The curious case of Mphasis's mini-rally

Mphasis Ltd shares behaved weirdly last week. On 13 February, the company reported December quarter earnings that were far below analysts’ expectations. For instance, analysts at Kotak Institutional Equities had estimated revenue for the quarter at $241 million. Mphasis’s reported revenue was over 6% lower at $226 million.

Still, Mphasis shares have risen by over 9% after the results were announced. This wasn’t a relief rally—i.e., when investors buy because things weren’t as bad as they expected them to be. Instead, investors seem to have concluded that the firm’s shares were already at rock-bottom levels, and hitting the sell button yet again didn’t make sense. In the past five years, Mphasis shares have underperformed the CNX IT index by over 77%, with matters worsening considerably in the past six months.

But why buy the shares instead? Thanks to the sharp underperformance, Mphasis’s valuations fell to around 10 times earnings, much lower than peers in the mid-cap IT space, who trade at around 15 times earnings. Besides, the firm has considerable cash on its books, amounting to over one-fourth of its market capitalization. And its dividend yield is fairly attractive at around 4%.

Of course, despite the recent mini-rally, its valuations remain much lower than peers. And this is unlikely to change quickly.

The company’s revenue fell by 5.6% sequentially last quarter, thanks to a continued decline in revenue from its promoter, Hewlett-Packard Co. (H-P), as well as a sharp fall in revenue from Digital Risk, a data analytics company that was acquired about two years ago. While the company had warned about weakness in the Digital Risk business some months ago, the fact that revenue from this segment fell by 33%, sequentially, came as a huge negative surprise. Besides, but for some cost reversals, margins would have fallen last quarter.

Analysts at Emkay Global Financial Services Ltd have cut their earnings estimates for the next year by as much as 8% after the company’s earnings announcement. They wrote in a note to clients, “While Mphasis appears cheap at less than 11 times estimated FY16 earnings, we highlight the continuous challenges on revenue growth for the company, which don’t seem to be abating. Mphasis also remains vulnerable to further downsides on margins, given the necessity to make the required sales and marketing investments to drive growth in the Direct Channel.”

All told, the company needs to show some stability in revenue and earnings before investors are willing to buy its shares on a sustainable basis.