The Hindu Business Line : VisualSoft Technologies: Buy

(From left) Messrs V. Krishnan, CFO, VisualSoft; Sashi Reddy, CEO, VisualSoft (and CEO AppLabs); Suresh Ramani, CEO, eSOLUTIONS; and Sudhakar R. Gunturu, MD, VisualSoft... Time to get cracking on the merger — P. V. Sivakumar.

INVESTORS with a penchant for risk can consider an exposure in the VisualSoft Technologies stock with a medium-term perspective. With the announcement of the stock swap ratio by the VisualSoft board, the stage is set for the merger of AppLabs Technologies and eSolutions with itself.

Post-merger, VisualSoft will be realigning its business with a focus on two areas: Outsourced product development (VisualSoft's focus area for the past couple of years) and software testing services (AppLabs core focus). The impact of this restructuring will start to pay-off only by March 2007.

Based on the earnings guidance offered by VisualSoft, the stock trades at a price-earnings multiple of 12 times its expected per share earnings for 2006-07.

Though the PEM appears reasonable, investors will have to factor in multiple risks associated with restructuring, which are:

Turbulence, near-term

As a standalone entity, VisualSoft proposes to reduce its focus on business process outsourcing (BPO) and concentrate on outsourced product engineering/development over the next few months. Over the last couple of years, VisualSoft has been strengthening its technology development expertise in this area.

With greater willingness on the part of Fortune 1000 companies to share the intellectual property for their products for development, companies such as Aztec Software, Persistent Systems, Aspire, and Symphony have prised open this market.

As VisualSoft is working with some of the Fortune 500 majors in this space, the potential is quite considerable.

However, the restructuring will contribute to a decline in VisualSoft's standalone financial performance in the next two quarters till March 31, 2006 as it reduces/eliminates its low-profit businesses.

According to the guidance offered, the company will clock revenues of Rs 150 crore and post-tax earnings of Rs 20 crore for FY 2005-06. As it has logged revenues of Rs 107 crore and post-tax earnings of Rs 12.1 crore, it is staring at two weak quarters.

The possibility of stock price weakness linked to earnings performance cannot be ruled out. Besides, the stock has almost doubled since the private equity firm, SAIF II Mauritius Company, an arm of Softbank, acquired a strategic 14 per cent equity stake from the promoters at Rs 127 per share in mid-August. A month later, Venture Tech Solutions, held by Mr Sandeep Reddy, and Chintalpati Holdings, held by Mr Srini Raju, took a combined 8.62 per cent in VisualSoft as portfolio investors.

Delivering on strategy

Following the AppLabs eSolutions merger, the combined entity is expected to log revenues of Rs 400 crore and post-tax earnings of Rs 70 crore in 2006-07, up 67 per cent and 120 per cent respectively over 2005-06. The outsourced product development division is likely to account for Rs 180 crore of revenue, a 20 per cent growth over the previous year. And software-testing services will grow to Rs 220 crore from Rs 90 crore in 2005-06.

While the revenue growth rate of 20 per cent in outsourced product development is realistic, the growth in profit margins will hinge on effectively cross-selling its services to the clients of AppLabs and managing the rising competition in this business.

The forecast revenue growth of testing services at 140 per cent with high profit margins in 2006-07 hinges on two elements. One, the revenue growth depends on AppLabs growing organically by 60-70 per cent and putting through another acquisition to bridge the revenue gap. The company is said to be at an advanced stage of negotiations for another acquisition in the testing space.

Two, the net profit margin for the testing business has been pegged at 13 per cent for 2005-06. Though the average profit margins are in the 25-30 per cent range for product testing, it is said to be lower as AppLabs is involved in integrating KeyLabs, an acquisition it made in the testing and certification space, in April 2005. The ability to move the margins back to the industry average in 2006-07 will hold the key to meeting forecast earnings growth.

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