Refco Global Research

April 26, 2005

India – Mid-caps

BUY
Rs 73 Spanco Telesystems
Initiating Coverage
Target Rs 120 (+64%)

All round growth

Bloomberg Code : KDM IN Expansion of 71% in the high growth call centre business to 2280
Reuters Code : KDM.BO seats, coupled with sustained business traction in its large size
www.spancotele.com project driven telecom system integration business is expected to
result in better business performance by Spanco Telesystems. We
expect revenue to grow at 48% CAGR between FY04-07 to Rs
NSE Nifty : 1971 1.98bn, with PAT growing faster at 56% CAGR over the same period
BSE Sensex : 6378 to Rs 226mn. Valuations are attractive at 6.7x FY06E EPS of Rs 10.7
and 5.4x FY07E EPS of Rs 13.3. We initiate BUY with a DCF based
price target of Rs 120.
Market Data Ramp-up in call centre – high profits ahead: Expansion of the
O/S Shares : 17mn call centre by 910 seats (400 domestic seats, an increase of 35%
Market Cap (Rs) : 1251mn and 510 international, a 231% growth) would enable the company
Market Cap (USD) : 29mn to leverage the outsourcing momentum in India and abroad. We
52 - wk Hi/Lo (Rs) : 86 / 21 expect the business to grow at a 52% CAGR to Rs 1104mn for the
Avg. Daily Vol. (3mth) : 104,834 FY05-07 period and PBIT to rise by 58% during the same period to
Face Value (Rs) : 10 Rs 174mn. Margins are expected to improve slightly from 14.7% in
FY05 to 15.8% in FY07 due to better utilisation of resources.
Telecom integration business – focus on large projects,
Share Holding Pattern (%) higher composition of annuity business: Spanco is likely to be
Promoters : 42.6 the key beneficiary of strong initiatives in segments like defence
FII / NRI / OCB : 6.7 (Rs 100bn), and state wide area networks (Rs 33bn), as it has
FI / MF / Banks : 4.3 already executed few projects in these fields. We believe that it
Non Pro. Corp. Holdings : 29.5 would help Spanco reach a critical size in terms of revenues (Rs
Others : 16.9 880mn by FY2007). Margins have improved significantly from
7.9% in FY04 to 20.9% in first 9-months of FY05. High return on
capital (140%) and better margins (19%) are expected to be
Price Performance (%)
maintained, as contribution from annuity business (10%) will offset
1mth 3mth 1yr
the fall in margins due to the competition that is witnessed in
Abs 12.1 8.3 189.7
bidding for large projects.
Rel to Nifty 14.3 6.3 185.5
Improvement in RoE and RoCE – case for re-rating – RoE and
RoCE are expected to improve smartly to 24.6% and 36.7% in
FY07 as compared to 15.1% and 19.8% in FY05 respectively.
Cash flow is expected to remain strong for the company. We
initiate BUY with a DCF based price target of Rs 120.
Price Vs Rel. to Nifty Valuation Summary
90 150 Y/E March (Rs mn) FY03 FY04 FY05E FY06E FY07E
Net Sales 474 613 1,005 1,691 1,984
EBIDTA 66 115 195 397 454
60 100
OPM, % 13.9 18.7 19.4 23.5 22.9
PAT 23 63 90 182 226
30 50 Growth, % 1.4 176.7 42.9 101.9 25.2
Refco Global Research

EPS, Rs 3.3 9.0 5.3 10.7 13.3

ROCE, % 17.0 21.3 19.8 36.0 36.7
0 0
ROE, % 10.0 21.8 15.1 24.5 24.6
Jan-01 Feb-02 Mar-03 Apr-04
P/E, x 22.1 8.0 13.6 6.7 5.4
Spanco (LHS)
Rel. to Nifty (RHS) EV/EBIDTA, x 9.4 6.4 7.9 3.8 3.1
P/BV, x 2.2 1.7 2.0 1.7 1.3
Source: Bloomberg, Refco Research
Source: Company, Refco Global Research estimates

Vikas Shah (vikas.shah@refcosify.com) Please refer to important Disclaimer on last page

+91 22 5667 9755 Refco Research (India) is also available on Bloomberg / First call
 Investment Summary

Ramp-up in Call centre business – high profits ahead

Total capacity Expansion of the domestic call centre business (Sparsh) by 400 seats to 1550 (up
expanded to 2280 seats by 35%) and international call centre business (Respondez) by 510 seats (up by
231%) to 730 seats will help the company capitalise on the rising outsourcing
opportunity in the domestic and international markets. Revenues are expected to
rise in alignment with the expansion and profits are expected to rise higher than
topline growth. We expect revenues to grow at CAGR of 52% to Rs 1104mn over
FY05-07 period, and PBIT to rise at CAGR of 57% during the same period to Rs
174mn.

The domestic call centre business (Sparsh) with 1550 seats, intends to leverage
the increased outsourcing of customer related services to specialised call centre
companies such as Spanco. Expansion in capacity, better utilisation rates and
higher billing rates (due to revision in billing rates for two large clients) will aid
higher growth in Sparsh from Rs 247mn in FY05 to Rs 397mn in FY07 at 27%
CAGR. Margins are expected to remain firm due to better utilisation and higher
billing rates.

The international call centre business (Respondez) along with 730 seats will have
the highest growth rate among the three business units at 76% CAGR over the
FY05-07 period and would be the prime driver of revenues and profit for the overall
call centre business of Spanco. Focussed concentration on addition of new
geographies and provision of high-margin non-voice services will aid in better
utilisation of resources. We expect revenues to grow from Rs 155mn in FY04 to Rs
707 in FY07. Margins at 16.2% for FY06 are better than domestic business, which
is 14.7% for FY06. We expect margin to remain buoyant on a higher utilisation
factor, which is expected to improve from current 1.0x to 1.15-1.2x by FY07.

Telecom network integration – focus on large projects, higher composition of

annuity business
Higher spending on network integration systems by public and private enterprises
will generate higher revenue and profits for the division. Focussing on large sized
projects in the public domain will facilitate the company in reaching critical size in
terms of revenues.

Large sized projects to be New initiatives undertaken by the company in the defence segment, state-wide
prime driver for the telecom area networks (SWAN) and broadband content delivery business would increase
business
its addressable market to Rs 150 bn plus (including hardware, 65-75%) over the
next 10 years.

Current orders in hand and visibility on the upcoming projects (under bid) will help
the company post revenues of Rs 760mn in FY06 as against Rs 529mn in FY05
The segment is expected to post CAGR of 34% over FY04-07 period.

April 26, 2005 2 Spanco Telesystems

 We expect a slight dip in margins on account of aggressive bidding of projects, but
believe that this would be compensated by the rising contribution of annuity
revenues (10-12%), up from 8-10% currently. Thus, we expect margins to remain
steady at around 19% for the telecom division. High return on capital employed is
expected to continue, as the division does not require any major incremental gross
capex except for working capital on increased business. Undertaking BOT project
will warrant initial investments, which may lead to an increase in capital employed,
depressing returns ratio.

Change in revenue mix

Call centre business to The company’s revenue is shifting in favour of the call centre business after the
overtake telecom business recent expansion by 910 seats. We expect that the telecom division’s share would
in FY06.
reduce from 52.7% in FY05 to 44.4% in FY07. The domestic call centre is
expected to constitute 21.8% in FY06 and 20% in FY07, while international call
centre would make up the remaining. A higher share of the international call centre
business would imply better profitability, as the business is more rewarding in
comparison to the domestic business given its higher margins and fast growth.

Change in Revenue Mix

96.2
100

80
59.8
60 52.7
44.9 44.4

40 35.6
25.4 33.3
24.6
20
22.8 21.8 20.0
2.4 14.8
0 1.4
FY03 FY04 FY05E FY06E FY07E

Telecom, % International Call Centre-Respondez, %

Domestic Call Centre-Sparsh, %

Source: Refco Global Research Estimates

Outlook and Valuations

Revenues to grow 48%
Each business unit is expected to grow at rapid pace over next two years, taking
CAGR over 2004-07, PAT to
grow 56% CAGR the company close to the Rs 2bn mark in FY2007. Higher spending on network
integration by the government would augur well for the telecom division, which is
expected to post a CAGR of 29% over FY05-07. We expect margins for the
division to remain steady in the range of 19% on PBIT levels from the current
20.2%.

April 26, 2005 3 Spanco Telesystems

 Rising outsourcing opportunities in the domestic and international market will give
fillip to the call centre business, which is expected to grow at CAGR of 52% over
next two years. Margins are expected to improve on better utilisation of resources.

We expect the company to post a 64% growth in revenue for FY05 to Rs 1005mn
and a 68% growth to Rs 1691mn in FY06. EBIDTA margin is expected to expand
by 70 bps in FY05 and 400 bps in FY06 on back of higher utilisation of resources in
the call centre business and high margin in the telecom business. PAT for FY05 is
estimated at Rs 90mn and Rs 181mn for FY06, implying a 100% increase.

EPS for FY05, on fully expanded equity is estimated at Rs 5.3 and Rs 10.7 for
FY06. For FY07, we believe that company would post modest growth of 25% in
PAT to Rs 226mn and EPS to Rs 13.3.

Overall Performance

2400 23.5 25
22.9
19.4 1984
2000 18.7 20
1691
1600
13.9 15
1200 1005
10
800 609
474 454
397
5
400 195
66 115
0 0
FY03 FY04 FY05E FY06E FY07E

Revenue, Rs mn LHS EBIDTA, Rs mn LHS EBIDTA Margins, %

Source: Refco Global Research Estimates

The stock is currently trading at 13.6x FY05E EPS of Rs 5.3, 6.7x FY06E EPS of
Rs 10.6 and 5.4x FY07E EPS of Rs 13.3.

Strong improvement in We believe that the stock is attractively valued since we expect that RoE and
RoE, RoCE RoCE will improve from 15.1% and 19.8% in FY05 respectively to 24.6% and
36.7% in FY07 respectively.

We feel that the stock should be re-rated based on improvement in returns ratio
and robust growth for coming two years.

DCF based price target As the company would be in a position to generate steady cash flow in all the
of Rs 120 businesses, we value the company based on DCF. We feel that the fair value of
the stock is Rs 120 (9.0x FY07E EPS of Rs 13.3)

We recommend BUY on the stock with a 12-month price target of Rs 120.

April 26, 2005 4 Spanco Telesystems

 Business - Telecom system integration

Spanco’s core competency lies in the telecom system integration. It provides

varied services to different kind of clients depending upon their requirement. The
telecom system integration market has been growing steadily over the years on
account of higher spending by public and private enterprises to strengthen IT
network infrastructure. The size of market to which Spanco provide its services is
estimated at approx. Rs 10bn. Public enterprises are the largest spenders (close to
70%) in the telecom system integration market.

Robust growth in telecom Spanco has around 5% market share and it is working at increasing the same by
business to continue focusing on large sized projects in the public domains such as defence and SWAN.
The company also provides solutions to private enterprises in the call centre
business amongst others.

Spanco’s telecom system integration business has three main

groups

Turnkey Solutions Group

The Turnkey Solutions Group primarily focuses on setting up networking
infrastructure for the access networks of the incumbent as well as competing local
exchange carriers on all the three medias viz. copper, fibre, and wireless. The
same group also caters to the networking infrastructure requirements of PSUs, and
utilities such as oil companies, railways, Indian defence etc. This group contributes
to around 50% of the division’s revenue.

Enterprise Networking Solution Group

The Enterprise Networking Solution Group offers call-centre solutions that include
Bandwidth Managers, Voice switches, IVR, Automated Call Distribution (ACD),
Computer Technology Integration (CTI), Data switches solutions, Wide Area
Networking (WAN) solutions and Local Area Networking (LAN) solutions. This
group generates 30% of the telecom revenues.

Support Services Group

The Support Services Group undertakes projects for domestic network
maintenance management and facility management services, domestic services for
carriers outsourcing the installation of networks and international installation and
support services. Around 20% of the revenues are derived from this group, which
includes an annuity income (AMC).

The company’s revenues in the telecom division can be divided into hardware (65-
70%), software (10%), support services (10%) and annuity (annual maintenance
contracts) (10%). The profits are derived from the value-addition (services)
provided to the clients.

April 26, 2005 5 Spanco Telesystems

 The company partners with various international telecommunication companies
such as Nortel Networks, Alcatel, and Polycom, as their business principals, whom
it partners with in bagging networking projects.

Revenue break-up/Client wise (%)

100%

80%

60%

40%

20%

0%
FY02 FY03 FY04 FY05E
PSU/Utilities Private Enterprise Defence Call Centre Solution

Source: Company, Refco Global Research Estimates

Contribution from PSUs (including carriers) has been rising steadily along with
defence. Private enterprise services (including call centre solution) are paving way
for large PSU contracts. We expect the mix to remain in favour of defence and
PSU (government) to the tune of over 70% for coming couple of years.

Future initiatives
The company is undertaking various initiatives to penetrate the
telecommunications integration market. It has been aggressive in bidding for large
government (local bodies) projects. The company is also concentrating on the
private enterprises space to get more orders as telecommunication infrastructure in
an organisation gains importance.

Focus Areas – defence, state bodies, exports

Investments by defence, Defence - The company has completed some pilot orders for the defence sector
SWAN to be prime drivers for and is hopeful of getting more projects as the sector opens up for more
the telecom business
investments in coming years. These projects will be taken along with large
telecommunication companies like Nortel, and Alcatel, which would supply the
equipment, while the system integration would be outsourced to Spanco. We
believe that the company would be successful in getting more orders, which will
further strengthen its position in the segment. The total size of the defence market
is around Rs 100bn, including equipment, over next ten years.

State Wide Area Networks (SWAN) - The government has issued guidelines in this
respect for proposed investments to be made in the segment. Substantial
investments are to be made by the state government at the district and taluka

April 26, 2005 6 Spanco Telesystems

 levels to strengthen the IT infrastructure to connect the various local bodies. The
total size of investments is estimated at Rs 33bn spread over 5 years, including
equipment. This is in line with the target set by the Government of India (up to 2%
of the annual non-plan budget) to upgrade the IT network for all ministries. The
models adopted would include BOT, which would warrant initial investments by the
company.

Broadband content delivery is another area of business for the company where
large telecom players intend to provide value added application services. The
addressable market size is estimated at Rs 2.2bn over the next couple of years.

Spanco is exploring opportunities in the Middle East and African market, and has
tied-up with local players to take on contracts for installation and networking
equipment. The company also has an in-house software programming division,
which has developed CTI and CRM products that can be deployed commercially at
the client’s location. The company is currently working in the US, UK and the
Middle East markets where it undertakes technology infrastructure management
and maintenance jobs. This will help the company extract higher margins, as cost
of software development is absent. This is likely to be a small part of the overall
telecom business.

Financial performance
The division is expected to close FY05 with revenue of Rs 529mn (+44% YoY).
The company has firm orders worth Rs 250mn and has strong visibility of gathering
another Rs 300mn from various projects in the pipeline. There are various other
Revenues to rise 29% CAGR
projects, which are likely to be taken up during the year. Given the company’s
over 2005-07, margins to be
maintained at 19% execution capability, we expect the company to post revenue of Rs 760mn for
FY06. Further, initiatives taken in the international market such as setting up a call
centre in Pakistan will help in getting similar orders from other countries.

As the company intends to focus on large sized government contracts, margins can
come under pressure due to competition in the bidding process. However, we
believe that a higher proportion (10-12%) of annuity business (AMC) for coming
years will arrest the fall in the margins. Thus we expect the margins in the telecom
division to remain around 19%. The company has recently ramped up its telecom
division to penetrate the market and increase its share. If revenues were unable to
keep pace with rising costs, the company would face severe pressure on margins.

The telecom division is expect to grow at 29% CAGR for the period FY05-07, while
PBIT is expected to grow at a 30% CAGR for the same period, aided by stability in
margins for the FY05-07 period at around 19%.

April 26, 2005 7 Spanco Telesystems

 Margins to remain steady
1000 25

800 20

600 15

400 10

200 5

0 0
FY03 FY04 FY05E FY06E FY07E
Revenue, Rs mn LHS PBIT, Rs mn LHS PBIT Margins, %

Source: Company, Refco Global Research Estimates

The company has been successful in pruning the capital employed in the telecom
business, and put the surplus in the call centre business. As the business model
works on a turnkey basis, capital requirement is low and hence the company was
High RoCE to be maintained
as further investments in line able to generate far superior returns in the business. RoCE was as high as 150%
with rise in revenues for the nine months ended Dec 04. Though the capex requirement continues to
remain low, we believe that the increasing turnover would result in high working
capital and thus capital required may increase to that extent. However, taking up
BOT projects will immediately call for initial investments, keeping a check on high
return ratio.

High return ratio to be maintained

300 180

250 150

200 120

150 90

100 60

50 30

0 0
FY03 FY04 FY05E FY06E FY07E
Cap. Employed, Rs mn LHS PBIT/Cap. Employed, % RHS

Source: Company, Refco Global Research Estimates

April 26, 2005 8 Spanco Telesystems

Business - Call Centre Services

Spanco has presence in the domestic call centre market through Sparsh and in the
international call centre area through Respondez. The call centre business
currently contributes to 47% of the topline as compared to 40% in FY04. After the
expansion in the number of seats, we expect the contribution from the division to
increase to 56% in FY06 and FY07.

Explosive growth in ITES business

According to NASSCOM, Indian ITES-BPO revenue (exports + domestic) grew by
56.4% over the past 6 years. It is expected to close FY05 at $5.7 bn as compared
to $3.9bn in FY04 and $2.7bn in FY03. Domestic business is expected to
contribute $0.6bn in FY05 as against $0.3bn in FY04 and $0.2bn in FY03. The
domestic business has witnessed a 70% CAGR over the last 6 years. The share of
the domestic business is expected to reach over 10% in the current year as
compared to 6% in 2000.

According to Gartner estimates, global offshore business process outsourcing is

currently at $124 bn, and is expected to touch over $200bn over next three years.
India’s share currently is at dismally low at 2%, and is expected to rise to 8% by
2008. This implies a three-fold jump in ITES-BPO business from India to $16bn by
2008, a CAGR of 40%.

Rise in the employee base

4000
3400

3000 2580

2088
1765
2000
1425

1000

0
Mar-04 Jun-04 Sep-04 Dec-04 Mar-05

Source: Company, Refco Global Research Estimates

The employee base of the company has steadily increased in order to meet the
rising demand in call centre services. At present, over 3200 employees are
engaged in the call centre business, while around 150 people form part of the
telecom group, which is witnessing strong recruitments in line with the growth in the
telecom division.

April 26, 2005 9 Spanco Telesystems

 Domestic Call Centre - Sparsh
Sensing the opportunity in the domestic market for outsourcing of customer care
related services, the company launched its domestic call centre in 2002. The
division has presence in 5 cities - Mumbai, Gurgaon, Pune, Bangalore and
Kolkatta. This helps the company to cater to a wide area and varied clients. The
capacity before the expansion was 1150 at end of December 2004, which has
increased to 1400 currently and finally moving to 1550 in Q1 FY05.

Clientele and verticals

Telecom, retail and banking Spanco provides call centre services that includes e-mail response management,
to be focus area web-site response management, community forum management, and telephone
response management. Some of the business solutions offered are CRM, inbound
marketing response, IVRS, automated voice response, etc. The verticals under
services are banking, insurance, media, telecom and retail. Some of the major
clients of the company include HLL (for the Sangam initiative), BSNL, MTNL,
Citibank, Hutch and Airtel. Telecom forms a major chunk of the revenues for the
division (85% in FY04). Other clients added in the recent past are Prudential-ICICI,
Xerox, Metlife, HP and Eureka Forbes. The company is initiating several other
processes catering to the other verticals such as banking and retail.

We believe that the domestic call centre would grow steadily, as outsourcing of
non-core business activities is an increasingly acceptable phenomenon in the
domestic market. We expect competition to increase in the domestic call centre
business, as large international players are eyeing the space. We believe that this
would indirectly benefit Spanco as it has a first mover advantage and would be
able to grow in an evolving market.

Billing rates and margins

Improvement in billing The market is growing and the significance of outsourcing is rising in the domestic
rates likely market. This will keep the rates higher despite an increase in competition. Spanco
currently provides services to a few large customers at below average billing rates.
We expect the rates for these clients to increase in FY06 and beyond. This will
increase the overall billing rate, thus improving the margins for the company.

Usage of spare time for non-voice jobs-to improve margins

The company intends to use the spare capacity in the domestic call centre for
providing non-voice services such as data redundancy to other BPO’s. We believe
that this will improve the overall utilisation of resources, thus improving the margins
and return on capital employed for the division.

April 26, 2005 10 Spanco Telesystems

 Financial Performance
We expect the revenues from Sparsh to grow by 27% over FY05-07 and PBIT to
improve by 37% during the same period. Margins are expected to remain steady,
as higher utilization of resources will take care of rising costs due to attrition,
training and marketing. We expect revenue to rise by 173% in FY05 to Rs 247mn
and 49% in FY06 to Rs 369 mn. PBIT is expected to rise by 100% in FY05 and
70% in FY06, implying margin expansion from 12.9% in FY05 to 14.7% in FY06.

Margins to improve
600 20

15
400

Margins to improve-better 10
billing rates and higher
utilisation 200
5

0 0
FY03 FY04 FY05E FY06E FY07E
Revenue, Rs mn LHS PBIT, Rs mn LHS PBIT Margins, %

Source: Company, Refco Global Research Estimates

Returns dipped in FY05 because of the capacity expansion by 400 seats. This is
expected to improve as margins remain steady and utilization increases. New
capex in the domestic call centre will be taken only if some big size projects are
available.

Return ratio to improve – as full capacity get utilised

500 20

400
15

300
10
200

5
100

0 0
FY03 FY04 FY05E FY06E FY07E
Cap. Employed, Rs mn LHS PBIT/Cap. Employed, % RHS

Source: Company, Refco Global Research Estimates

April 26, 2005 11 Spanco Telesystems

 International Call Centre - Respondez
The global outsourcing business is catching up pace in the low cost countries like
India, Philippines, Ireland and others. India’s dual strength in the technology and
skilled personnel, places it in an advantageous position to extract more business
from countries like UK and US.

Ramp-up in capacity – in direction of high growth

Capacity expansion from 220 Spanco has recently completed its expansion of seats capacity from 220 seats to
to 730 seats 730 seats at a total cost of Rs 275mn, financed through the composite equity issue
and loans. At the end of FY05, 368 seats were operational and the company
expects to ramp-up the utilisation by adding close to 40-50 agents every month to
reach the full capacity. We believe that the company would be able to get more
business in the segment, as demand is expected to remain strong and grow at
faster rate with a full-fledged marketing office as a 100% subsidiary Global
Respondez Inc. in the US.

Tie-up with Aegis Inc., a leading outsourcing player in the US with seat capacity of
4000, is expected to augur well in terms of pitching for more business. We believe
that better utilisation in terms of usage of spare capacity due to world time
differential will add to the margins and help the return ratio improve.

Clientele and verticals

Respondez’s services offerings can be classified into two– inbound services and
outbound services. The services offered in the inbound segment involve customer
support services, helpdesk and query handling, tele-sales and order-booking and
technical support. Out bound services involve B2B/B2C customer acquisition, lead
generation, win-back programs and telesurveys.

Its clientele includes Air-India, health practice Software Company, the second and
fourth largest telecom carriers in the UK and directory assistance services.

Billing rates and margins

Billing rates to remain stable The international call centre segment is expected to witness competition from large
and margins to be
maintained
players. However, given the growth in the market, all players would be able
increase their share. Process handling capability at lower cost will be instrumental
in maintaining billing rates and margins. Respondez will ramp up capacity @40-50
agents per month to reach the optimum capacity of 730 seats from the current 368
seats. Inbound and outbound rate at approx. $11/hr and $9/hr respectively, is
expected to remain steady and offering high value added services would help the
company to extract higher rates. Currently the company is focussing on the US and
UK markets and hence is unable to fully utilise the capacity. We expect the
company to add more geography under its fold or alternatively offer non-voice
services to increase the margins and return ratio.

April 26, 2005 12 Spanco Telesystems

Financial performance
Respondez is expected to witness robust growth in FY06, with increase in capacity
utilisation. We expect revenues to rise by 76% growth over the FY05-07 period,
with the growth in FY06 is estimated to be 145% to Rs 562 mn. Profits will rise at a
lower pace at 73% over the same period as rising cost in terms of increased
marketing cost will keep margins under check.

Margins to remain under check

800 35

30
600
25

20
400
15

10
200
5

0 0
FY03 FY04 FY05E FY06E FY07E
Revenue, Rs mn LHS PBIT, Rs mn LHS PBIT Margins, %

Source: Company, Refco Global Research Estimates

Return ratio to better in next two years

500 35

30
400
25
300
20

15
200
10
100
5

0 0
FY03 FY04 FY05E FY06E FY07E
Cap. Employed, Rs mn LHS PBIT/Cap. Employed, % RHS

Source: Company, Refco Global Research Estimates

We believe that the company would be able to generate better return on assets, as
it succeeds in inching up the utilization level of assets from 1.0-1.1x at present to
over 1.15-1.2x by FY07 This will significantly improve returns and make the
business self-sustaining.

April 26, 2005 13 Spanco Telesystems

Concerns

Absence of non-voice business

Spanco generates almost all its revenues in the call centre business from the
voice-based services. It has been shown that inclusion of non-voice based services
helps to improve margins and the business is long-term sustainable. Though the
market for voice based BPO services provides more room for growth, fierce
competition also eats up the margin. Voice based services have higher attrition
than the non-voice services, due to the monotonous nature of work. This is an
industry-wide phenomenon, which puts pressure on margins due to high training
costs. We expect this to continue for the company and our assumptions take into
account the high training costs.
The company is taking efforts to include non-voice services during the unutilised
period. We believe that if the company were successful in ramping up the non-
voice business, it would add to the existing margins and improve returns.

Rising competition in the call centre business

Call centre business in the domestic as well in the international market has been
rising, putting pressure on the billing rates and margins. There are numerous BPO
outfits, far larger in size as compared to Spanco, which pose a threat to the
company’s plans to ramp-up quickly. Thus, company has to differentiate in terms of
value added services provided and reduce cost. Its capability in the network
integration business helps to keep the cost per seat at low levels, thus arresting
significant fall in margins. In the domestic market, its first mover advantage will
work in favour of the company and increased outsourcing possibility in the
international market will increase business for the company.

Weakening dollar and high attrition rate pose problems

The company’s international call centre business primarily focuses on the US.
Weakening of the dollar would pose a problem for the company if the rates were
not re-negotiated. The company has also to manage the high attrition levels,
common to the industry. High training cost can impact margins if attrition rates do
no stabilise.

Telecom business – focus on government contracts

Spanco is contemplating an increase in the business from the telecom division by
focussing on large sized government contracts for networking infrastructure
management. This includes state governments, local bodies, PSUs/utilities and
defence. Though these contracts are large in size, they take time to fructify and
involve blockage of working capital as these projects are turnkey in nature. Any
delay in awarding contract may impact our estimates.

Further equity dilution likely to fund expansion

Spanco has been aggressively pitching for large sized contracts in the call centre
as well in the telecom business. Any success on call centre business front may
require adding capacity, which may call for capital infusion. Thus, we feel that any
equity dilution in near to medium term may impact RoE and RoCE for the next
year.

April 26, 2005 14 Spanco Telesystems

Financials

Spanco registered a 41% jump in revenues to Rs 250 mn in Q3 FY05 aided by

robust growth in the call centre business. Telecom business witnessed a drop in
revenue but registered strong growth in the margins, which helped the company
post 50 bps expansion in the EBIDTA margin to 19.4%. Higher depreciation due to
expansion and incidence of deferred tax brought down the PAT by 10% to Rs
13.4mn. For the nine months ended Dec 04, a revenue jump of 58% to Rs 619mn
resulted in 42% growth in PAT to Rs 50.4mn. Margins shrunk due to expenditure
on expansion - revenues are expected to follow in the forth-coming quarters.

Quarter & Nine Months ended Dec '04

(Rs mn) Q3FY05 Q3FY04 Chg (%) 9M FY05 9M FY04 Chg (%)
Telecom division 109.3 118.7 (7.9) 299.2 230.5 29.8
Sparsh 71.2 24.8 187.4 171.4 57.7 197.0
Respondez 69.6 34.4 102.3 148.0 102.8 43.9
Total Revenue 250.1 177.9 40.6 618.5 391.0 58.2
Total Expenditure 201.5 144.2 39.7 501.6 306.7 63.5
EBIDTA 48.6 33.7 44.4 116.9 84.3 38.7
Margin, % 19.4 18.9 18.9 21.6
Interest 3.8 4.1 (5.3) 10.9 9.7 12.6
Depreciation 19.2 11.0 73.7 40.9 30.6 33.4
PBT 25.6 18.6 37.8 65.1 43.9 48.1
Other Income 0.4 0.2 60.7 0.9 1.0 (13.2)
Tax 7.0 3.2 116.0 11.9 6.6 79.8
Deferred tax 5.6 0.6 3.6 2.8
Tax rate (%) 49.1 20.8 136.4 23.9 21.4 11.7
PAT 13.4 15.0 (10.3) 50.4 35.6 41.8
Equity 169.9 69.9 143.2 169.9 69.9 143.2
EPS, Rs 0.8 2.1 (63.1) 3.0 5.1 (41.7)

Source: Company, Refco Global Research Estimates

Segmental performance
Telecom division witnessed a 1300 bps expansion in PBIT margins for Q3FY05 to
21.5% as compared to 8.7% in the previous year. Revenues however, declined by
8% as high margins projects were taken up as against large sized contracts.
Reduction of capital required in the business expanded the returns from the
business to 163% on an annualised basis. We expect the trend to taper a bit, but
the business is expected to continue to post high return on capital.

The call centre business formed 56% of the total revenue, out of which Sparsh
made up for 28.5% and Respondez for the remaining. Margins for both the division
declined as the company went in for large expansion, putting money in fixed
assets, resulting in high depreciation charges. PBIT margin for Sparsh declined
from 19.5% in previous year and 13.6% in previous quarter to 9.5% currently.
Respondez also posted a decline in margins from 26% in Q304 and 19.8% in Q205
to 15.4% in Q305.

April 26, 2005 15 Spanco Telesystems

Outlook and valuations

Spanco’s recent expansion in the call centre business is expected to result in 56%
of the revenue coming from the call centre in FY06 and FY07 as compared to 47%
in FY05. The telecom division, which formed a major chunk of Spanco’s revenues
in FY03 and FY04, is expected to pave way for call centre business as its share
drops to 44% in FY06 and FY07.

Though the telecom division betters the call centre business in terms of return on
capital, it cannot grow as robustly as the call centre business. We believe that the
company’s strategy to focus on call centre business by expansion of number of
seats to 2280 will pay off well in FY06 and FY07.

Change in Revenue Mix

96.2
100

80
59.8
60 52.7
44.9 44.4

40 35.6
25.4 33.3
24.6
20
22.8 21.8 20.0
2.4 14.8
0 1.4
FY03 FY04 FY05E FY06E FY07E

Telecom, % International Call Centre-Respondez, %

Domestic Call Centre-Sparsh, %

Source: Refco Global Research Estimates

We expect that the robust growth in the call centre business and aggressive focus
on the telecom networking integration business will aid the company in posting a
48% growth in revenues for the FY04-07 period and a 56% growth in PAT over the
same period. Margins in the telecom business are expected to be stable, while call
centre business margins are likely to improve over next two years on the back of
better utilisation of resources.

We expect the company to post a 64% growth in revenue in FY05 to Rs 1005mn

and a 68% growth to Rs 1691mn in FY06. EBIDTA margin is expected to expand
by 70 bps in FY05 and 400 bps in FY06 on the back of higher utilisation of
resources and better margin in the telecom business. PAT for FY05 is expected to
be Rs 90mn and Rs 181mn for FY06, implying a 100% increase.

April 26, 2005 16 Spanco Telesystems

EPS for FY05, on fully expanded equity is estimated at Rs 5.3 and Rs 10.6 for
FY06. For FY07, we believe that company will post a modest growth of 25% in PAT
to Rs 226mn and EPS to Rs 13.3.

Overall Performance

2400 23.5 25
22.9
19.4 1984
2000 18.7 20
1691
1600
13.9 15
1200 1005
10
800 609
474 454
397
5
400 195
66 115

0 0
FY03 FY04 FY05E FY06E FY07E

Revenue, Rs mn LHS EBIDTA, Rs mn LHS EBIDTA Margins, %

Source: Refco Global Research Estimates

The stock is currently trading at 13.6x FY05E EPS of Rs 5.3, 6.7x FY06E EPS of
Rs 10.6 and 5.4x FY07E EPS of Rs 13.3.

We believe that the stock is attractively valued as RoE and RoCE are likely to
improve from 15.1% and 19.8% currently to 24.6% and 36.7% in FY07.

We feel that the stock should be re-rated based on the expected improvement in
the returns ratio and robust growth for coming two years.

As the company would be in a position to generate steady cash flow in all the
businesses, we value the company based on DCF. We feel that the fair value of
the stock is Rs 120 (9.0x FY07E EPS of Rs 13.3)

We recommend BUY on the stock with a 12-month price target of Rs 120.

April 26, 2005 17 Spanco Telesystems

Annexure - Background

Incorporated as Kadambari Leasing Ltd. in 1984, it acquired the telecommunication

business of M/s Spanco Tele-systems Ltd in 1999. The company consequently
changed the name to Spanco Tele-systems and Solutions Ltd. The company is
engaged in wide range of services in the telecommunication segment.

Spanco started as a telecom equipments company with products in EPABX, paging

and cellular services. In 1996 - 97 Spanco added Analog and Digital radio products
to its products range, thereby catering to the requirements of Media provisioning as
a part of turnkey solutions offering. In 1998 SPANCO formed the Turnkey Solutions
Group, which was focused at providing end-to-end turnkey solutions to
PSU/Utilities with project management and project execution offerings. It also
caters to the telecommunication infrastructure requirement of the private players
and defence. The company is contemplating to increase the share of defence
related jobs as it sees huge opportunity in coming years.

The Company forayed in to call centre services in the domestic and the
international markets under the name Sparsh and Respondez respectively. It has
been able to ramp up the capacity in both the initiatives to 1550 and 730
respectively by end 2004, up from 1150 and 220 respectively earlier.

Thus the company functions in two broad segments of Telecom Integration

Services and Call Centre services.

Composite Issue- To fund expansion in the call centre business

The company concluded a rights-cum-public issue of 10mn shares at Rs 25 each
(including premium of Rs 15), to fund its expansion plans in the call centre
business in December 2004. The total project of Rs 394mn to expand its call
centre capacity by 910 seats was partly funded by bank loans of Rs 117mn and
internal accruals of Rs 26.5mn and balance coming from the composite equity
issue.

April 26, 2005 18 Spanco Telesystems

DCF Valuation
(Rs mn) FY03 FY04 FY05E FY06E FY07E FY08E FY09E FY10E Terminal
Sales 474 613 1,005 1,691 1,984 2,142 2,314 2,499 2,699
Growth, % 30 29 64 68 17 8 8 8 8
EBITDA, %) 13.9 18.7 19.4 23.5 22.9 21.0 20.0 19.0 18.5
EBITDA 66 115 195 397 454 450 463 475 499
Work. Cap, days 162 186 138 120 142 130 130 120 115
Chg in WC 59 103 66 178 213 (7) 61 32 (5)
Op. cash flow 6 12 129 218 241 457 402 443 505
Tax (% of EBITDA) 8.7 4.8 9.3 9.0 9.8 15.0 15.0 15.0 15.0
Tax 6 6 18 36 44 67 69 71 75
Capex/EBITDA, % 159.2 74.9 212.1 17.7 15.4 12.0 12.0 12.0 12.0
Capex 104 86 413 70 70 54 56 57 60
Free cash flow (104) (80) (302) 113 126 336 277 315 370
NPV of FCF (80) (266) 87 86 201 146 146 151

Source: Refco Global Research Estimates

Cost of Capital/Terminal growth

WACC
Rf 6.5%
Rm 15.5%
Beta 1.00
Cost of equity 15.5%
Cost of debt 10.5%
WACC 13.70%
Terminal Growth 5.0%

Source: Refco Global Research Estimates

Fair Value Per share – Rs 120

Total NPV of FCF (Rs mn) 399.4
NPV of terminal value (Rs mn) 1967.4
Total NPV (Rs mn) 2366.8
Net Debt/(Net cash) (Rs mn) 321.9
Equity Value (Rs mn) 2044.9
Equity value per share (Rs) 120.4
Source: Refco Global Research Estimates

Sensitivity Analysis
Terminal Growth
4.0% 4.5% 5.0% 5.5% 6.0%
11.7% 153 163 175 188 204
12.7% 128 136 144 154 165
WACC 13.7% 108 114 120 128 135
14.7% 93 97 102 107 113
15.7% 80 83 87 91 96

Source: Refco Global Research Estimates

April 26, 2005 19 Spanco Telesystems

Income Statement
Y/E Mar, Rs mn FY02 FY03 FY04 FY05E FY06E FY07E
Telecom 364 453 368 529 760 880
Domestic Call Centre - 14 90 247 368 397
International Call Centre - 7 155 229 562 707
Total Revenue 364 474 613 1,005 1,691 1,984
Growth, % 30.2 29.3 61.8 68.2 17.3
Expenses 324 408 498 810 1,294 1,529
Growth, % 26.1 22.0 62.8 59.8 18.1
Raw Materials 280 329 261 308 440 470
% of sales 77.0 69.5 42.6 30.7 26.0 23.7
Employee Cost 15 30 117 257 429 510
% of sales 4.1 6.3 19.1 25.6 25.4 25.7
Selling/Admin Cost 29 49 119 245 425 549
% of sales 7.9 10.4 19.5 24.3 25.1 27.7
EBIDTA 40 66 115 195 397 454
Growth, % 63.3 74.9 69.6 103.9 14.8
EBIDTA, % 11.0 13.9 18.7 19.4 23.5 22.9
Other income 1 2 7 4 10 10
Interest 6 15 17 14 60 48
Depreciation 5 16 45 64 110 120
PBT 30 36 61 121 236 296
Current tax 6 6 6 18 35 44
Deferred tax 2 7 (8) 12 20 26
PAT 22 23 63 90 182 226
Growth, % 1.4 176.7 42.9 101.9 25.2
Net Margin, % 6.2 4.8 10.3 9.0 10.8 11.4

Source: Company, Refco Global Research Estimates

April 26, 2005 20 Spanco Telesystems

Balance Sheet
Y/E Mar, Rs mn FY02 FY03 FY04 FY05E FY06E FY07E
Equity share capital 70 70 70 170 170 170
Reserves & surplus 134 157 220 427 570 748
Networth 204 227 290 597 740 918
Deferred tax liability 2 9 (1) 11 32 57
Loan Funds 40 158 250 385 360 320
Total Liabilities 246 394 539 994 1,132 1,295

Gross Block 79 190 259 689 759 829

Less: Depreciation 6 22 66 130 240 360
Net block 73 168 192 559 519 469
Capital work in progress - - 17 - - -
Investment 23 16 16 56 57 57
Inventories 31 60 63 83 139 163
Sundry debtors 137 173 141 275 463 571
Cash & bank balance 23 46 18 63 85 138
Loans & advances 24 18 223 151 185 245
Current liabilities (53) (81) (119) (165) (278) (299)
Provisions (13) (6) (12) (29) (38) (48)
Net current assets 150 210 313 379 556 770
Total Assets 246 394 539 994 1,132 1,295

Source: Company, Refco Global Research Estimates

Cash Flow
Y/E Mar, Rs mn FY02 FY03 FY04 FY05E FY06E FY07E
Pre-tax profit 30 36 61 121 236 296
Depreciation 5 16 45 64 110 120
Interest Provided 6 15 17 14 60 48
Interest Paid (6) (15) (17) (14) (60) (48)
Others (0) (1) (17) 5 (9) (10)
Chg in working cap (67) (41) (122) (30) (156) (160)
Tax paid (6) (5) 0 (18) (35) (44)
Operating cash Inflow (38) 5 (34) 142 145 202
Capital expenditure (58) (104) (86) (413) (70) (70)
Free Cash Flow (96) (99) (120) (271) 75 132
Investments (23) 6 0 - (0) -
Equity Capital Raised 111 - - 250 - -
Loans Taken / (Repaid) 19 118 92 135 (25) (40)
Dividend (incl tax) - - - (29) (29) (38)
Net chg in cash 12 25 (28) 45 22 53
Opening cash position 9 21 46 18 63 85
Closing cash position 21 46 18 63 85 138

Source: Company, Refco Global Research Estimates

April 26, 2005 21 Spanco Telesystems

Key ratios
Y/E Mar FY02 FY03 FY04 FY05E FY06E FY07E
Per Share Data
EPS, Rs 3.2 3.3 9.0 5.3 10.7 13.3
Cash EPS, x 4.0 5.6 15.4 9.1 17.1 20.4
EBITDA / Share, x 5.8 9.4 16.4 11.5 23.4 26.7
Book Value, x 29.2 32.5 41.5 35.2 43.6 54.1

Valuations
PER, x 22.4 22.1 8.0 13.6 6.7 5.4
Price / CEPS, x 18.2 12.9 4.7 7.9 4.2 3.5
Price / BV, x 2.5 2.2 1.7 2.0 1.7 1.3
EV / Sale, x 1.4 1.3 1.2 1.5 0.9 0.7
EV / EBITDA, x 12.9 9.4 6.4 7.9 3.8 3.1
DPS, Rs 0.0 0.0 0.0 1.5 2.0 2.5
Dividend Yield, % 0.0 0.0 0.0 2.1 2.8 3.5

Returns, %
RoCE 16.4 17.0 21.3 19.8 36.0 36.6
RoNW 11.0 10.0 21.8 15.1 24.5 24.6
RoA 30.8 13.5 30.1 16.1 35.1 48.2

Margins, %
Operating Margins 11.0 13.9 18.7 19.4 23.5 22.9
Net Margin 6.2 4.8 10.3 9.0 10.8 11.4
Effective Tax Rate 25.8 36.7 -3.9 25.3 23.2 23.7

Turnover, days
Debtors T/O 138 133 84 100 100 105
Creditors T/O 53 62 71 60 60 55
Working Capital T/O 151 162 186 138 120 142

Gearing Ratio, x
Total Debt/Equity 0.2 0.7 0.9 0.6 0.4 0.3

Source: Refco Global Research Estimates

Ratings: Relative to Index

Buy > 10%
Market Outperformer > 5% < 10%
Market Performer ± 5%
Market Under Performer < 5%
Sell < 10%

April 26, 2005 22 Spanco Telesystems

 2,500 Net Sales & Growth 80 250 Net Profit & Growth 200

2,000 200
60 150
1,500 150
40 100
1,000 100
20 50
500 50

0 0 0 0
FY03 FY04 FY05E FY06E FY07E FY03 FY04 FY05E FY06E FY07E
Net Sales, Rs mn Growth, % Net Profit, Rs mn Growth, %

EPS & Growth 25 EBITDA & Net Margin

14 200
12 20
150
10
100 15
8
6 50 10
4
0 5
2
0 -50 0
FY03 FY04 FY05E FY06E FY07E FY03 FY04 FY05E FY06E FY07E
EPS, Rs Growth, % EBITDA Margin, % Net Margin, %

12 EV/EBITDA (x) 3.0 P/BV (x)

10 2.5

8 2.0

6 1.5

4 1.0

2 0.5

0 0.0
FY03 FY04 FY05E FY06E FY07E FY03 FY04 FY05E FY06E FY07E

40 ROCE & RoE (%) 2.0 EV/Sales,(x)

35
30 1.5
25
20 1.0
15
10 0.5
5
0 0.0
FY03 FY04 FY05E FY06E FY07E FY03 FY04 FY05E FY06E FY07E
ROCE RoE EV/Sales

Source: Refco Global Research Estimates

April 26, 2005 23 Spanco Telesystems

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