FINANCIAL ANALYSIS: When The Going Gets Tough



It was too good to be true. The dream run of the Indian IT sector seemed to
defy the law of gravity, as much in India as in the rest of the world. Then
things changed. From its peak of 4,500, the Nasdaq starting falling rapidly,
sending shivers across the world. What began as a slowdown in the dot-com world
soon spread up the supply chain into consulting companies, software and hardware
companies in the US gradually seeping into India and now in Europe and the rest
of Asia as well. At the end of the fiscal, everyone was praying that the bottom
had reached.

While last year, everyone in the industry was talking ESOPs worth millions of
dollars and jumping from one salary hike to another, this year, pink slips were
more in fashion for many Indian IT professionals here as well as overseas. Led
by the dot-com debacle, IT companies have been cutting staff to remain
profitable. This is the case even in India where layoffs were relatively
uncommon.

While companies had been reporting over 100% growth in sales and profits,
quarterly profit warnings have now become the norm across the Indian IT
firmament. And for investors, of course, the news could not have been worse. The
frantic fund-raising activities of software companies also slowed down with a
number of companies deciding to stay away from the markets. At the same time,
the bigger companies continued to reach out to global capital markets by listing
their shares on the Nasdaq and NYSE. Satyam, Aptech and Silverline raised monies
from ADR issues and some of them also acquired companies that are increasingly
available at bargain prices. SSI, the most prolific acquirer took over four
companies–Inndsoft Systekh, Ablon Orion, 3rd Agenda and Indigo International–during
the year. Even mid-sized companies like Infotech Enterprises, Melstar and
Compudyne Winfosys made acquisitions. Given the high level of cash that some of
the majors like Wipro, Infosys and HCL Technologies have in their coffers, we
expect some major acquisitions from them as the market touches the bottom.
Indian entrepreneurs are still getting used to mergers and acquisitions. Among
the few domestic M&A that clicked, the notable ones were Ajax Software by
ICICI Infotech and Thermax Software by Global Tele Systems. As reality strikes,
there is bound to be some consolidation among mid-sized companies in the
domestic markets, leading to a mature IT sector in the coming years.

The domestic stock markets moved almost in tandem with the Nasdaq–the
barometer of the global technology sector, falling from the 5,000’s to 3,000’s
during the year, the downfall being led by the tech sector. Of the 54 IT
companies for whom stock data is available, the average fall has been over 70%
while DSI-10, which stood at 2,626 at the beginning of the year eased to just
837 losing over 68% reflecting the overall IT sector slowdown. While the Nasdaq
meltdown has contributed significantly to the slowdown, the role of the
speculators and market operators in the total investor disinterest in the
technology sector cannot be condoned. Like last year, a number of companies
converted themselves into software companies attracting investment from reputed
financial institutions. This worked towards image boosting and successfully
attracted retail investors.

The coming year brings a host of challenges as well as opportunities for the
IT sector and investors. Clearly, it is the top rung players who have maintained
their growth rates and investment. It has become imperative for investors to
verify the credentials of a company before they take the plunge. As the markets
touch the bottom, it is time to accumulate high quality IT stocks at bargain
prices.

The DQ analysis is based on latest audited data from 54 companies, with
collective revenues of Rs 14,703 crore. Certain companies that had a March 31
fiscal year end were unable to provide audited reports. Similarly, for companies
with year endings of June 30 and September 30, the data used pertains to the
previous year.

The authenticity of all data is assured by the fact that all the data is
audited. However, given the fact that the data pertains to different years–2000
and 2001–inter-company comparisons cannot be made nor does this data reflect
the current performance of the company. The analysis does not take into account
the associated or group companies as these are yet to be incorporated in
accounting figures under Indian laws. Therefore, companies like Mastek,
Silverline Technologies, HCL Technologies and NIIT that have a large proportion
of operations from subsidiaries would have been ranked differently. Moreover,
some companies restructured their operations during the year, which included
selling or hiving off a part of the business. The past performances of such
companies have been ignored, as that would have resulted in a different ranking.
Such companies include Sonata Software, PentaMedia Graphics and Mascot Systems.

Finally, numbers by themselves do not tell a complete story. Only a deeper
analysis of the company behind these numbers can provide an accurate picture.
Consequently, there are companies in these lists whose performances in the past
or even in the current year were excellent in terms of accounting numbers but do
not qualify for applause. These are, of course, the vagaries that any analysis
purely based on numbers can provide.

Sales

Sales is perhaps the most important criterion for determining the strength of
a company as we move into a polarized IT world where market share is supreme. A
proof of this polarization is that the top tne companies have almost 71% of the
total revenues, compared to 75% last year whereas the bottom ten constituted a
meager 1% of overall revenues. This dampening of polarization is also due to the
entry of companies that had just completed their initial public offers were able
to show significant sales during the year. Besides, few companies have changed
their ranking in a significant way over the previous period. This also
reiterates the importance of size in the IT sector.

Profits

While sales may be the most important factor in the market place, in terms of
meeting the objectives of the shareholders, profits are sacred. Here too, the
trend has been toward consolidation. The top 10 companies have provided 78%
contribution to the total net profits of the sample improving it from 76% last
year. At the same time, the bottom 10 contributed only 0.21% of the total
profits. The only hardware company to make it to the top 10 is Moser Baer.

Gross block

The Indian information sector has been a resource-starved sector and serious
investment in fixed assets such as infrastructure has been made only in recent
years. This too has largely been funded by retained profits.

More recently, some companies–most of them in software services–have
grown by tapping the capital markets in India and abroad. Six companies raised
funds through GDR and ADR issues. The level of investment by the bottom 10
companies was, however, limited to just 1% of the total, thus pointing to the
limited investments made by the smaller companies due to lack of funding.

Sales growth

Methodology

Finding one parameter to rank all companies of different sizes, ages
and segments is indeed a difficult task. Therefore, we have used a set of
static and dynamic parameters to define our concept of performance. These
include sales, profits after tax, gross fixed assets and return on capital
employed as our static criterion. Apart from this, non-static parameters
like growth in sales, profits and assets have also been used to rank the
companies.

To evaluate and rank a company’s performance based on all the
parameters, a final ranking is also presented. Starting with sales, most
of the figures reveal a high degree of skew. This meant that a few
companies at the top have very high profits and sales while a vast
majority have very low figures. When ranking such a sample, variance in
the data could make simple ranking difficult and even unfair. To avoid the
problems of simple ranking when the data is skewed, as is the case of IT
companies, we have used proportional ranking for the overall evaluation.

Consider that that the top ranking company in sales, got 100 points.
The following companies are given points in proportion to their sales
achievement against the first company. Thus a company, which may be second
in line but has only half the sales of the first company is given only 50
points. Consequently, companies who are at the bottom of the list would
get only very few points. This in overall terms gives importance to size
in ranking rather than just a position in the list.

All parameters were not equal in importance and equal ranking of
parameters may not have been the best choice. However, to avoid any
subjectivity in our rankings, we weighed all parameters equally.

Growth in scales is the key to survival and prosperity. A number of small
companies and those who had raised capital on the comeback trail figured at the
top. The average sales growth of the entire sample improved from 47% as compared
to 45% in the previous year. The top 10 players grew almost 120% over the
previous year showing their resilience despite a large base on which they have
shown this growth. The bottom 10 could only show 15% sales growth indicating the
slowdown has hit these companies severely.

Profit growth

The line-up of toppers in terms of growth in profits seems more or less a
repetition of the sales growth list as profits seem clearly linked to sales
growth. Here too, the companies that are making an entry into the IT sector or
are on the comeback trail reach the top of the lists. The average jump in net
profit was 91% compared to 84% in the previous year. The growth of the top 10
companies in this list is 240% against a 63% decline of the bottom 10. Future
profit growth is a major factor in determining the investment attractiveness of
a stock. Even past profit growth is a good indicator of a company’s likely
performance as many companies are able to show similar profit growth over a
period of time. However, sharp profit growth could indicate a discrepancy in
accounting or some large inflows that may not recur in future.

Gross block growth

Gross block growth is based on the increase of gross fixed assets of a
company. Some of the mid-sized companies had a good gross block growth, and they
can well attempt to enter the big league. The assets of the top 10 grew by 141%
as against 39% of the bottom 10. This is reflective of the vast disparities in
asset acquisition by companies. Investment in assets will see some of these
companies register healthy sales and profit growths over the next few years.
This applies to software companies as well. Moreover, only companies with
well-equipped and state-of-the-art facilities would be able to get business at
the price that they want. The average gross block growth during the year was 57%
as compared to 56% in the previous year.

ROCE

Return on capital employed (ROCE) is perhaps the best measure of a company’s
efficient operations and a clear indicator of how its bottolline performance
actually is. ROCE comprises the operating profits of a company divided by the
total capital employed in a company. This is the sum of shareholders’ funds
and loans. From this total, intangible assets such as prior year losses,
patents, capitalized expenses are deducted. ROCE is a measure of how efficiently
a company operates both in terms of its margins as well as usage of capital. In
a sector where finance has been a problem, a high ROCE is a good indicator of a
company’s performance. Apart from Wipro, most in the Top 10 rankings are older
and established as compared to last year, which saw far younger companies
leading the band. Notably, average ROCE declined from 31% last year to 30%,
which indicated two things. One, a number of companies had made substantial
investments, which are yet to yield results in terms of profits and two, the
general slowdown of the sector.

Conclusion

The winners are clearly the ones who not only have high investments in fixed
assets but also those who have sizable sales and profits. These companies placed
a high premium on growth and yet were efficient users of capital. Further, this
year, the results also reflected the resilience of top players who continued to
show high growth rates despite the slowdown in the sector. Some of the companies
at the top are ones that are relatively new entrants and yet show excellent
growth. While in some of the cases this growth may not be sustainable in the
future, we can be sure of some industry leaders in this set.

Financial Database 

All financial analyses have been carried out by Sushanto
Mitra
of Technology Capital Partners

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