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From THE HINDU group of publications
Sunday, July 29, 2001












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US turnaround holds the key

Krishnan Thiagarajan

FOR the medium-sized software companies, a sharp turnaround of the US economy is critical as it holds the key to greater offshore opportunities from both the US and Europe.

The CEOs of the frontline/medium-sized companies feel that the mindset of the management of Fortune 500 and Fortune 1000 companies towards offshore outsourcing has turned favourable over the past few months. As cost efficiency, enhanced productivity and pressure on profitability becomes the order of the day, it is obvious that the offshore value proposition is something US companies cannot afford to ignore.

At the same time, they feel the delay in the decision to `outsource' to India could be attributed to differing perceptions on economic gloom and expectations of a pick-up in corporate IT spending in the US and Europe. While a recent Gartner 2001 IT Spending and Staffing Survey claims that 56 per cent of 589 respondents plan to spend more on IT in absolute terms in 2001 than in 2000, a recent survey by Morgan Stanley has reached a diametrically opposite conclusion.

According to the Morgan Stanley Survey of chief information officers in 225 of the 500 largest US companies, 50 per cent of the CIOs claimed they planned to cut back on IT spending. Since this debate is unlikely to be resolved easily and the growth momentum of both frontline/medium-sized companies slackened in the first quarter of 2001-02, Nasscom, the Indian software association, has decided to revise the growth estimates downwards for Indian software companies. The growth estimates have been pruned to 37 per cent in dollar terms (and around 40 per cent in rupee terms) in 2001-02 vis-a-vis the compounded annual growth rate of over 60 per cent in the last five years.

In this backdrop, the evaluation of risks associated with medium-sized software companies assumes even greater importance. The relatively lower price earnings multiple enjoyed by medium-sized companies can be attributed to their inability to evolve risk mitigation strategies and its frontline counterparts. Owing to lower cashflows, constrained business spreads and narrower client bases, these companies are generally affected more in an economic downturn vis-a-vis frontline companies. From an investment standpoint, investors need to carefully consider these risks before taking an exposure in these companies:


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*Client concentration: One of the biggest risks associated with medium-sized companies is ``client concentration''. Smaller companies have built up their business mainly around a single client and, over the years, use this to widen their clientele base. However, the success rate on this count has been low. The downside to excessive exposure to a single client is two-fold -- it leaves them vulnerable to a sharp drop in billing rates or variations in pricing terms in contracts, and exposes them to considerable credit risks.

Most of the key players among medium-sized companies suffer from high client concentration risk. For instance, for the year ended 2000-01, Compaq Computer Corporation, US, accounted for 88 per cent of the revenues of Digital Equipment (India). Similarly, General Electric was Mascot Systems' largest customer, accounting for 38 per cent of its 2000-01 revenues. And the top five and top ten clients accounted for 55 per cent and 66 per cent of the 2000-01 revenues. In relative terms, the client concentration of Polaris Software was lower, with Citigroup being its largest client and accounting for 29.2 per cent of its 2000-01 revenues. Its top five client concentration was also better at 32 per cent for 2000-01. However, this is considerably higher than the client concentration levels of frontline companies such as Infosys, Wipro and HCL Technologies.

*Credit risk: To add to the client concentration risks, the credit risk (of the accounts turning bad and irrecoverable) is much higher for medium-sized companies vis-a-vis frontline companies. For Mascot Systems, Polaris Software and Sonata Software, the average receivable days at 86, 83 and 94 days is significantly higher than the receivable days of Infosys at 58 days in 2000-01.

*Geographic diversity: As the sharp slump in the US economy clearly demonstrates, the need to have a geographically-diverse revenue profile is imperative from the long-term business perspective. On this count, some of the medium-sized companies were better placed than their frontline peers because they were actively scouting for on-site clients, which necessitated broadbased geographic exposure. For example, Mascot Systems achieved a balanced diversification across geographies, with the US, Europe and Asia-Pacific accounting for 65 per cent, 12 per cent and 23 per cent of its 2000-01 revenues.

Similarly, Polaris also has a fairly balanced spread, with the US, Europe, Asia-Pacific/West Asia and India accounting for 65 per cent, 20 per cent, 9 per cent and 6 per cent of its 2000-01 revenues. However, for players such as Digital Equipment and Sonata Software, whose revenue concentrations from the US at 81 per cent and 84 per cent in 2000-01 are fairly high, the lack of geographic diversity may be a constraint. Most of the players are attempting to get around this issue by setting up marketing offices and using existing client references to ramp up business volumes. Given the language barrier, cultural differences and stringent visa procedures in European nations other than the UK, penetrating or scaling up the European market may be a tough proposition.

*Vertical domain/technology concentration: The economic slowdown in the US has clearly highlighted the fact that companies which focus on multiple domains ranging from manufacturing, telecom, financial services, healthcare or utilities are better equipped to battle cyclicality than the ones focussed on specific domains. Although this risk element clearly falls in the realms of strategy, it assumes significance from the investment standpoint. Obviously, the risks associated with a contribution of 66 per cent from banking, financial services and insurance for Polaris, or 57 per cent for Silverline Technologies from financial services, is significantly higher than the contribution of 33.7 per cent from banking, insurance and financial services for Infosys in 2000-01. Though some players are attempting to broadbase their domain expertise through acquisitions/organic growth, it is obvious that it may be a time-consuming and difficult exercise.

Similarly, as late entrants in the software development space, most of the medium-sized players have been excessively focussed on the e-commerce/Internet space instead of spreading themselves across legacy-based, client server and other technology environments. For instance, the contribution of 58 per cent of revenues from e-commerce for Sonata or 48 per cent from eBusiness for Silverline Technologies exposes medium-sized players to much higher risk than Infosys, which restricted its Internet revenues to 29 per cent in 2000-01. Such players as Mastek and Trigyn Technologies, with excessive dotcom exposures,

were hardest hit in the dotcom flame-out that occurred last year. Although e-commerce/Internet will continue to offer the greatest growth opportunity in future, it is a moot point if players have to necessarily spread themselves so thin on the technology front.


Section  : Industry
Next     : Medium-sized software companies -- Survival
           strategy in slowdown era

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