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Zylog Systems — IPO: Invest at cut-off


A focussed business model and reasonable valuations make Zylog Systems an attractive offer




Mr Sudarshan Venkatraman, Chairman.

K. Venkatasubramanian

Investors with a one/two-year perspective can subscribe to the initial public offer from Zylog Systems, considering its business prospects and reasonable asking price. Zylog is a Tier-2 software services and solutions provider to a predominantly US clientele. The company provides services such as application development and maintenance, enterprise infrastructure management and quality assurance and testing. It also has product platforms for seamless integration of various software applications for telecom, manufacturing and banking clientele.

Additionally, Zylog derives significant revenues from partnering with system integrators/solution providers, independent software vendors (ISV) and value-added resellers (VAR).

Business Outlook

The company, which began operations in 1996, is different from the typical IT outfit, in that it generates 81.5 per cent of its revenues from services rendered onsite. While BFSI (Banking Financial Services and Insurance) and telecom are its key operational verticals (together contributing 56 per cent of revenues), Zylog generates significant revenues from retail, manufacturing and healthcare verticals.

Zylog’s revenues have grown at a compounded annual growth rate of about 58 per cent the past four years, driven by certain key operational metrics and strategic moves.

Zylog’s business is driven by the software solutions that it offers and a ‘collaborative sales model’. The latter means that it acts as a channel partner for some big international players such as Sun, Microsoft, and HP.

Besides helping the company tap the business of these players, this model aids it to acquire clients independently through aggressive marketing.

Zylog derives its revenues from servicing specific business units of large corporations rather than by providing enterprise-wide solution(s) that larger players offer.

Apart from making the business less volume driven, this strategy enables greater focus, allowing Zylog to provide tailored IT, consulting services and product platforms to its clients. The association with the bigger players has also, over the years, given it greater scope for value-addition to the international players’ portfolio as well as its own.

Second, the company derives 46 per cent of its revenues from fixed price billing, which is milestone-based. This indicates that the company may have robust means of estimating timelines and expertise required towards completion of projects. This could help in smoother revenue realisations.

Third, the top 10 clients contribute 25.6 per cent of its revenues, indicating that client concentration risks are not high. MCI, its top client, a telecom company in the US, contributes about 4 per cent of its revenues. A healthy trend in client additions (the company has 16 million dollar clients) and a repeat business percentage of 88.9, are positive indicators.

Expansion Plans

Zylog plans to raise about Rs 126 crore at the upper end of the IPO price band from this IPO. Apart from this, it has raised Rs 43.8 crore through preferential allotment and Rs13.15 crore from a bank term loan. The company plans to spend about Rs 66.7 crore (Rs.7.6 crore has already been spent) to set up two offshore development centres (ODC) in Chennai, to increase its offshore presence. This could help the company improve its margin profile (by lowering costs) and acquire a more desirable offshore-onsite mix.

A sum of Rs 81.8 crore has been earmarked for working-capital requirements and an unspecified amount towards possible acquisitions. This is expected to be an overseas acquisition, which could help tap new locations (other than the US) to cross-sell expertise and, possibly, offshore part of the work.

Risks

The company now derives 98 per cent of its revenues from the US. This, together with the fact that the company has not entered into any forward contract towards hedging its dollar exposure, renders the company vulnerable to rupee appreciation risks. Zylog’s acquisition plans need to be watched for overall strategic fit to its offshore/onsite operations and the possible margin pressures that such an acquisition could add.

As a relatively small player, the company also faces considerable competition from Tier-1 companies and established Tier-2 players, which may have deeper pockets. This could exert pricing pressures. Other execution and financial risks such as attrition and wage inflation are applicable to Zylog as well.

Valuation

At the upper end of the price band, the offer values the company at about 11 times the current earnings, on the post-offer equity base. This is at a discount to other Tier-2 IT services companies such as i-Gate, Hexaware and Mastek. The EBITDA (earnings before interest depreciation and amortisation) margin at 17.1 per cent compares reasonably well with that of i-Gate and Mastek.

Offer Details

Zylog is offering 36 lakh shares, representing a 21.89 per cent stake, in the price band of Rs 330-350. The offer is open from July 20-25. Motilal Oswal Investment Advisors is the book running lead manager to the issue.

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