Did you know KPIT Technologies is one of the earliest Indian IT Software companies to go public way back in 1999?
After Infosys listed in June 1993, it took a while for the other companies in the sector to start going public. The current flagbearer for the Indian IT sector, TCS, did not list until 11 years later, in 2004. By then, KPIT had already been a publicly listed company for nearly five years.
In January 2018, management of KPIT proposed a merger and demerger with the C.K.Birla groups privately held IT Services company, Birlasoft.
Wait, merger and demerger?
The merger of KPIT and Birlasoft will create a USD 700+ Million entity which will immediately demerge into two separate companies:
1. KPIT Technologies (a USD 220+ Million revenue company, post-merger), a global leader in Automotive Engineering and Mobility Solutions, evolving from the existing Engineering business of KPIT.
2. Birlasoft (a USD 500+ Million revenue company, post-merger), a new Digital Business IT Services company, focusing on mid-tier IT space, formed by combining Birlasoft with KPIT’s IT business.
A quick overview of KPIT Technologies. It had FY18 revenues of ~USD 530 Million (at INR 69 / USD) from two distinct business lines.
- Bespoke business software development and maintenance, what is traditional IT Services and
- broadly called Engineering or Product Engineering Services, designing software that controls physical components like the powertrains in automobiles
Traditional IT Services made up 61% of its FY18 revenue, the remaining 39% came from Engineering Services.
The plan is to first merge KPIT with Birlasoft and from the combined entity, demerge the Engineering business into a separate entity. The merged (traditional IT Services) entity will be called Birlasoft and the demerged (Product Engineering Services) entity will retain the identity of KPIT Technologies.
The KPIT FY18 annual report says the combined Birlasoft will have “starting revenues of USD 500+ Million” (at INR 65.04/USD), implying Birlasoft FY18 revenue at current rates is ~ USD 148 Million (the remaining USD 323 Million from the former KPIT)
The stated rationale: Competitiveness
Post the restructuring, the IT company, Birlasoft will become one amongst the largest midcap IT companies with core focus on digital. We believe, it will have a proper mix of ERP and digital revenues. We trust that it will be able to service customers, both in BFSI as well as the manufacturing verticals…
The Engineering company, KPIT Technologies, will be sharply focused on automotive engineering…
The merger and demerger process, post approval from the regulatory bodies will enhance the potential of growth, profitability and thus, value creation, in the individual businesses.
The real rationale: Valuations
Birlasoft will add ~27% incremental revenue to the former KPIT. hardly enough to dramatically change the competitive game. Also, there is a USD 2.5M expense to doing this reshuffling exercise of which USD 1.9M was incurred in FY18 which is not trivial considering this was 3.3% of KPITs FY18 EBITDA.
The reason then for the entire restructuring exercise, is clear from this statement:
This (KPITs original) mix of revenues does not clearly bring out our identity and this also negatively affects the valuation.
To the markets, a Rupee in earnings is not the same as any other Rupee in earnings.
For instance, the market values earnings delivered by one of its favourites, Hindustan Unilever, higher than the same level of earnings by others. I wrote about it here [The curious case of HUL and how markets play favourites]
Chart shows KPIT share price returns versus MidCap IT peers, rebased to 100 in April 2010.
KPIT shares have lagged peers over the last few years. Even peers who have delivered similar earnings have been rewarded with higher share price increases.
KPIT stock has been amongst the worst of its peers who generated similar earnings.
That has changed since Oct 2017. While all of IT, especially Midcap IT has been surging since late 2017 (visible on the chart above), unlike in the past, KPIT shares have performed competitively, only behind Mindtree and Hexaware.
KPIT share performance since the time the Birlasoft deal was announced in late January 2018 have done even better relatively.
KPIT stock’s outperformance since October 2017 could be just money chasing a relatively cheap IT stock or some advantaged insiders who knew about the upcoming deal. It’s strong upward move since January is evidence of what the market thinks of the potential impact on shareholder value from the demerger of businesses lines.
The hope probably is that the Engineering Services business will get rerated similar to earnings multiple of similar companies like L&T Technology Services. Whether it plays out remains to be seen.
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Disclosure: Mindtree is part of my core quantitative value portfolio. KPIT is in my satellite momentum portfolio, an experiment I wrote about on capitalmind. Nothing in this post