Monday, February 14, 2022

Persistent Systems: Acquisition To Strengthen Microsoft Azure Competencies Globally


CMP: Rs4413  

Target Price: Rs5000

* PSYS has entered into an agreement to acquire assets of Data Glove Inc (DGI), its Indian subsidiary and affiliate entities based out of Australia, UK, Canada and Singapore. Additionally, Persistent Systems Germany GmbH will acquire Data Glove's subsidiary in Costa Rica. The total purchase consideration is USD90.5mn (~1.95x EV/S on adj. CY21 sales), payable in cash.

* Deal rationale: Through this acquisition, PSYS will enhance its partnership with Microsoft, strengthen expertise in Azure-based digital transformation and other offerings in the Microsoft stack, as well as expand its geographic footprint (near-shore delivery center in Costa Rica and presence in US and India) and talent pool. Building on Microsoft Azure's impressive growth, these expanded capabilities will bolster the company's existing partnership and serve as the foundation for a new dedicated Microsoft business unit at PSYS. In addition to client sales and service delivery, this newly formed unit will focus on Microsoft training and certifications, working closely with community colleges and regional universities to foster new talent.

* Deal details: PSYS will pay an aggregate consideration of USD90.5mn, which includes  1) an upfront payment of USD50.69mn, subject to customary adjustments for working capital, debt and cash on closing; 2) maximum earn-outs of USD34.88mn to the founders of DGI over the next two years, contingent on the achievement of certain performance thresholds; and 3) a retention and performance-based payment of USD4.93mn to key employees of DGI over the next three years, depending on employment continuity and business performance. The transaction does not require any government or regulatory approvals and is expected to close within 4-5 weeks.

* Call highlights: 1) PSYS expects Microsoft Azure relationship to scale to ~USD75mn post the transaction (existing ~USD25mn Azure practice and ~USD50mn from DGI). IBM and Salesforce practices are already USD100mn+ on a run-rate basis. 2) Gross margin profile of DGI is slightly lower than that of PSYS, but due to lower SG&A costs, DGI has a similar EBITDA margin profile as PSYS. 3) PSYS expects ~75bps of impact on EBITM in FY23 due to the impact of employee retention payments and amortization charges, which the company expects to be absorbed by synergy benefits over a period. 4) DGI derives around 75-80% of revenues through the Microsoft channel (billed to Microsoft or catering needs of clients referred by Microsoft). 5) The company plans to draw USD35mn debt to fund the transaction. 6) PSYS plans to amortize the acquired intangibles over a period of seven years. 7) PSYS suggested that recurring revenue was ~USD46mn in CY21 as the balance revenue may not continue post the transaction and ownership change. 8) The earn-outs are based on DGI delivering 22.5% YoY growth. 9) The company indicated that the top client revenue run rate is in the range of USD8-10mn+, while revenues from the top 5-7 customers are in the range of USD2-4mn+ for DGI.

* Our view: The acquisition accelerates and deepens PSYS's Azure competencies, and bolsters vertical capabilities within the Microsoft ecosystem. DGI will also add a near-shore delivery center for PSYS in Costa Rica and expand its presence in the US and India to meet rising talent needs. The deal will enable PSYS to capture market share by taking advantage of growing Azure and Microsoft-led opportunities. The transaction is expected to add ~5% revenue in FY23 but to be low single-digit dilutive to EPS due to a 75bps EBITM impact (employee retention payment, amortization charges) and lower other income. We have yet not factored in the transaction in our estimates, pending its closure. We have a Buy rating on PSYS with a TP of Rs5,000 at 40x Dec'23E EPS.

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