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Krishnan Thiagarajan

IN A tough year, most key medium-size software companies took on the frontliners in the core services business and stayed afloat (though some of them posted negative growth rates). Going forward, it appears that offshore outsourcing will become more and more `strategic' in content and may flow only towards the major vendors, such as Infosys Technologies or Wipro, which have the scale and size to support large clients.

This has put the medium-size software players in a dilemma. As scale and size gain in importance, these players are debating whether to continue their focus on generic software services or look at newer opportunities such as IT-enabled services.

Irrespective of which strategy they employ, the message that is coming out loud and clear is that if these companies have to thrive, they will have to focus on "differentiation" — in service offerings, focussing on specific vertical segments and specialising in higher-end technologies. If these companies are to succeed, it is imperative that they move away from the bread-and-butter activities of application development and maintenance services.

The returns story

Business Line examined the returns from these stocks between September 21, 2001 (the day on which BSE Sensex and the Business Line Technology Index touched the lowest level in 2001) and April 10, 2002 to examine whether any lessons can be learnt from the returns logged during this and subsequent periods. An observation of returns revealed the following:

Focus on scalability: Over the past year, at least half a dozen prominent medium-size companies — including Digital GlobalSoft, Silverline Technologies, Mascot Systems, Polaris Software and Mastek — focussed on achieving scalability. As most of these players were generic software players (involved in the application development/maintenance business) like the frontliners, each employed a different strategy to achieve scalability.

Digital GlobalSoft strived to establish itself as an offshore development partner of its parent Compaq Computer Corporation. Silverline Technologies attempted to use a couple of high profile acquisitions to leapfrog into the big league.

Mascot Systems stepped up the marketing efforts to bag orders in the US and Europe, while Polaris Software strengthened its internal systems and processes to attract clients in the BFSI (banking, financial services and insurance) areas. Mastek entered into a tie-up with Deloitte Consulting to broadbase its service offerings and acquire domain expertise. And the returns tell the story. Most of these stocks were trading close to their 52-week lows on September 21. Through the relative success of their different strategies, most of them recorded fancy returns of over 200 per cent between Sept.21 and April 10.

The only exception was Silverline Technologies, which recorded a mere 98 per cent return, as its high-profile acquisition strategy appears not to have worked so far.

But the valuation of these stocks at current levels is being called into question after the Infosys revenue forecast announced this week. On the strength of a strong performance, some stocks, such as Digital GlobalSoft and Mastek, are trading at price earnings multiples that are higher than those of the frontline stocks, such as Satyam and HCL Technologies.

Similarly, the PEM differential between frontline and medium-size companies, which used to be 8-10 times in earlier years, has narrowed to 3-6 times in recent months.

Fundamentally, the strategies of most of these medium-size players are still in a state of flux. If, going forward, large-scale offshore outsourcing contracts are to flow to frontline companies and modest growth rates of 10-15 per cent from software services become the norm, the narrowing PEM differentials may widen in the coming quarters. The future valuation of these medium-sized majors hinges upon "differentiation in offerings involving greater expertise in specific verticals" and a "more diversified set of service offerings".

Focus on IT-enabled services: In an otherwise dull year for the software services industry, companies such as Infotech Enterprises, e-Serve International (part of the Citibank group and earlier known as Citicorp Securities and Investments) and MphasiS BFL (through its call centre subsidiary MSourcE) focussed on IT-enabled services, which were the flavour of the season. According to Nasscom, the apex association of the software industry, the IT-enabled services industry is likely to grow nearly 70 per cent this year — from revenues of Rs 4,100 crore in 2000-01 to over Rs 7,000 crore in 2001-02.

The IT-enabled services cover the gamut of services ranging from customer interaction centres, BPO (business process outsourcing), and GIS (geographic information systems) to engineering services. Among these, BPO was key focus area for these companies. Other companies that jumped on to this bandwagon are Hinduja TMT and GTL. The returns logged by some of these companies touched astronomical levels. For instance, the returns between September 21 to date of Infotech Enterprises was 598 per cent; e-Serve International 296 per cent; and MphasiS BFL 620 per cent.

Considering the small base from which these companies started, their valuations of appear stretched and, in a few cases, even higher than the valuation for pure frontline companies. At these levels, the valuations are so finely balanced that there is no scope for earnings disappointment. Though the potential for this area is huge and growth rates of over 50 per cent appear achievable, most of these companies appear overvalued at current levels.

Second, the competition is these segments is slated to perk up sharply (at least in the near term, especially in the transaction processing services) from frontline majors such as Wipro, HCL Technologies, TCS and Infosys, which are aggressively entering this area to improve their employee utilisation rates. Finally, this area is all about clinching orders from newer customers. Hence, the risk of unstable and fluctuating revenue flows is far greater than a pure software services strategy.

We also examined the returns logged by software majors in two time-frames — first, between December 13, 2000 (when the BL Technology Index was at a high) and March 31 2001, when the first round of profit warnings were announced by the US/European IT companies. And the second, from March 31, 2001 and March 31, 2002 to find out how much the investors would have gained/lost by holding individual stocks for the whole year (passive approach to investing).

Bigger downside: The uncertainties and risks associated with investing in medium- and small-size companies are starkly brought out by the comparison of returns over this period vis-à-vis the frontline companies.

In the first round of declines between December 13, 2000 and March 31, 2001, while the frontline stocks declined 40-55 per cent, most medium-size companies, including Silverline Technologies, Polaris Software, Mascot Systems, Mastek and Trigyn Technologies, declined 60-85 per cent. Clearly, the downside of investing in such stocks is evident from the negative returns.

Since most of these stocks had already declined substantially, most of them logged relatively lower negative returns between March 31, 2001 and March 31, 2002, barring a few exceptions, such as Mascot Systems, Geometric Software, MphasiS BFL and Infotech Enterprises, which recorded substantial positive returns, as their growth story started revealing itself.

Active management is the key: As far as the medium- and small-size companies are concerned, active portfolio management is the key. This is basically because both the downside and upside are higher than frontline companies. Unless investors monitor their investments prudently — timing their entry and exit — the returns from these stocks over an extended time-frame could be significantly lower than those from passively managed frontline software companies.

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