The Hindu Business Line : Aztec Software: Hold

While the demand for product engineering services is encouraging, Aztec's ability to mine its top five clients and enhance volume growth from its new clients holds the key to its valuation.

Mr K. B. Chandrasekhar, Chairman, Aztec Software.

Investors can retain their holdings in the Aztec Software stock. It trades at a price earnings multiple of 15 times its trailing four-quarter per share earnings.

Though we remain fundamentally bullish on Aztec's core business of software product engineering and testing, its disappointing performance in the first quarter of 2006-07 induces an element of caution. The strong client addition in the latest quarter, the step up in sales and marketing spends and the sustained demand for outsourced product development (OPD) services lend confidence to Aztec's growth prospects.

However, since OPD involves working with early stage companies (financed by venture capitalists), any slowdown in technology or venture capital spending in the US can adversely impact the company. That apart, the high client and geographic concentration, the entry into new technology segments, and the increasing competition add to the overall risks. In this backdrop, investors should use any weakness to buy into the stock in a phased manner.

Disappointing Q1

The overall performance of Aztec for the first quarter ended June 30, 2006 turned out to be lower than market expectations. While consolidated revenues perked up by eight per cent, the post-tax earnings declined by 12 per cent. This was attributable mainly to the salary hikes and increase in sales and distribution expenses, which shrank the operating profit margin by 3.4 percentage points to 20.8 per cent on a sequential basis.

Since this comes close on the heels of a modest four per cent growth in revenues and a six per cent rise in post-tax earnings clocked by Aztec in the fourth quarter, its second quarter will be watched closely. Clearly, project volumes that have slowed in the past two quarters will have to pick up in the coming quarters. With good client addition and a step up in sales efforts blended with Disha (its testing arm) in the first quarter, Aztec expects the benefits of higher volumes and better service to kick in, in the coming quarters.

The contribution of the top five clients has increased to 55 per cent from 53 per cent in the previous quarter and that has been powering the growth of Aztec. Even with the top ten client contribution coming down to 66 per cent (from 70 per cent), high client concentration is likely to remain a cause for concern.

Expanding its portfolio

As a fairly established player along the entire product-engineering life cycle ranging from development, testing and maintenance, Aztec is expected to benefit from the fairly stable demand environment in the US for OPD work. The company has been consistently making investments in new technology based services such as Web 2.0, Software as a service or WiMax to stay ahead of the technology curve and servicing its highly specialised product clientele.

In the past year, the company has expanded its range of offerings in the OPD space to include services such as performance engineering, security engineering and database architectural services. In addition, it has announced its entry into two new technology segments: Wireless and networking technologies and embedded and devices technologies. Apart from adding a few clients in these areas, the company is actively scouting for acquisitions that will help jumpstart its growth by filling its technology gaps.

Any specialised small-size acquisition at reasonable valuations can prove to be a positive trigger for the stock.

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