The Hindu Business Line : Tata Elxsi: Buy

Strong business environment for offshoring, encouraging demand for product design and engineering services and good financial performance are positives.

VISUAL EFFECTS will complement the core revenues from product design.

Investors with one/two-year perspective can consider taking exposure in the Tata Elxsi stock. At the current market price, the stock trades at a price-earnings multiple of 17 times its annualised 2006-07 per share earnings. Even in the latest correction in the market, the stock remained fairly stable. The returns from this stock are likely to be sedate and linked strongly to the company's financial performance and growth plans.

The sustained improvement in the business environment for offshoring, the encouraging demand for product design and engineering services, the strong third quarter financial performance and the association with the Tata group lend strength to the company.

However, the high exposure to project-based business, scale-up challenges, slowdown in end-user markets in the US, and appreciation of the rupee remain the key risks.

Key Segments

Tata Elxsi classifies its business broadly into two key segments: Software development and services, and systems integration and support services. Over the past four years, the company has consciously transformed its revenue profile from systems integration to software development and services.

For instance, systems integration, which accounted for 39 per cent of its revenues in 2003-04, had dwindled to 14 per cent in the first nine months of 2006-07.

This switch is clearly linked to the low profit before interest and tax (PBIT) margins of systems integration (below 10 per cent) vis-à-vis software development (at over 20 per cent).

The software development and services segment comprises three key focus areas: Product design services, design and engineering services, and visual computing.

The company offers product design services to a whole host of industries that range from automotive, consumer electronics, semiconductors, media, storage and wireless apart from handling IP and product solutions in these areas. Over 70 per cent of its employees are in this segment.

In engineering design services, the company is primarily involved in mechanical design for consumer products, electronic enclosures, FMCG packaging and transportation. It enjoys a roster of blue-chip clients for which it has executed projects, including GM and Toyota in automotives, Hindustan Lever and Procter and Gamble in packaging, Whirlpool and Maytag for consumer appliances and several international design firms. Finally, Tata Elxsi's Visual Computing Labs has created animation, special effects and gaming services for the entertainment industry.

Using its experience garnered in the domestic film and advertising industry, including films such as Dhoom 2 or Salaam Namaste, the company has bagged some significant work in Hollywood. Given the high quality manpower available at reasonable cost, the animation and gaming industry is likely to provide huge potential for Tata Elxsi in the coming years.

The steady rise in the operating profit margins in the last few quarters testifies to this strategic switch to software development.

For the nine months ended December 31, 2006, the company reported profit before interest and tax (PBIT) margins of 24 per cent for the software development and services segment compared to 20 per cent in the corresponding previous period.

Over the same period, both the revenues and PBIT margins from the systems integration business has been on a decline.

The contribution of systems integration to overall revenues fell to 14 per cent from 19 per cent. The PBIT margins were also lower at 7.8 per cent vis-à-vis 13.6 per cent over the same period.

Considering the niche focus of Tata Elxsi, it enjoys return on equity and capital employed in the 50-60 per cent range, significantly higher than most of its mid-sized peers.

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