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Krishnan Thiagarajan

A good order pipeline and operational flexibility may be the beneficial fallout of the proposed demerger of the software solutions segment by NIIT. However, the learning solutions segment may continue to be a drag on valuation, says Krishnan Thiag arajan.

Mr R. S. Pawar, Chairman, and Mr Viswanathan Anand, brand ambassador_Embarking on a demerger of software solutions to unlock value.

SINCE the announcement of the demerger of the software solutions business by the NIIT management in the last week of October, the stock has seen a steady uptrend. The stock, which was trading at about Rs 154, has marched up by over 75 per cent to touch the current levels of Rs 276. Clearly, the sharp run-up in the stock appears to suggest that the markets perceive the valuation of the sum of the parts (software solutions and learning solutions separately) to be greater than the whole of NIIT.

Shareholders can stay invested as there may be scope for gains. It is likely that the flexibility offered to the software solutions business — to be listed as NIIT Technologies — and good order pipeline may improve the stock valuation. However, at the current price, fresh investments may be avoided as substantial upside from these levels may be limited. As NIIT Technologies is to be separately listed in the stock exchanges, investors can choose to participate in the standalone company after the completion of the legal formalities over the next four-six months.

Rationale and terms of demerger

Over the years, the NIIT senior management has consistently held the view that there were tremendous synergies between the learning solutions (NIIT's education and training division) and software solutions (including systems integration and product distribution) segment of the company. But in the last two challenging years (2001 and 2002) for the IT industry, the revenue profile of NIIT (on a quarterly basis) have shown that the revenues of both the divisions have moved down in tandem, with hardly any cushion in tough times.

The synergies between the education and software business appear to have played out. And the company's decision to demerge the software solutions segment recently has followed thereafter. The knowledge solutions business, which is now a part of the software solutions segment, is to be reclassified under the learning solution segment. Every shareholder of NIIT will receive 75 shares of NIIT Technologies and 50 shares of NIIT, which will retain the learning solution business. The current equity base of NIIT is Rs 38.7 crore. Additional equity shares will be issued by NIIT as a part of the demerger.

Driven by Software solutions

Given the fluctuating fortunes of the software solutions and learning solution segments, the valuation will hinge largely on the future course of NIIT Technologies. For the 12-month period ended September 30, 2003, the global consolidated revenues from the software solutions (IT services and systems integration) segment was Rs 519.3 crore (The company has extended the year-end to March 2004). On this, it recorded operating profit margins of 19 per cent. Excluding knowledge solutions, which accounted for 21 per cent of revenues in this 12 months period, the revenues work out to Rs 411 crore.

Given the pending order-book position of $125.7 million ($57 million executable over the next 12 months) as on September 30, 2003 and the focus on three promising verticals — airlines, insurance and retail, in particular — the company is likely to perform in line with the industry growth rate of 25 per cent. For 2003-04, NIIT Technologies may end the year with revenues of over Rs 515 crore. Assuming further that NIIT Technologies records an OPM of 20 per cent and net profit margin of 10 per cent (subject to NIIT Technologies being kept debt-free or minimum debt ), the per share earnings may work out to about Rs. 17.

The tricky question is the price-earnings multiple (PEM) that can be accorded to a medium-sized company such as NIIT Technologies. The future valuation triggers being priced into the stock are two factors. One, the spin-off has created the flexibility to offer strategic equity stakes to its strong clientele in small chunks over a period of time. This may help impart the much-needed stability to the earnings stream of NIIT Technologies.

Two, this demerger will also help it use the equity base as an acquisition currency in future, having made a few small acquisitions in the past. Given these triggers and with offshore outsourcing getting more strategic , assigning a price earnings multiple (PEM) upwards of 12-15 times may be reasonable. Any higher PEM will enhance the measure of comfort in the stock to the existing shareholders.

Learning solutions: Slower growth

According to NIIT's senior management, the learning solution segment is passing through a phase of restructuring, which will take at least a year or two to start yielding results. Both the revenues and OPMs will take time to stabilise. This may prove to be a drag on valuation over the next year or so.

But NIIT's learning solution strategy of moving into the developed world, academic alliances with universities and the launch of Planetworkz to create trained manpower for the BPO sector is likely to pay off in the medium term.

However, the integration of the knowledge solutions business with revenues of Rs 109 crore (will be added to the existing revenues of the learning solution segment of Rs 236.3 crore for the twelve month period ended September 30, 2003) may help stem the declining trend in OPM's to some extent. As the learning solutions segment may continue to be a drag on overall valuation, it is advisable for investors to avoid fresh exposures.

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