Allied Digital Services - “Allied to Growth” - BUY (Target Rs304, Upside 33%)

CMP Rs229, Target Rs304, Upside 33%

IMS business to drive 29% revenue CAGR over FY10-12

The experience and expertise in system integration (SI), technological depth, wide onsite reach and sizeable remote infrastructure make ADSL a leading IMS player in the domestic market. The company has gained a strong foothold in the US market with the acquisition of EPGS in mid-FY09. After struggling initially, EPGS is now on a sturdy growth path with FY11 revenue expected at US$55mn, a growth of 28% yoy despite offshoring. Overall IMS revenues of the company are expected to witness FY10-12 CAGR of 38% v/s 16% for SI segment. Resultantly, IMS revenue share would increase from 56% in FY10 to 64% in FY12. 

EBIDTA to expand 200bps over FY10-12; to reach 22% in FY12

ADSL’s margin improved significantly by 200bps in FY10 driven by implementation of hybrid delivery model in EPGS, cross-selling of value-added services to EPGS clients, revenue mix shift in the domestic business towards high-margin IMS segment and towards RIM within. As per the management, EPGS operating margin has improved to 7% from near 0% when acquired. We expect ADSL’s OPM to expand by 100bps each in FY11 and FY12 on further expansion in EPGS OPM (to 17-18% over next two years), continued revenue mix shift towards IMS/RIM and contribution from recently entered Lenovo deal.

To turn FCF positive in FY11; growth without dilution/leverage

We estimate ADSL to have turned CFO positive in FY10 and become FCF positive in FY11. Augmentation in CFO and FCF over FY10-12 would be driven by robust revenue growth, margin expansion, reduction in working capital intensity (due to decline in SI revenue share) and no significant capex (current NOC/SOC utilization is low). This and the robust Cash balance (Rs2.2bn, 20% of m-cap) eliminate the need for equity issuance and balance sheet leverage to fund growth over the next 3-4 years. Another pleasant feature about ADSL is its pure RoE of 20%+ (driven by high RoA) as the company has negligible leverage. The utilization of significant C&E would only improve RoE in the coming years. 

Robust 34% earnings CAGR; valuations cheap at 5.6x FY12 P/E

A strong revenue growth of 29% over FY10-12 and material margin expansion (200bps) would drive robust 34% earnings CAGR for ADSL. Given the strong earnings growth, significant improvement in cash flows and a robust/liquid balance sheet, we believe that current valuation of ADSL at 7.5/5.6x FY11/12 P/E is extremely attractive. Further, concerns with respect to EPGS growth/profitability may lessen considerably over the next couple of quarters through demonstrated performance. We see significant valuation re-rating to 7.5-8x FY12 P/E over the next 6 months.