader in corporate governance. Breach of corporate policies Infosys has historically followed a well-articulated policy of executive retirement at the age of 60, with Mr NRN Murthy himself being a strong proponent of the policy. Similarly, all the founders have time and again mentioned about not letting family manage the business. More surprising was Rohan Murthys entry into Infosys as Mr NRN Murthys Executive Assistant. Whilst this is a position of power but not of control, the manner in which Rohan Murthy was brought in raised eyebrows to put it mildly. High promoter representation on the board The promoters Board representation is significantly higher relative to their shareholding in the company. Whilst NRN Murthy, S Shibulal and Kris Gopalakrishnan collectively hold ~10% stake in the company, they represent 23% of the voting rights on the Board. With the highest promoter representation and the lowest proportion of independent directors on the Board, Infosys Board independence appears to be the weakest among the tier-1 firms.
Exhibit 13: Infosys ownership structure
Promoter representation on the board Promoter ownership Active promoters NRN Murthy S Shibulal Kris Gopalakrishnan Combined shareholding of active promoters Source: NSE, Ambit Capital research 4.47% 2.20% 3.41% 10.08% 23.08% 15.94%

Five-year performance
25,000 20,000 15,000 10,000

share

price

4000 3500 3000 2500 2000 1500 1000 Mar- Jun- Aug- Nov- Jan09 10 11 12 14 Sensex Infosys Tech.

Source: Bloomberg

Financials
` mn Revenues PAT FCF FY11 68,230 46,070 FY12 83,210 66,800 FY13 94,210 86,510 275,010 337,340 403,520

Source: Company, Ambit Capital research

Exhibit 14: Measuring the board independence

Company Infosys TCS Wipro HCL Tech Promoter shareholding 15.9% 73.9% 73.5% 61.8% Promoter representation on the Board 23.1% 9.1% 7.7% 20.0% Non-independent directors on the Board 46.2% 45.5% 23.1% 20.0%

Source: Company, NSE, Ambit Capital research

Peculiar guidance pattern leading to extreme volatility There has been a pattern in Infosys guidance and outlook over the last three years. It sets a lower expectation in the fourth quarter of the year and over-delivers in the following quarters, causing extreme volatility in the share price. Indeed, Infosys has repeated this pattern yet again by indicating on 12 March 2014 that it will settle at the lower end of the guidance for FY14 and giving a weaker outlook for 1HFY15.

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Technology
Exhibit 15: Playing with investors expectations? 8% 6% 4% 2% 0% -2% -4% -6% Setting lower expectation in 4Q 25% 20% 15% 10% 5% 0% -5% -10% -15% -20% -25% Share price performance on the day of results - RHS Change in next year guidance (mid-point of guidance) - LHS Actual vs guidance (mid-point) LHS

Mar-2014*

1QFY12

1QFY10

2QFY10

3QFY10

4QFY10

1QFY11

2QFY11

3QFY11

4QFY11

2QFY12

3QFY12

4QFY12

1QFY13

2QFY13

3QFY13

4QFY13

1QFY14

2QFY14

3QFY14

Absolute volatility range (RHS)

Source: Company, Bloomberg, Ambit Capital research; Note: Infosys abandoned the quarterly guidance from 1QFY13 * Infosys management announced in an Investment Banking Conference that it will meet the lower end of the FY14 revenue guidance (11.5-12%)

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KPIT Technologies
Magnified margins
KPIT Technologies margins appear to be overstated given the accounting policies and estimates that are different from its peers. Its accounting policy of excluding reimbursements both from income and cost (contrary to accounting policy followed by companies such as Infosys, TCS and Persistent Systems) benefits its margins by ~50bps according to our calculations. Furthermore, its actuarial assumption of salary increase for retirement benefit obligations is significantly below that of peers (5% vs peer average of 7%). Margin management through change in accounting policy During FY12, KPIT Technologies changed its policy of booking re-imbursement expenses. KPIT mentioned in its FY12 annual report that the reimbursement expense billing has been netted off against the actual expenses whilst previously the reimbursement billing was accounted as income in revenues and as expense in the costs. The third-party license sale amount now appear in revenues only to the tune of the margins on such sale (earlier the full sale amount used to appear as revenue and the cost of the license as direct cost). The new policy is not consistent with that followed by Infosys, TCS and Persistent (the other companies do not mention the accounting policy in this regard). These companies follow the policy of booking the third-party licence sales under revenue as well as costs (these companies book it under third-party items, Equipment and software cost and Purchase of software license and support services, respectively). This change in policy makes the operating margins appear artificially better than the historical margins and that of competitors, because operating margin is now calculated by dividing the operating profit by a lower denominator (revenues). Indeed, our calculations suggest that just because of this change in accounting policy, FY11 EBITDA margins were overstated by 50bps.
Exhibit 16: Margin impact from change in re-imbursement accounting policy
` mn FY11 Revenue FY11 EBITDA EBITDA margins Earlier policy 10,230* 1,484 14.5% New policy 9,870** 1,484 15.0%

Five-year performance
25,000 20,000 15,000 10,000

share

price

520 420 320 220 120 20 Mar- Jun- Aug- Nov- Jan09 10 11 12 14 Sensex KPIT

Source: Bloomberg

Financials
` mn Revenues PAT FCF FY11 1,484 946 221 FY12 2,166 1,454 396 FY13 3,214 1,990 503

Source: Company, Ambit Capital research

Source: Company, Ambit Capital research *reported revenue in FY11 annual report ** restated FY11 revenue in FY12 annual report

We have assumed that all the restatement in FY11 revenues is due to change in accounting policy of excluding the re-imbursement from the revenues and costs. Given this change in accounting policy is margin neutral (reimbursements are removed from both revenue and costs), we have used re-stated FY11 EBITDA (from FY12 annual report) for margin calculations. Lower salary increase estimate for retirement benefit accounting The retirement benefit obligations of a firm depend to a large extent on the underlying variables such as discount rate (to calculate present value of future obligations), long-term salary increase rates, attrition, demographics, return on plan assets etc. Manipulation of any of these variables could materially impact the eventually calculated liability. Whilst KPIT Technologies discount rate estimates are conservative as compared to the industry average (8.5% vs industry average of ~8%), its salary increase estimate of 5% appears to be too low relative to the industry average of ~7% (see Exhibit 17). Furthermore, KPITs retirement benefit obligations are unfunded (i.e. there are no plan assets).

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Technology
Exhibit 17: Retirement benefit actuarial assumptions
Company FY11 KPIT Tier 2 peers Mindtree Hexaware Tech Mahindra Infotech Enterprises NIIT Tech eClerx Persistent Systems Tier 1 peers TCS Infosys HCL Tech Wipro 8.0% 8.0% 8.4% 8.0% 8.25% to 8.5% 8.6% 8.1% 8.4% 8.0% 8.0% 7.5% 7.8% 4% to 12% 7.3% 6% to 10% 5.0% 4% to 9% 7.3% 7.0% 5.0% 4% to 7% 7.3% 7.0% 5.0% 8.0% 8.0% 7.7% 8.0% 8.1% 8.0% 8.5% 8.5% 8.6% 8.6% 8.5% 8.6% 8.5% 8.7% 8.0% NA 8.6% for funded and 8% for non-funded 8.0% NA 8.0% 8.3% 10-12% 6.0% 10% for first year and 10% for first year and 7.5% thereafter 7.5% thereafter 9% for first year and 8% thereafter 7.5% to 10% 9.15% to 9.4% 4.0% 7.0% 11% for first year and 9% thereafter 7.5% to 10% 9.15% to 9.4% 4.0% 7.0% 6.0% NA 9% for non-funded and 7.5% for funded 6% to 8% NA 5.0% 7.0% 8.3% Discount rate FY12 8.5% FY13 8.5% FY11 5.0% Salary increase FY12 5.0% FY13 5.0%

Source: Company, Ambit Capital research

Poor cash flow generation at subsidiaries KPIT Technologies cash conversion has been materially weaker than the peers, largely due to poor cash generation at the subsidiaries. As shown in Exhibit 18 below, KPIT has infused significant amounts of cash into the subsidiaries with weak cash generation profile.
Exhibit 18: Burning cash at subsidiaries
` mn CFO Capex Investment in equity shares of subsidiaries Investment in equity shares of associates Investment in preference shares of associates Cash & Cash Equivalent from acquisition of subsidiaries FCF FCF including acquisitions and investments in subsidiaries and associates Cash conversion KPIT (Consolidated) KPIT (Standalone) KPIT (Subsidiaries) Source: Company, Ambit Capital research FY11 645 -422 -463 0 0 37 222 -203 FY12 1,005 -609 -2,088 -98 -278 146 396 -1,922 FY13 1,203 -701 -1,255 0 0 0 503 -753

43% 46% 41%

46% 100% 4%

37% 70% 3%

Higher use of subcontractors KPIT uses subcontractors to a significantly larger extent as compared to its tier-2 peers. This artificially inflates the revenue per employee (given sub-contractors are not included in the reported headcount) and gives a prima facie impression of better employee productivity.

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Technology
Exhibit 19: Higher subcontractors use artificially inflates the employee productivity
Company/Metric KPIT (Consolidated) KPIT Standalone KPIT (Subsidiaries) Tier 2 peers eClerx Persistent Systems Hexaware Infotech Enterprises NIIT Tech Mindtree Polaris Tech Mahindra Tier 2 peer average NA 4.0% 7.2% 2.6% NA 3.0% 6.5% 9.6% 5.5% NA 4.2% 7.7% 2.2% NA 3.5% 5.8% 10.6% 5.7% NA 4.1% 8.9% 3.9% NA 3.6% 5.9% 9.6% NA 22.6% 26.3% 11.7% NA 13.2% 40.6% 28.7% NA 23.6% 30.3% 11.1% NA 16.7% 37.3% 52.2% NA 19.7% 36.0% 18.8% NA 17.9% 40.3% 59.3% 32.0% NA 5.0% 7.9% 3.1% NA 3.4% 7.5% 12.0% 6.5% NA 5.4% 9.4% 2.7% NA 4.1% 6.8% 12.7% 6.8% NA 5.4% 11.3% 4.8% NA 4.5% 6.7% 11.9% 7.4% 0.9 1.2 1.6 1.4 2.1 1.6 1.5 1.3 1.5 1.1 1.5 1.7 1.7 2.1 1.7 1.6 1.3 1.6 1.1 1.9 2.1 1.8 2.5 2.0 1.7 1.4 1.8 Subcontracting cost as % of Revenue FY11 14.5% 2.8% 28.0% FY12 17.2% 2.2% 27.6% FY13 17.7% 3.3% 24.5% Subcontracting cost as % of Operating Cost FY11 46.5% 13.5% 65.1% FY12 50.5% 9.6% 66.5% FY13 52.0% 12.4% 64.9% Subcontracting cost as % of Total Cost FY11 17.1% 3.3% 33.8% FY12 20.1% 2.7% 31.9% FY13 20.7% 4.2% 27.3% Revenue per employee (INR mn) FY11 1.5 NA NA FY12 1.9 NA NA FY13 2.7 NA NA

6.0% 23.9% 28.5%

Source: Company, Ambit Capital research

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Institutional Equities Team

Saurabh Mukherjea, CFA Research Analysts Aadesh Mehta Achint Bhagat Aditya Khemka Akshay Wadhwa Ankur Rudra, CFA Ashvin Shetty, CFA Bhargav Buddhadev Dayanand Mittal, CFA Deepesh Agarwal Gaurav Mehta, CFA Karan Khanna Krishnan ASV Nitin Bhasin Nitin Jain Pankaj Agarwal, CFA Pratik Singhania Parita Ashar Rakshit Ranjan, CFA Ravi Singh Ritika Mankar Mukherjee, CFA Ritu Modi Tanuj Mukhija, CFA Sales Name Deepak Sawhney Dharmen Shah Dipti Mehta Nityam Shah, CFA Parees Purohit, CFA Praveena Pattabiraman Sarojini Ramachandran Production Sajid Merchant Sharoz G Hussain Joel Pereira Nikhil Pillai
E&C = Engineering & Construction

CEO, Institutional Equities

(022) 30433174

saurabhmukherjea@ambitcapital.com

Industry Sectors Banking & Financial Services Cement / Infrastructure Healthcare Banking & Financial Services Technology / Telecom / Media Automobile Power / Capital Goods Oil & Gas / Metals & Mining Power / Capital Goods Strategy / Derivatives Research Strategy Banking & Financial Services E&C / Infrastructure / Cement Technology Banking & Financial Services Real Estate / Retail Metals & Mining / Oil & Gas Consumer / Real Estate / Retail Banking & Financial Services Economy / Strategy Automobile E&C / Infrastructure Regions India / Asia India / Asia India / USA USA / Europe UK / USA India / Asia UK Production Production Editor Database

Desk-Phone (022) 30433239 (022) 30433178 (022) 30433272 (022) 30433005 (022) 30433211 (022) 30433285 (022) 30433252 (022) 30433202 (022) 30433275 (022) 30433255 (022) 30433251 (022) 30433205 (022) 30433241 (022) 30433291 (022) 30433206 (022) 30433264 (022) 30433223 (022) 30433201 (022) 30433181 (022) 30433175 (022) 30433292 (022) 30433203 Desk-Phone (022) 30433295 (022) 30433289 (022) 30433053 (022) 30433259 (022) 30433169 (022) 30433268 +44 (0) 20 7614 8374 (022) 30433247 (022) 30433183 (022) 30433284 (022) 30433265

E-mail aadeshmehta@ambitcapital.com achintbhagat@ambitcapital.com adityakhemka@ambitcapital.com akshaywadhwa@ambitcapital.com ankurrudra@ambitcapital.com ashvinshetty@ambitcapital.com bhargavbuddhadev@ambitcapital.com dayanandmittal@ambitcapital.com deepeshagarwal@ambitcapital.com gauravmehta@ambitcapital.com karankhanna@ambitcapital.com vkrishnan@ambitcapital.com nitinbhasin@ambitcapital.com nitinjain@ambitcapital.com pankajagarwal@ambitcapital.com pratiksinghania@ambitcapital.com paritaashar@ambitcapital.com rakshitranjan@ambitcapital.com ravisingh@ambitcapital.com ritikamankar@ambitcapital.com ritumodi@ambitcapital.com tanujmukhija@ambitcapital.com E-mail deepaksawhney@ambitcapital.com dharmenshah@ambitcapital.com diptimehta@ambitcapital.com nityamshah@ambitcapital.com pareespurohit@ambitcapital.com praveenapattabiraman@ambitcapital.com sarojini@panmure.com sajidmerchant@ambitcapital.com sharozghussain@ambitcapital.com joelpereira@ambitcapital.com nikhilpillai@ambitcapital.com

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Technology

Explanation of Investment Rating

Investment Rating Buy Sell Expected return (over 12-month period from date of initial rating) >5% <5%

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