DIGITAL INDIA: Focus on SW Services

Though more than 100 IT companies are listed on the Bombay
Stock Exchange, the top five alone command 85% of the total market cap. The
reason is not difficult to find. The sheer size of the top companies in terms of
their revenues and employee strength allows them to dominate the market. While
the second and third rung companies fare poorly in terms of valuations, we have
witnessed how some of these companies have moved up the ladder. The number of
such companies, though, has been negligible. Scaling up the business after a
particular stage is difficult and calls for an ability to foresee the market and
invest in the right kind of technology and set-up.

Digital India is one such company, which is on the threshold
of entering the big league of software players. The company is in the process of
scaling up its software services business with plans to become a major software
player in the next three years.

Origin in hardware

Digital India started operations in 1988 as Digital Equipment
India, a 51% subsidiary of the US-based Digital Equipment Corp. Set up to
manufacture computer hardware, Digital also provided software services with
adequate help from the parent company. It provided onsite operations in the
initial years and gradually shifted its focus to offshore activities.

Digital India made losses in the first couple of years after
incorporation and after making profits for the following two years, dipped back
into the red. The final turnaround happened in 1994. At the same time, its
parent also witnessed tough times in global markets and was ultimately acquired
by Compaq in 1999.

With the acquisition by Compaq, Digital India became a
subsidiary of Compaq. Compaq, which already had operations in India, decided to
separate the hardware and software business of Digital India. It acquired the
hardware business of Digital India for Rs 83 crore and a non-compete fee of Rs 5
crore. Consequently, Digital India became a pure software company with focus on
software services. While Compaq holds 51% in Digital India, FIIs and FIs hold 8%
each, mutual funds hold 4%, corporate bodies hold 4% whereas the balance is held
by the public.

Software oriented

Digital India’s key focus areas are telecom, systems
engineering services, infrastructure management, e-procurement, e-CRM, content
management and Internet security. Currently, it earns the major part of revenues
from enterprise and e-commerce services, and is gradually making its mark in
vertical segments, which include telecom, finance and insurance. In the first
nine months ended March 2000 of restructured operations of the company, its
entire revenues of Rs 61.3 crore came from software services. Though 28% lower
than 1999, these figures are not comparable because earlier, the company’s
revenues mostly came from hardware and related services, which were sold off to
Compaq. This time, almost all the revenues came from software exports, with the
domestic sector share at less than 1% of the revenues.

Despite the impressive growth reported in the software
segment, Digital India’s client concentration is a cause for concern. The
company gets approximately 90% of the business from the parent Compaq, with 20
non-Compaq clients accounting for the balance revenues.

While
the company is making efforts to increase the revenues from non-Compaq clients–it
has set up a number of offices in the US to push its marketing efforts–revenues
from Compaq remain unreasonably high. However, Digital India claims to have
benefited from Compaq, which has provided it with its mission-critical business
and support in terms of technology and infrastructure. Digital India claims that
it is better placed to attract quality human resource due to the MNC branding.

Digital India has been recruiting aggressively in order to
keep up with the industry rate in the software services segment. Since March
2000, the employee strength has jumped from 479 to over 1,100. Digital India
operates from its three software development centers in Bangalore spread across
103,000 Sq ft.

Digital India’s results for Q2 ended September 2000
reflects the company’s consolidation of its operations in software services.
The Q2 revenues of Rs 40 crore were 41% higher than Q1. However, almost 60% of
these came from onsite operations. Digital India claims the higher onsite
component was due to new business it garnered during the quarter. It expects to
gradually shift these offshore. Digital India’s clients include NEC, Fujitsu,
Nortel Networks, Goldman Sachs and Avaya.

Expansion plans

Ever since its hardware business was hived off, Digital India
has been under pressure to increase its software performance. Although the
company was engaged in software activities in a small way, the transition from
an integrated player to a pure-play software services company posed a serious
challenge to the company. While the last year was spent on restructuring its
operations and defining the company’s offerings, Digital India is now on the
path to leverage its capabilities built over the transition period. Realizing
the need to have a marketing set-up in place, Digital India has expanded its
reach by setting up new offices in US, Europe and Asia. The acquisition of
non-Compaq clientele has been primarily a result of this initiative. Digital
India plans to increase the business from independent clients from the current
10% of the revenues to 50% of the revenues in the next three years.

In terms of service offerings, Digital India plans to focus
on finance and insurance sector apart from the high-growth telecom sector. The
company has formed an advanced technology group to develop competencies in
emerging technologies and mapping these across the various business units within
the organization. The group will develop and incubate competencies in emerging
technologies and synchronize these with business opportunities for Digital
India. As a strategy to focus and increase its presence in the finance and
insurance sector, Digital India has opened an office in New York. It has
appointed Santec Systems as its channel partner to focus on the telecom sector.
It has tied up with Geneva-based Software Business Support (SBS) to offer
similar services in Europe, a major telecom and wireless market. In the
Asia-Pacific, Digital India has partnered with 2ii Technologies in Korea.

The US continued to be the major market for the company,
although the company is making efforts to tap the European and Asian markets.
This is reflected in the quarterly revenue composition wherein revenues from the
US have declined from 90% in Q1 to 82% in Q2. While Asia-Pacific remained
constant at 5%, the revenues from Europe sharply rose from 5% to 13%.

Digital India plans to expand its facility to meet its growth
target of becoming a Rs 500-crore company by 2003. It has bought an additional
space of 20 acres and expects to add 200,000 Sq ft of infrastructure by June
2001 at a cost of Rs 69 crore. It has estimated an overall capital expenditure
of Rs 75 crore over the next two years, to be met through internal accruals.

Financials consolidating

Digital India reported revenues of Rs 71 crore and a net
profit of Rs 20.9 crore in the year ended March 2000. Having established a
marketing network and with new clients, Digital India is now in the
consolidation phase. It reported revenues of Rs 28.6 crore in the Q1 ended June
2000, which have further increased by 41% to Rs 40.5 crore in September 2000.
The company has also improved its operating margins substantially in Q2 of the
current fiscal compared to the Q1 2000 and fiscal 1999. Operating profit margin
stood at 25% in quarter ended September 2000, 16% in quarter ended June 2000 and
22% in fiscal ended March 2000.

Despite growing concerns over the company’s ability to keep
pace with the industry growth, Digital India has performed exceptionally in a
very short period. Based on the company’s performance in H1 2000 and the
ramp-up in human resource, we expect the company to report revenues of Rs 170
crore and grow at more than 90% in fiscal 2002. The company should also witness
higher offshore driven revenues, which should help it improve its operating
margins. However, these are not expected to be substantial due to the higher
operating expenses relating to the additional facility expected to come up by
mid-2001.

Investment potential

Digital India was traded at Rs 514 (December 15) discounting
its projected March 2001 EPS by 42 times and March 2002 EPS by 22 times. Digital
India touched a high of Rs 1,500 during the IT boom in February 2000 but
declined sharply to Rs 250 in October. The stock recovered smartly after the
announcement of its excellent Q2 results. The company’s effort in expanding
its operations, building infrastructure and team to deliver services seem to be
yielding results. We expect Digital India to report strong growth backed by its
marketing efforts and support from its parent company. We however remain highly
concerned about the share of revenue from Compaq. Although Digital India is
committed to bring down Compaq’s share from 90% to 50% by 2003, we still
consider this share unduly high and detrimental to rise in the share price.
Digital India is in a critical phase of operations and the market will closely
watch its quarterly results. Consequently, we expect the share price to move in
tandem with the announcement of the results. We however see little downward risk
from the current levels and a fall in the share price from the current level
will provide good buying opportunity. Buy on declines.

Sushanto Mitra

is the founder of Technology Capital Partners

The views reflected here are of the author and not of this publication. No
liability is accepted for losses based on the information presented here.