OVERVIEW: Tech Shining

Thanks to Indian IT’s growth story, India is now better known for its
techies and call agents rather than its elephants and snake charmers. The credit
for this must go not only to the entrepreneurs who were quick to spot this
opportunity but also to the government that, for once, let go of its control
mania to allow the sector to grow unfettered. However, now as the sector has
matured, the challenges for the entrepreneur are greater, and while the
opportunity for growth still remains, the areas such as software development
services and BPO services are now quite crowded, with little space for new
businesses to emerge.

With the maturity, the excitement of the early years has been replaced by
quiet growth and consolidation. So in the middle years, there are no dramatic
happenings, but the major players have all been building strengths in different
verticals so as to complete their services portfolio and move up the food chain.
The big three, having accomplished the billion dollar turnover milestone, are
now working hard to reach the next target-of getting the $100 mn accounts.
This they hope to accomplish through a series of acquisitions, overseas delivery
centers, entering new geographies, and aggressive recruitment. Out of the
limelight, but growing stronger, nevertheless, are the niche players-some of
them in the product areas have spent the last couple of years in investing into
IPR development, marketing and distribution, as well as some acquisitions. We
believe that some of the headline news is going to come from these product
companies as they begin to generate interest for their offerings from global
corporations and leapfrog into the big league. The middle rung companies
continue to look at survival rather than growth, trying hard to maintain margins
in an increasingly harder business situation.


On Capital Employed
Block Growth

The early part of the year saw the much-awaited TCS IPO, as well as that from
Datamatics, joining the ranks of listed companies after many years of
operations. There were no other major IT-related IPOs due to the uncertain
political situation and a flurry of IPOs from other emerging sectors. The other
major corporate activity was in the area of M&As where one saw reasonable
number of transactions. Among the biggies, Technologies BPO Service Limited,
Northern Ireland, a joint venture with HCL Tech and British Telecom, acquired
the assets of the AnswerCall Direct Contact Centre in Northern Ireland in a deal
worth Rs 29.4 crore. A number of BPO companies are now setting up centers nearer
to their clients to increase the number of outsourced processes and have greater
stickiness to clients. Mumbai-based Patni, which had come out with an IPO in
2004, also acquired a US-based IT services company, Cymbal Corporation, for $68
mn to enter the telecommunications segment. i-flex Solutions, the banking
product company, acquired Equinox Corporation, a provider of BPO services to
mortgage institutions, auto financers and credit card companies. It also
acquired Login, a French provider of front and middle office treasury software.

Following in the footsteps of the Big Brothers, the mid-cap companies also
took up the inorganic route of expansion by acquiring companies domestically as
well as internationally. Pune-based Aztec completed the acquisition of Disha
Technologies India by paying $12.1 mn. Flextronics acquired Bangalore-based
telecom technology company, Deccanet Design, which provides design services in
telecom infrastructure and mobile handhelds.

Helios & Matheson acquired US-based Maruthi Info Tech Incorporated and
Jayamaruthi Software for a cumulative amount of $7.5 mn to augment the
development of strong overseas marketing infrastructure and expanding the client

They Ranked
Rank 2004-05 2003-04
1 TCS Infosys
2 Infosys Wipro
3 Wipro HCL
4 Aztec Moser
5 Moser
6 Satyam Patni
10 Cranes
11 Tata
12 Hexaware
13 Geometric
14 Geodesic HCL
15 Flextronics
16 i-flex
17 Subex
18 Patni Polaris
19 Infotech
20 Nucleus Tata
21 Jetking
22 Sonata
23 Rolta Blue
Star Infotech
24 Hinduja
25 iGate
27 Zenith
28 KLG
29 Helios
30 RS
The IT Stocks Moved

IT stocks rocked in FY 2004-05. While the BSE Sensex
grew by 15%, the BSE TecK raced ahead with a 45% jump.
No point comparing the other tech index, Nasdaq, which grew by a
marginal 4% only

In the BPO sector, Hinduja Group’s HTMT acquired 100% of US based Source
One Communications for $8.5 mn, from its holding company. The company had also
acquired C3, a Philippines-based call center, and is enroute to reaching a
critical mass in this sector. There were other acquisitions in the BPO space but
outside the listed space. In a small but trend setting transaction, the telecom
software product company, Subex Systems, acquired certain assets and liabilities
related to the Fraud Centurion product from Lightbridge, a leading value-added
transaction processing company. This acquisition helped Subex add 14 new clients
in the fraud management solutions domain.

The overall trend in M&As is clearly that companies are acquiring targets
for a specific advantage in terms of customers, domain, or geography. H ence
companies are looking at M&A as a route for growth in a very particular
direction rather than a means of growing turnover. This is certainly a
refinement of the strategy seen in the early phase of M&As by Indian
companies. We believe that this trend will continue and Indian companies will be
constantly scanning the environment for acquisition targets in the US and
Europe, to further improve their front-end marketing resources as well as
enhance their service offerings.

Apart from M&As, companies also formed JVs and alliances to strengthen
their positions in the market place. The Big Three were fairly active in this
area, tying up with software product vendors and systems integrators to reach
out to a larger number of clients. As the Indian software services sector grows
in size and starts delivery of strategic consulting services as well, a number
of software product majors will be looking at tie-ups with Indian software
companies for product implementation and consulting services. This trend is
likely to continue as Indian companies become the center point for third-party
software development, and other industry players would want to align with them
for getting closer to their clients.

We Ranked Them
one metric to measure the performance of all companies of different
sizes, ages, and segments is indeed an impossible task. We have used
a set of static and dynamic parameters to determine the overall
rankings. These include sales, profits after tax, gross fixed
assets, and return on capital employed. Growth in sales, profits,
and assets of a company that are dynamic in nature have also been
used to rank the companies.

Starting with sales, most of the
figures reveal a high degree of skew. This means 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 makes 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, proportional ranking has been used for this

This implies that the top ranking
company in any parameter, say sales, gets 100 points and 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 one is given
only 50 points. Companies which are at the bottom of the list would
thus get only very few points. This, in overall terms, gives
importance to size in ranking rather than just a position in the

All parameters are necessarily 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 chose to give equal weightage to all the parameters.

The continuance of improving fortunes of the global technology sector and
bullish conditions in the Indian bourses saw the BSE TecK index moving faster
than the NASDAQ and BSE Sensex.

On a y-o-y basis, the total market capitalization of the 71 companies
analyzed saw an increase of 118%. Among these, the Top 10 companies, in terms of
market capitalization, as on 31st March 2005, saw a rise of 126% over the
previous year, and the Bottom 10 companies saw a rise of 69% in the same period.
To reflect on the consolidation taking place in the Indian technology sector the
Top 10 market capitalized companies formed 92% share of the total market
capitalization of the 71 companies. The increasing consolidation in the services
sector, however, does not reflect the growth of a few niche product companies,
some of whom could very well leapfrog into the big league in the next couple of

Our analysis has been made using a sample of 71 companies, which together had
revenues of Rs 50,968.3 crore. The data used for this study was strictly based
on the latest audited figures available from the companies. In some cases, where
the results of a few companies whose fiscal year ended on March 31, 2005 were
not available, the previous year’s figures were used. Similarly, companies
whose year ending is 30th June, 30th September, and 31st December, the data used
pertains to the previous year.

data used for this study was strictly based on the latest audited
figures available from the companies.

While we are by and large satisfied with the rankings that in some ways also
reflect the changing fortunes of the individual companies, numbers often do not
reflect the whole truth and, therefore, there could be some aberrations.

How they performed
A look at how the listed companies performed on various parameters:

Sales: Fiscal 2005 saw large IT companies ramping up sales, while
their smaller cousins were still struggling to find their feet. Within the
group, the share of Top 10 companies continued to improve, from 73% of total
revenues to 78% of total revenues, of the sample. Very few companies have been
able to change their rankings in a significant way over the previous period,
reflecting the maturity of the sector and the vendor consolidation being carried
out by the global corporations.

Profits: Like sales, the Top 10 companies’ share in the overall
profits has improved from 86% to 90% of the total net profits of the sample. In
case of the rest of the sample size, profit share has decreased from 14% to 10%.
The fact that the profits are increasingly skewed clearly indicates that despite
the upturn in demand the fortunes of the second and third rung companies has not
really undergone any changes from the times of the tech meltdown.

Gross Block: The Top 10 companies’ decreased their share of gross
block to 64%, from 77.5%, whereas the rest of the companies, as per the sample,
increased their share from 22.5% to 36%. This reflects that the investments made
in infrastructure, by the top companies, in the last couple of years, allowed
them to expand capacity without adding fixed assets, while the smaller companies
are only now investing in capacity build-up.

Sales Growth: Growth in the sector came back with a bang. The Top 10
companies have improved their growth rate and have grown 44% over their previous
year’s sales. On the other hand, the rest of the sample size, in terms of
turnover size, have also witnessed 18% growth in sales, reflecting the growing
divide among the fortunes of top and bottom companies. We believe that this
trend is going to continue and is especially true for the software services

Profit Growth: The net profit of the sample grew by 52%, reflecting
the improving fortunes of the sector led by growing demand and improving scales
of economy. The Top 10 companies managed to grow by 46%, along with the rest of
the sample size reporting 130% profit growth. The lower profit growth of the top
rankers probably reflects the fact that recovery happened earlier for the big
companies while the smaller ones saw a major improvement in fortunes only this
fiscal, after the meltdown.

Gross Block Growth: Gross block growth is based on the increase of
gross fixed assets for a company. The year witnessed equated growth in gross
block among all the companies, led by the Top 10. The average growth in the
gross block stood at 27%, with the Top 10 companies growing by 33%, and the rest
of the sample, in terms of the gross block, growing by 12%. This is another
indicator of the fact that the smaller companies are unable to generate
resources to invest into infrastructure and, in an era of increasing order
sizes, are getting left out of the outsourcing party that their bigger rivals
are enjoying.

ROCE: Return on capital employed (ROCE) is perhaps the best measure of
a company’s efficient operations both in the utilization of resources as well
as profitability. ROCE is defined as operating profits of a company divided by
the total capital employed in a company. This is the sum of shareholder funds
and loans. From this total, intangible assets such as prior year losses,
goodwill, patents, and 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 is no longer a problem, a high ROCE is a
good indicator of a company’s ability to make efficient use of capital.
Notably, average ROCE increased from 30.05% last year to 32.18%, which indicated
that a number of companies that have made substantial investments are starting
to yield results slowly. The ROCE of the Top 10 companies declined from 60.03%
to 50.95%, whereas the rest of the sample grew from 15.86% to 18.72%.

Where do we go from here
With the markets in the software services as well as BPO services getting
largely controlled by the Big Three and a few of the other majors, the days of
the small and medium software companies would seem to be limited. While this may
be true for most companies, we believe that it is here that the skills of an
entrepreneur come into the fore, one who can convert a bleak situation into an
opportunity. Most small and medium software services companies are trying hard
to become bigger in size by taking on larger clients. Going forward, it will be
the level of domain knowledge, ability to create IPR and value-added services
that will determine the success of the mid market companies rather than the
increases in turnover. Those who are unable to make this crossing could be wise
to look at being acquired by larger entities or by getting their clients to
invest into their companies so as to establish long-term relationship, thereby
reducing marketing costs.

The smaller companies that have gone into the product development domain have
also successfully shown the path to prosperity by leveraging their cost
competitive development skills to seek out niche markets where there is limited
competition. For these companies, raising additional capital and increasing
revenues would be key as they invest heavily into marketing infrastructure and

From an investment perspective, we continue to believe that the Indian IT
sector offers an excellent investment avenue for retail investors. Apart from
the big three where there is scope for considerable appreciation in the medium
term, there are a few diamonds among the product companies that could provide
handsome returns to investors as the markets continue to remain in the positive
zone. There are likely to be some IPO offerings from both BPO and software
services companies that can be subscribed. However, caution must be exercised
while investing into IPOs of small and middle rung companies which we believe
continue to remain prone to margin pressure and slow revenue growth. These
stocks may go up in the initial period, soon after the IPO, but are unlikely to
continue their rise over a significant period of time. Also, the liquidity in
these small cap stocks is low and it may not be always possible to exit from
them in the stock markets. Investors would be well advised to exit a major
portion of their investments in such companies soon after their listing.

Sushanto Mitra The
author is the founder of Technology Capital Partners

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