Digital: The going gets tough? - Views on News from Equitymaster

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Digital: The going gets tough?

Mar 30, 2001

Digital has been one of the growth engines that the IT sector in India has been riding high on. It was uniquely poised when it entered the software arena. It has been in the hardware business for quite sometime and was recognized as a very strong brand in the markets. Due to this very reason the company did not change its logo when it changed its business.

Digital: Growth engine
  1QFY01 2QFY01 3QFY01
Revenue (growth QoQ) 54.6% 41.4% 30.0%
Operating margins 16.40% 25.10% 35.40%
Net margins 20.20% 33.20% 31.50%
EPS (growth QoQ) 257.2% 131.0% 23.8%

So when the company entered the new business so closely related to its previous area of interest the company not only inherited a strong brand name but also a strong knowledge about the market in terms of requirements and clients. Compaq was the major source of its income and continues to be so with more than 85% of the business coming from Compaq.

With a brilliant team at the helm the company started to grow fast leveraging on its relationship with Compaq. The company acquired new clients and has been looking at decreasing it dependence on Compaq by acquiring new customers. The sequential growth for Non-Compaq business revenues for the 3QFY01 was 66% compared to the growth in Compaq revenues, which was 26%.

On March 15, 2001, Compaq lowered its earnings outlook for the first quarter of FY2001 to US$ 0.12 from US$ 0.14 per share, essentially flat with the first fiscal quarter of FY2000. The company was affected due the tightening of tech spending by the companies in the US. Compaq’s revenues for the FY01 were US $ 42 bn (Rs 1,953 bn). Therefore, the business that it gives to Digital is not even 0.1% of its revenues. Digital is implementing supplying chain management solutions for Compaq in the US and SAP in Europe. The areas would no doubt help Compaq to reduce costs and improve operating margins. Therefore, the probability of Compaq cutting down on these businesses seems to be quite low.

Certain sections of the press have reported that Digital is seeing elongation in sales cycles. However, the company has managed to sustain the momentum in client additions. Also the concerns expressed include the Canadian hi-tech giant Nortel Networks Corp, being one of the top clients of Digital. The size of business that Nortel out sources to Digital is miniscule compared to Nortel’s size.

This news seems to be bad enough for the apprehensive to press the panic button. But as always the tough times will separate the boys from the men. In a scenario where companies that are clients to Digital are facing prospects of lower revenues, elongation of its sales cycle is a natural consequence. The prospective and existing clients would also take a hard look at the work being done before spending precious dollars on IT projects. Therefore, those companies that can present a value proposition will have a piece of the shirking pie. Is Digital up to it? At least it seems to have managed more clients in the bleak environment and that could be an indication of things to come.

At a current market price of Rs 447, the stock is trading at a P/E multiple of 22 times its 3QFY01 annualised earnings.

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