by Aakash Athawasya

For Indian markets, the IT services sector has become an investor haven during the Covid19 pandemic, thanks to its specific appeal in a reeling domestic economy: a global client base, an increasing reliance on digital solutions in the age of social distancing, and a renewed focus on remote engagement. The Happiest Minds IPO has benefited from this enthusiasm.

The initial public offering [IPO] for Happiest Minds began on 7 September with investors eligible to buy 42 lakh shares in the technology company. By the morning of 9 September, investors already bid for 1.64 crore shares, over 40 times the subscription, and one entire day was still left. By the end of the subscription period, the IPO was oversubscribed 150 times.

The IPO’s listing goes against this era’s overall trend of celebrating IT product companies in the 'disruptive' mould, run by especially youthful founders. Ashok Soota founded IT services firm Happiest Minds in 2011 at 68 years of age, and is now well into his 70s. He is no newbie to IT – he was the former vice chairman of Wipro, senior vice president of Shriram Refrigeration, and co-founder of MindTree. Soota and his founders set up MindTree in 1999, foreseeing the outsourcing boom that was soon to hit India, and their first investor was the now deceased VG. Siddhartha, the founder of the Indian coffee chain, Cafe Coffee Day. 

In 2007, Soota took MindTree public at Rs. 425 per share, and since then its price has increased by 146%. However, all wasn’t rosy for the newly publicly listed company. Several cracks began to emerge in the management over business strategy, particularly between Soota and Vice Chairman Subroto Bagchi over the former’s decision to enter the mobile handset market. MindTree announced the closure of the mobile handset business in October 2010, with Soota leaving the company he co-founded three months later.

Fast forward to 7 September 2020, Larsen and Toubro (L&T) holds the majority stake in Soota’s former company MindTree, and his new company Happiest Minds’ IPO was set to hit the market, expecting to fetch Rs. 702 crores. MindTree’s financial health is going through testing times. In comparison to its peer group, which consists of TCS, Infosys, HCL Tech, Wipro L&T Infotech and Tech Mahindra, MindTree’s yearly growth was the worst of the lot, recording a net loss of 16.34%. For the most recently concluded quarter, MindTree was over-reliant on its top account, excluding which its revenue fell by 16% on a quarterly basis largely weighted down by travel, transportation and hospitality.

IPO Breakup

Around 4.2 crore shares in the IT services company was on offer, with a price band of Rs. 165 to Rs. 166 per share. The total offer size of Rs. 702 crores would be divided into two parts - a fresh issue of Rs. 110 crores split into 67 lakh shares, and an offer for sale [OFS] of Rs. 592 crores, split into 3.5 crore shares. The offer for sale will be monetized by executive chairman and director Ashok Soota’s 12% stake of 84 lakh shares valued around Rs. 140 crore and investor JP Morgan’s PE firm CMDB II selling 2.72 shares valued at around Rs. 452 crores.

Prior to the IPO, the promoter and promoter groups held 61% of the company, public and employees held 34.2%, and others holding 4.1%. Following the issuance, the shareholding will change to promoter and promoter group holding 52.3%, public and employee holding 42.9% and others holding 3.9% of Happiest Minds. 

The fresh issue will be divided based on QIBs, non-institutional investors and retail investors at 75%, 15% and 10% respectively. The book running lead managers [BRLM] for the IPO are ICICI Securities, and Nomura Financial Advisory and Securities.

According to the company, the net proceeds from the fresh issue will serve two objectives, to meet the long-term working capital requirements, and for general corporate purposes. 

Strengths

1. Strong IT services brand: The company has built a strong brand in a slew of digital offerings including IT services, application development and deployment, and disruptive technology growth.
    
2. High customer revenue generation and repeat revenues: Despite operating in a competitive and matured market, the average revenue per customer has increased by 22% between FY2019 to FY2020, from $500,000 per customer to $614,000 per customer.
    
3. Scalable business model: Across industries, functions and geographies, the business model allows scalability, and delivers steady growth with key operational drivers which include - revenue mix, contract structure, utilization rates and bill rates.
    
4. End to end capabilities: Happiest Mind’s core competency is its full lifecycle software development services which includes initial design and prototyping, product development and testing, component design and integration, product deployment, performance tuning, porting, cross-platform migration and ongoing support.
    
5. Strong R&D capability: The company focuses on next-gen technology to cope with the digital evolution. Offerings are constantly updated to keep up with the changing times. Three offerings created by the company to future proof their digital transformative initiatives are 

• Automation - for infrastructure automation, test automation, industrial automation, DevOps automation and robotic process automation)
• Blockchain - advisory services to leverage blockchain to solve business problems and implement smart contract solutions
• Drones & Robotics - leveraging capabilities in engineering, IoT and AI capability to create new offerings with a focus on surveillance and retail markets and traffic management 

6. Agile engineering and delivery: Owing to the host of technology capabilities, the company can offer customers with effective and quality software solutions using agile scaling frameworks.

Risk factors

1. Revenues are highly dependent on US customers: In the Financial Year 2020, 77.5% of revenues from operations were from external customers in the United States alone. Global factors which could adversely affect the economy of the US would adversely affect Happiest Minds business, financial conditions and operations.
    
2. Rapid growth management will be difficult: The previous three fiscal years saw high but organic growth, in the future rapid growth could put significant demands on management personnel, resources and systems. Happiest Minds saw its net profit grow from Rs. 14.2 crores in FY19 to Rs. 71.7 crores in FY20, and the first quarter of FY21 already recorded net profit of Rs. 50.2 crores, almost 70% of the net profit of the previous year. The April to June quarter also recorded an improvement in the EBITDA margins by 21.4%.
    
3. Success depends on senior executives, promoters and key personnel: If the company is unable to bring in other senior executives, client relationships and growth cannot be maintained effectively.
    
4. Concentrated revenues: A high portion of the revenues are generated by a small number of customers. Any loss in customer base will lead to a reduction in revenues by a greater proportion, particularly because the company is not an exclusive IT services provider for their customers. As of June 2020, Happiest Minds had 148 active customers.
    
5. Termination of customer contracts: Happiest Minds does not maintain long-term commitments with customers.  Agreements with customers last for a period of one to five years, until terminated. Despite having a substantial majority of revenues from repeat business, engagements with customers are singular in nature.
    
6. Evolving industry: The information technology industry is rapidly changing and evolving, making it difficult to evaluate future prospects and risk management.
    
7. Strong competition by domestic and international peers: The IT services realm is highly competitive, and inability to compete, coupled with pricing pressures and loss of market share could adversely affect the company’s financial performance.
    
8. Third party software: The company incorporates third party open source software into customer deliverables and any failure to company with the terms of the software licenses could lead to a liability.
    
9. Limited verticals serviced: Happiest Minds is dependent on a limited number of industry verticals and any fluctuation in the demand for these outsourced services could hurt revenues.
    
10. Immigration restrictions: The vast majority of the company’s employees are Indian nationals and any restriction on immigrants or work permits in the United States, Europe or other countries could hamper growth and adversely affect the financial performance of the company.

Business Breakup

Happiest Minds describes itself as a ‘Mindful IT Company’ catering to the digital transformation for enterprises through a host of technology products. The main offerings are pivoted by the company’s three centers of excellence (CoEs) which include, the internet of things (IoT), analytics/artificial intelligence (AI) and digital process automation (DPA).

Data source: Happiest Minds red herring prospectus

The product offerings are segmented under the following business units [BUs]:

1. Digital Business Services [DBS]: This segment which accounts for 50% of the company’s revenue aims at three offerings. Firstly, driving digital transformation in improving customer experience, productivity, and business outcomes. Secondly, improving the quality of data on the customer’s platform by providing assistance in designing and testing of operations. Thirdly, consulting services for migration of applications to the cloud.
   
    
2. Product Engineering Services [PES]: This PES segment brings in 28% of the revenue for Happiest Minds. PES builds products and platforms that are ‘smart and connected,” by providing both hardware and software knowledge. This unit helps clients begin the digital onboarding process by building prototypes and minimum viable products [MVPs] on a cloud and mobile friendly platform complete with supported test automation.
   
    
3. Infrastructure Management & Security Services [IMSS]: The final 22% of the revenue is brought in by the IMSS segment, which provides end to end monitoring for customer’s application and technical infrastructure as well as services to mid-sized technology companies, specifically with reference to their data center, cloud infrastructure and applications. Happiest Minds’ security offerings, through this BU include, cyber and infrastructure security, governance and risk compliance, data privacy and security and identity and access management.

The company also boasts a diverse industrial mix preventing dependence on a single segment. The management has previously stated that 76% of the company’s business has been unaffected by the Covid-19 pandemic. The most impacted verticals of travel, retail and manufacturing account for 24% of the revenues to Happiest Minds. Edutech, HiTech and BFSi verticals continue to be the highest revenue contributors to the company.

Data source: Happiest Minds red herring prospectus

Board of Directors

Financials

As per the company’s financials, the revenue grew at 27.5% between FY18 to FY19, and at a slightly lower 18.3% in FY20. In Q1FY21, Happiest Minds recorded a revenue of Rs. 177 crores. EBITDA for FY18 was negative Rs. - 39.4 crores, but thereafter grew. In FY19 and FY20, EBITDA stood at Rs. 30.1 crores and Rs. 76.9 crores respectively. The EBITA margin for FY20 was at 13.9% which represents an expansion of 460 basis points over the previous financial year. In Q1FY21, the EBITDA margins further improved to 21.4% which was due to the appreciation of the rupee over the dollar, lower lease rentals and leverages of selling, general and administrative (SGA) costs. The management is of the opinion that core higher EBITDA margin is sustainable going forward.

The net profit for Happiest Minds at Rs. 14.2 crores and Rs. 71.7 crores for FY19 and FY20. For the first quarter of FY21, the company recorded net profit of Rs. 50.2 crores.

For the ongoing FY21, management is looking to improve the EBITDA margin to 21-22 percent. The management attributed the rise in net profit for Q1FY21 was due to ongoing cost cutting as well as rent reduction for its staffing parks owing to the implementation of work from home.

Cash flow from operating activities for FY18, FY19, FY20, and Q1FY21 was Rs. 10.3 crores, Rs. 57.6 crores, Rs. 112.2 crores and Rs. 33.3 crores respectively. This points to a CAGR of 124% for cash flow from operating activities between 2018 to 2020.

Valuation

Looking at the valuation, basic EPS according to the company stood at Rs. 7.04 per equity share, while diluted EPS stood at Rs. 5.36 per equity share, for the year ended March 31 2020. Taking the higher price band of Rs. 166 per share, this would give Happiest Minds a price to earnings ratio of 23.6 times. 

However, it should be noted that during the April to June quarter, a Series A 14% non-cumulative compulsory convertible preference (CCPS) shareholder converted 3,58,728 CCPS into equity shares at a ratio of 1:163, leading to an addition in equity shares by 5.8 crores. Hence, the total equity shares at the end of Q1FY21 of Rs. 2 face value stands at 10.2 crores.

The three main domestic industry peers, as mentioned in the company’s red herring prospectus are Tata Consultancy Services (TCS), Infosys, Larsen & Toubro Infotech (LTI) and MindTree.

Happiest Minds’ sales between FY18 to FY20 grew at a CAGR of 22.8%. The digital space is expected to grow at a CAGR of 20% between FY18 to FY25, and the company is well-positioned to carry on with this sustained growth rate. Peers within the IT services industry are growing at a higher CAGR growth of 26% to 36%, this points to scope for improvement going forward.

The spending on global technology is expected to grow at a CAGR of 6.3% between FY18 - FY25 reaching $6,080 billion in 2025. The leaders in the technology rush will be software and engineering research and design (ER&D) verticals, growing at a CAGR of 8% within the period.  

It should be noted that because of the Covid-19 pandemic, IT spending is expected to decline over the next 4 to 8 quarters after which the demand will pick up, driving higher investments and growth rates.