The Hindu Business Line : Medium-sized software companies

THE smiles are back. And the body language of key executives has turned more confident and the mood among employees relatively upbeat in select medium-sized software companies over the past six-nine months. For the purpose of this analysis, medium-sized companies are mainly those with revenues between Rs 75 crore and Rs 750 crore.

This mood change is also reflected in the re-rating of this segment in the stock market . This re-rating has not been across-the-board though; it has been staggered and on a stock-specific basis.

The first ones to start riding this mid-cap wave were MphasiS BFL, Hexaware, i-flex solutions, Subex Systems and Hughes Software. The ones which joined them later were iGate Solutions (which witnessed a sharp run-up following the induction of Mr Phaneesh Murthy as CEO and acquisition of Quintant in July) and KPIT Cummins (on the strength of a good business model).

However, outside this mid-cap bracket, some prominent stocks such as Mastek, Digital GlobalSoft, Polaris Software and Aztec Software did not participate in this rally or lost value, which were attributable to distinctly company-specific events.

Differing trends

The April 10 management guidance from Infosys Technologies highlighting margin pressures knocked the wind out of frontline companies and affected their stock performance across-the-board. With offshore getting mainstream in the US, the volume growth for these companies is expected to be robust.

But they will have to contend with margin and profit growth pressures, high billing rates relative to their mid-size peers and the challenge of transforming themselves from being an Indian software factory to global players.

Most companies have projected relatively conser-vative 18-20 per cent growth in revenues and 12-15 per cent growth in post-tax earnings. This may be revised upwards as the year progresses.

Relatively, select medium-sized companies, after going through nearly one-and-half years of painful restructuring, have emerged stronger. Mainly, it has come out of a realisation on three fronts:

Widening gulf: The gulf between the top five frontline companies and their medium-sized counterparts has widened considerably since the slowdown. In 2001-02, most companies posted negative revenue growth and only a few managed to keep their heads above water.

Based on this experience, the scaling up strategies of these companies are intended to compete with their own peers in the medium-sized segment rather than expend energies and finances playing catch-up with the frontline players.

Building differentiation: Before 2000, as long as there were no demand constraints, the medium-sized companies were able to replicate the model of frontline companies and claim to be in every vertical, technology or business practice.

But following the downturn, the need to build differentiation among business models has become a commercial imperative. Most players have attempted to achieve this by operating in a limited number of verticals and across a few promising technologies.

Outgrow staff augmentation: Most medium-sized companies have scaled down the staff augmentation resources they built up during the bullish times. In addition, they have also realised that this is not a sustainable model for a long-term player in the software market.

To top it all, for fiscal 2003-04, the management guidance of revenues and post-tax earnings of a few select players has been fairly strong and above the industry average . Consider the topline and bottomline growth guidance (on a smaller base) of the following companies:

Hughes Software: 55-60 per cent and 60-70 per cent respectively;

MphasiS: 30-35 per cent and 40-45 per cent;and

Hexaware: 30-35 per cent and a consolidated net profit before tax of $5 million.

Challenges and risks

On the strategy and operational front, medium-sized software companies will continue to face a slew of challenges and risks ranging from:

Differentiated business model: The business model conceived by companies in the form of an interplay of verticals and technologies is a good model to follow in the near term. Increasingly, companies are likely to position themselves in terms of building a combination of annuity revenues from strategic client(s).

This is being complemented by around four to six prominent and quality clients in both verticals and technologies with potential to scale-up on an ongoing basis.

As a second line of defence is the strategy to focus on at least three among a company's top ten clients with good ramp-up capability to be able to take the position of their top five clients, if the need arises. But sooner or later, this model may also prove to be less of a differentiator.

From a valuation standpoint, the challenge for these companies will be to keep creating a differentiated mosaic of revenue streams which will enable them to command a premium price-earnings multiple over its peers.

Management attrition: Currently, the key medium-sized companies, such as Hexaware, iGate Solutions and Zensar Technologies, have high profile chief executive officers.

They have the marketing savvy, board-level connections among potential clients and charisma to make a difference to their companies' performance. Any attrition among these CEOs can have an adverse impact on the stock prices of their companies vis-à-vis the frontline ones, which may be able to manage this a lot better.

Control over SG&A expenses: The ability of these companies to protect operating margins or keep improving them hinges on controlling their selling, general and administrative expenses. The challenge for companies appears to be two-pronged. Almost every year, these companies are likely to continue to face consistent pressure of salary increases. Though variable-based compensation may be the way forward, even that may be only a limited window of opportunity.

The companies will be able to derive sustainable benefits only if they have the tools and methodologies, which will help generate rich productivity payoffs on an ongoing basis.

Second, the repeat business percentages from clients are substantially lower than their frontline peers. By enhancing the repeat business and mining the existing clients, companies may be able to optimise on their selling (and marketing) expenses.

Onsite-offshore mix: As offshore gets more mainstream, the challenge for these companies will be to enhance the offshore mix to at least 50 per cent from the existing 30-35 per cent in most cases.

Typically, onsite business has higher billing rates but lower margins. For offshore it is vice-versa.

As onsite billing rates will continue to come under greater pressure in the global markets, moving work offshore will help provide greater revenue stability and improve operating margins in the medium-term.

Acquisition bytes

INITIATING, integrating and managing an acquisition will always remain a dicey proposition. Traditionally, acquisitions have been used by medium sized software companies as a model for scalable growth. But the record of companies which have put through acquisitions in the past three years has hardly been outstanding. Consider the three key acquisitions put through in 1999-2000:

Silverline Technologies acquired Seranova Inc. to add strategy consulting to its plain vanilla software development. Prior to this, it acquired CIT Inc. Sky Capital International — its second largest client.

Led by ING Barings, the strategic investor, BFL Software and MphasiS decided to merge to complement each other's expertise — the former in plain vanilla software services and the latter in the technologies domain.

Similarly, the strategic investor, Indo Ocean Chase Capital, brought Leading Edge Systems and e-Capital Solutions together and latter renamed it as Trigyn Technologies.

Evaluating these deals three years hence, the Silverline acquisition of Seranova can be termed as a failure. Currently, the company is involved in a piecemeal sale of its business practices and key client accounts to players such as Cognizant, Tata Consultancy and others.

Trigyn, too, has remained an indifferent performer and the acquisition which was expected to help scalability has hardly materialised. And among the three, MphasisBFL has been the only fairly successful one so far. Even this acquisition was initially bogged down by painful integration and restructuring issues.

Burden of integration

Coming back to 2003, the recent Polaris-OrbiTech merger has been the highlight of the industry segment this year. In June 2002, the Chennai-based Polaris Software announced the historic merger with OrbiTech, a Citigroup subsidiary. This was a merger intended to help Polaris to strategically move higher up the value chain and position itself as a player both in the products and services market.

But putting through the Polaris -Orbitech merger has not been easy. Nearly a year after the merger announcement, challenges dog them on at least three fronts:

Integration challenges involving positioning of the products business of Orbitech into the services business of Polaris. Considerable management time and attention has been devoted to bringing the compensation structures in the two companies in alignment with each other.

The products business accounted for only 14 per cent of the revenues of the merged entity in the quarter ended June 30, 2003. The ability to scale this up to say 25-30 per cent of revenues will be a big challenge.

The transition of Orbitech from a cost to a profit centre has contributed to a sharp drop in the operating margins of Polaris. The timeframe over which the operating margins can be pushed up from the depressed levels continues to remain an uncertain variable.

Though an acquisition strategy makes a lot of sense on paper, the challenges and risks associated with large mergers are quite high. And the "make or break" characteristic in large-scale acquisitions is something which investors will have to bear in mind as consolidation in IT services gathers momentum.

Stock take

Investors may consider paring exposures in i-flex solutions and re-entering at lower levels. Exposure in the Subex Systems stock may be contemplated in small lots (these two are largely product companies).

Investors may avoid fresh exposures in all service stocks.

We recommend a hold on Digital GlobalSoft, MphasiS BFL and Geometric Software. In Hughes Software, investors may pare exposures and re-enter later.

In stocks such as Hexaware Technologies, iGate Global Solutions, KPIT Cummins, Zensar Technologies and NIIT, investors can prune exposures on every uptrend.

Until the fundamentals improve, investors in Mastek and Polaris Software may consider a switch to the frontline and other Tier-II stocks.

Article E-Mail :: Comment :: Syndication

Stories in this Section
Obstacles to good financial reporting

Godavari Fertilisers: Take the market route

Medium-sized software companies — Programming a revival

Evolving business models

Mapping the risks

A market high on drugs

Pharma Stocks: Bounty of good returns

Expectations `peg' values higher

Sterlite Industries: Shifting plans, confusing signals

HPCL/BPCL privatisation — The SC verdict and after