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Digital: Raring to go - Views on News from Equitymaster
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  • Jan 19, 2002

    Digital: Raring to go

    Digital Globalsoft Ltd. erstwhile Digital Equipment India Ltd. (DEIL), is a 51% subsidiary of Compaq. The company has successfully restructured itself from a hardware to an IT services company. The break neck speed at which the company has transitioned from selling services instead of hardware reflects a very capable management team at the helm.

    For FY02, the company is set to post a 70% plus growth rate in topline, a number that would make all software heavyweights green with envy. The sector itself is expected to grow at a more sober rate of 25% according to our estimates. Many would point to a growth on a lower base but the rebuttal is that it is the second rung software companies that have been the worst hit in wake of the slowdown in demand. For example Mphasis BFL that has revenues almost equal to Digital will most likely post a marginal decline in revenues for FY02.

    What makes this company so special? Firstly, its parentage. Being a subsidiary of Compaq, the company earns a significant amount of revenues (85% in 3QFY02) from services that it performs for the parent. The hardware giant, Compaq (revenues of US$ 33 bn in CY01), plans to increase the contribution from services to 33% of turnover in a span of three to four years from 20% currently. This would be a very big opportunity for Digital as it gets 70% of the work that is outsourced by Compaq from India. Compaq also outsources to other companies, which include Mphasis, TCS, and Wipro.

    Service offerings 2QFY02 3QFY02  
      % of revenues Rs m % of revenues Rs m Change
    eApplications 44.0% 384 42.0% 366 -4.7%
    Systems Engineering 18.0% 157 20.0% 179 13.9%
    Enterprise Solutions 22.0% 192 23.0% 197 2.6%
    eInfrastructure 11.0% 96 12.0% 106 10.4%
    Telecom 4.0% 35 2.0% 16 -54.2%
    Advanced Technology Group (ATG) 1.0% 9 1.0% 5 -42.7%
    Total   873   869  

    Compaq is the largest manufacturer of web servers. In FY01, the company shipped more than 1 million servers, giving it 27% market share worldwide. A large part of the services require getting these services up and running is outsourced to Digital as one of the company’s core capabilities is application re-engineering and migration. This is a big positive as large numbers of corporates still have software solutions running on platforms that are now considered to be ‘legacy’ systems.

    Digital’s expertise in Compaq platforms like OpenVMS and Tru64UNIX, gives it an edge over others. Thus, Digital has a two-fold advantage. Firstly, it is the preferred service provider and secondly, it has more experience in these areas compared to its competitors. Consequently, e-application is the largest revenues stream for the company. In 3QFY02, the contribution of this revenue stream was 42% to the total revenues. The e-applications service portfolio also includes application development and integration, and application management.

    The division is likely to see strong growth from areas likes integration and migration. For the last two quarters (2QFY02 and 3QFY02) Indian IT services companies have seen steep growth in revenues from these service offerings. This is due to the fact that being primarily offshore-driven, these services can be availed at very competitive rates. Thus, gives the client a high ROI as these services eventually benefit in terms of opportunity to lower costs and enhance productivity. Further, the trend towards consolidation of technologies (for example migration from VMS and VAX to Alpha servers) provides growth opportunities.

    The e-Infrastructure business unit (12% of revenues in 3QFY02) focuses on opportunities in outsourced IT-based business process solutions. The solution offerings include a wide range of Microsoft products, high-end technical support centres, enterprise management solutions, security solutions and high-end SAP solutions. Digital has been awarded ‘Single Global Infrastructure Implementation Partner’ status by Unilever.

    The offshore delivery partner agreement with Unilever has provided depth to the partnership. The company feels that there is a strong possibility that the size of this relationship will expand further. Increasingly large corporates in the west are working with a fewer vendors. Corporates initially offer a small pilot project to the vendor and on successful completion the project size is ramped up. This has been the case with Digital.

    Following the successful completion of the pilot project, the Digital team is now engaged on Unilever sites at locations in US and Europe. There is also an offshore component to the project. Services are being offered from offshore facilities in Bangalore. The business unit also bagged an order for global Windows 2000 deployment for a Fortune 500 company in the entertainment sector. Its services also include application packaging for automated desktop deployment for large enterprises. The division has commissioned an application services and packaging factory for a Compaq’s Operations Management Center in Europe.

    Digital is actively pursing a strategy to generate revenues from products as operating margins from the products business are comparatively much higher as compared to services. The company has adopted a very smart strategy of buying out existing products, upgrading them and reselling them. As of now the company has avoided creating products on its own.

    Digital in 1QFY02 purchased an electronic data interchange (EDI) product from Compaq along with its intellectual property rights (IPR). Digital plans to improvise this product based on the latest technologies like XML. It will continue to provide support to existing clients of the product, which includes Ericsson, Boeing, ABB, Phillips and Lego. This will also give Digital access to such large companies for marketing its service portfolio.

    In 3QFY02, the company acquired another product, a document management product from Compaq. This acquisition of ‘Compaq Archive’ was for a consideration of US$ 2.5 m (Rs 120 m). The product is an electronic information lifecycle management solution for managing storage and retrieval of critical information. Digital has acquired an existing product and now will invest in enhancing the existing product. The company will also provide services to integrate the products with the customers existing systems (like SAP R/3) in place. The other groupware the software can be integrated with are Microsoft Exchange, Lotus Domino and Documentum.

    Particular Wipro Infosys Satyam HCL Technologies Hughes Software Digital GlobaSoft
    RONW 34.0% 45.3% 59.8% 25.0% 31.4% 37.4%
    ROA 26.2% 36.8% 42.4% 23.6% 23.8% 28.4%
    ROIC 33.6% 45.3% 52.9% 25.0% 31.4% 37.5%
    Working capital to sales 40.7% 42.0% 42.0% 81.7% 62.6% 58.2%
    Current ratio (x) 3.3 3.5 4.2 6.7 3.0 3.3
    Debtor days (days) 73.0 58.1 112.3 100.7 95.4 67.4
    OPM 26.2% 40.2% 36.5% 50.7% 36.3% 27.2%
    Revenues per employee (Rs) 1,998,229 1,933,238 1,498,569 2,331,829 1,318,061 1,551,040
    Cost per employee (Rs) 424,696 730,122 288,466 459,400 389,104 563,400

    Not only does Digital have strong growth prospects, its financials are comparable to the best in the industry. However, the concern with the company is that its client concentration is very high and any unpleasantness in the relationship with Compaq could severely impact the company’s valuations. Perhaps this is the reason that Digital trades at a very subdued P/E multiple compared to its performance. At the current market price of Rs 579, the stock is trading at a P/E multiple of 21x its 9m FY02 annualised earnings. We expect the earnings to grow at a CAGR of 35% in the future. This translates to a PEG ratio of 0.6x. Thus, the valuation certainly looks very attractive over a three-year time frame.



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