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Krishnan Thiagarajan

The high attrition rates, outsourcing backlash, rupee appreciation and intense peer competition are challenges facing the company.

RETAIL investors with a high penchant for risk can consider investing in the book-built initial public offering (IPO) of Datamatics Technologies at the higher end of the price band of Rs 110. The price band for the offer has been fixed at Rs 101-110 on a face value of Rs 5 each. Investing at the cut-off price of Rs 110 may be preferable, as these investors will remain entitled to subscription, even if the final issue price settles at a lower level in the bidding process. Risk averse investors may, however, avoid this offer as the business process outsourcing market is still in its infancy and the risks associated with seeking an exposure in the BPO space through this IPO is fairly high. Besides, the high attrition rates, prospects of an outsourcing backlash from the US, intense competition from software and other third-party BPOs and margin pressures may be high in the near-to-medium term. Even the price earnings multiple at 14-16 times its latest annualised per share earnings is quite stiff, given the associated risks. Datamatics Technologies (Datamatics) is making this offer to finance investment in subsidiaries and associates, repayment of term loans and pursuing an overseas acquisition strategy for growth.

Positive factors

Scaleable business model: The business model of Datamatics focusses on processing transactions and content, which are purely non-voice based. This has been broadly categorised in the offer document under three heads: Content management, back office processing and related software services. Under content management, Datamatics is providing services for the legal, scientific and medical community. Its prominent clients under this head are Lexis Nexis (a division of Reed Elsevier Inc.) and Cadmus Communications Inc. In back office processing, Datamatics offers services for financial and accounting, tax processing and claims processing, and HR Services. Some of its key clients are Ford Motor Company, CPA firms such as Aronson & Co, Fidelity Investments and ABN Amro . In software services, it is handling document management and data migration solutions for its clients. Some of the clients in this category are Hummingbird and Computer Sciences Corporation.

Good growth potential: The IT-enabled services industry has strong growth potential, with growth rates which will outperform its high profile sibling — software services. Datamatics, with its good client profile, is positioned to ride on the BPO wave. Its financials have grown at a consistent rate and rest on a sound footing. On a consolidated basis, for the nine months ended December 31, 2003, Datamatics has clocked total consolidated revenues of Rs 72.7 crore and post-tax earnings of Rs 21.2 crore.

Risks and challenges

Pricing and margin pressures: The client concentration levels for the top five clients are reasonable. But the rise in the revenue contribution of the top client to 26 per cent for the nine months ended December 31, 2003 is a cause for concern. This contribution is up from 19 per cent and 17 per cent for the year ended March 31, 2002 and 2003 respectively. Such a high dependence on a single client exposes Datamatics to pricing pressure and, by extension, can have an impact on its gross and net profit margins.

High attrition rates: The attrition rates in the BPO business are likely to jump sharply in the coming year or so. Practically all the software majors and some third-party BPO providers are focussing on non-voice BPO services. With this refinement in the business model of these players, the attrition rates may perk up and affect the competitive ability of Datamatics. Second, as a part of its business model, Datamatics is working with 1,200 knowledge associates, who are not on their employment rolls. As there is no contractual commitment with this group, it exposes the company to performance risks on this score.

Intense competition and geographic risk: As the IT-enabled services market is still in the nascent stage of evolution, it is likely to witness heightened competition from software companies with BPO subsidiaries, captive back-ends of the US and European multinationals and a host of third-party BPO outfits. At this stage, cut-throat competition is likely to expose the sector to high attrition rates and sustained margin pressures in the near term. Over the next three years, the BPO space is likely to face competition from other low-cost locations such as the Philippines or China.

Outsourcing backlash and rupee appreciation: The federal and state legislation proposed in the US in an election year may have an adverse impact on the BPO companies. Since non-core, but critical, activities of multinationals are outsourced to low-cost locations such as India, BPO companies remain far more vulnerable to an outsourcing backlash. In addition, the appreciating rupee is also turning out to be a challenge, which has to be managed proactively by all BPO players, including Datamatics. The offer opens on April 12 and closes on 19 and the lead manager is Enam Financial.

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