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Krishnan Thiagarajan

FROM an investment perspective, investors have to be fully aware of the risk variables that dictate the valuation of medium-sized software companies.

On a relative basis, frontline software companies are better equipped to weather a slowdown and capitalise on an upturn than their medium-sized counterparts.

So, risk mitigation or `de-risking' assumes greater significance in this case. Some of the key risks are:

Client replacement risk

The focus of medium-sized companies has largely been on working with a limited set of large clients. Though this brings in greater predictability to the revenue stream, it also exposes the company to the risk of `client replacement'.

Client-replacement risk is the need to replace a large project coming to an end with another client of a similar size or a set of clients making up to those revenues.

Consider Mastek. After recording six successive quarters of sequential revenue growth, Mastek stumbled in the fourth quarter ended June 30, 2003, with a sequential decline in revenues.

This was because of the completion of a few large projects (including the London Congestion Charging, a time-bound project) at around the same time and failure to get projects of a similar size.

The need to monitor this across medium-sized companies assumes importance. For instance, Exult and Deutsche Leasing are the largest clients for Hexaware; FedEx for MphasiS; Cummins for KPIT Cummins, GE for iGAte Solutions, and Citigroup for Polaris and i-flex solutions.

Client concentration and credit risk

The excessive exposure to a few large clients also raises the risk of client concentration and associated credit risk. For instance, in 2002-03, a keyJapanese client of MphasiS BFL scaled down its business sharply, which led to some near term apprehension. But given its relatively broad-based client portfolio, the company was able to ride out of the storm with ease.

And this also calls for a close monitoring of credit risk arising from accounts receivables on an ongoing basis.

Billing rate risk

As medium-sized companies are competing with frontline companies in garnering application development/management contracts from large clients, they are likely to remain exposed to billing rate risks.

Almost all medium-sized companies with a stable set of clients have claimed that they have not experienced any near term billing rate pressures, as their average offshore billing rates (in the $18-21 bracket) are already at the lower end of the billing chain.

But as offshore gets more mainstream , frontline companies may use their scale and size to drive down offshore rates.

With relatively less bargaining power, the medium-sized companies may be forced to fall in line. However, the impact of this may hinge on the verticals, quality of the relationship with the client and nature of jobs handled by medium-sized companies.

Technology/vertical concentration risk

In the evolving business model, medium-sized companies are working on an interplay of a couple of verticals and a few chosen technologies. These have emerged out of important lessons from the slowdown.

In the case of Hughes Software, for instance, the telecom meltdown in end-2000 had a devastating impact on its financials of Hughes. As the order flows from equipment manufacturers or carriers slackened, it switched its focus to telecom service provider space and later moved into business process outsourcing.

Fortunately for Hughes, the telecom environment is showing signs of recovery. A combination of new clientele such as Lucent and expansion of its relationships with Nokia, or NEC has put it on the revival path.

Similarly, Geometric focussed on the product life-cycle management space has enlarged its focus to become systems integrator. For other players such as Kale Consultants, the focus on the airline vertical or for Mastek, the government vertical or KPIT Cummins, manufacturing can be a risk prone focus area.

Going forward, these twists and turns may be applicable to other medium-sized companies. However, de-risking and differentiation will hinge on the success of individual companies in deepening their vertical expertise and widening their base of customers in the chosen technologies.

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