Polaris – A good value punt?

We think Polaris Financial Technology Limited is a good punt in the (oft misused) context of value investing.

Rather than presenting our thoughts in a structured paragraph format we have tried to present this one as an excerpt of a conversation between us (Niren:N and Abhinav:A)

N: I think it’s worth punting in Polaris, the risk – reward is clearly in our favour.

A: Why do you say so? Simply because there is buzz in the papers, news channels about the services division being sold? What are the broad numbers like, I have no clue?

N: There is talk of services division of Polaris being put up for sale. The division with FY13 Rs 1780 crs of revenues (77%), gross margins of 33.44%, EBITDA margins of 20.4% or Rs364 crs. Now compare that with the market cap of Polaris of Rs 1125 crs and cash equivalents of Rs 490 crs.

A: Will there be any takers for this one? What is your guesstimate of the deal value?

N: If you look at general deals in the midcap IT space in services business the buyer is interested in the access to clients and ready to use facilities of the sellers. This is a pure Application development and maintenance work which tends to be sticky. In this particular case, it seems that Citibank (also 19% shareholder of the company) is almost 50% of the services piece. Citi is the largest outsourcer in the BFSI space and clearly a great account to have for any large IT vendor to make in-roads / grow the BFSI practice. I don’t know but maybe a Wipro – telecom heavy, Cognizant – Healthcare focused, LT Infotech looking to ramp up in BFSI space.

Coming to deal value, given that it’s a reasonably profitable business, it can get an average of 0.9 – 1.3 x Revenues OR 6-8x EBITDA. The possible range of values using these matrices is Rs 1600 to Rs 2900 crs. With almost 9.95 crs shares, the per share value can range from Rs165 to Rs300.

A: Why is the market valuing the same business at such a sharp discount to even midcap IT plays?

N: Sir, clearly has to do with the perception of the management, the general discount and non-interest for Midcap IT, The large hoarding of cash and hence the risk of possible mis-allocation etc. At the same time it’s perplexing since Institutional holding is high at 28% . Dividend payout is in the range of 20-25%.

A: Assuming the deal will go through, do you think the stock will become another of those huge cash bargains?

N: Citibank, through its subsidiary – Orbitech Ltd. (previously known as Citicorp Overseas Software ltd) owns a 19.7% stake in Polaris while the current promoters own 29.2%. Also the Employee Welfare trust of both orbitech and Polaris own 2.7% of the company. It is my hope that with Citi on board, being a large shareholder and the largest customer as well they would have significant influence in ensuring that the proceeds will be distributed in an appropriate manner.  In any case, we may not want to wait for the distribution of the said proceeds, the market price will reflect the deal if it goes through.

A: What about the balance products business?

N: It seems that Mr. Arun Jain is very gung-ho about his products business from the multiple interview and concall transcripts. Products have revenues of Rs530crs, gross margins of 50% and EBITDA margins of 11.5%. Post amortizations and finance cost this is actually a loss making business. (FY13 operating loss at Rs 42crs). While gross margins look fine, most of the EBITDA is invested in the high Sales and marketing cost, given the hope of the management that they will able to scale this business significantly. Licence revenues are 14%, maintenance at 38% and implementation is 48%. They have won 39 large deals in FY13, with a deal pipeline of more than $800m.

A: What if the deal doesn’t go through? What’s the downside protection?

N: The stock has moved from Rs 100 to Rs 115 on the back of this buzz in the press. At CMP of Rs115, there is a Rs5 dividend. Valuations on a trailing basis are as follows: PE – 5.7 , PB – 0.85 , ROE – 15% , EV / EBTIDA – 1.2.  It may trace back to its earlier levels of Rs100-105 but given the dividend of Rs5 , my hope is that’s the bottom for the stock – a  downside of 10%.

A: What’s the possible upside?

N : I am valuing the services business at Rs185 a 10% premium to the lowest range of valuations explained earlier. The premium is a function of the profitable nature of the business and attractiveness of Citi as its largest customer. To add to this the Rs50 of cash per share on the books and the products business. One can assume that the loss making products business negates the existing cash on the books in the worst case. Hence a possible target price of Rs185 – an upside of 60%.

A: But isn’t it one of those EVER PREGNANT NEVER DELIVERED (EPND) stories, what’s the difference this time around?

N: While there is no surety given the track record of the promoters having been in the same situation for a couple of times earlier and then things not going through at the last moment. There are a few management actions which suggest that this time it could indeed be different (to use the oft abused phrase).

•     The  separation of the services and products division done recently by a task force formed by the Board of Directors for enhancing shareholder value.

•      The clarification given to the exchange expressly not denying the said rumours but rather alluding to the fact that there are no material events as yet for them to intimate to the exchanges.

Having said all of this, I still have only a 40% probability of the deal going through. What’s the logic – I don’t know – I have none but can mail you a complex model to justify the assumption of my probabilistic estimates.

A: Net-net what are we looking for?

N: So net- net we are looking at punting here in a stock which fits in all the (holy grail) VALUE criteria of statistical cheapness but with trigger of value likely to be unlocked basis the management actions and the news flow (there is no smoke without fire syndrome). On a Fermat Pascal framework, conservatively the payoff looks like 40% prob of a 60% upside vs a 60% prob of a 10% downside. Net – Net 18-20% return in a six months time frame plus 4-5 % dividend yield.

A: Makes sense maybe, but what allocation do you think we should put in here?

N: Well, this is a tricky one. I was thinking of this one more from a substitution angle given the plethora of value traps / junks / duds in our portfolio. How about converting from the existing basket the least preferred and building up a 5% weight.

Given our fancy for trying to manufacture our luck, we think Polaris suits the bill well.

We hope to seek your comments, suggestions and feedback as always

Best of Manufactured Luck!!!!