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Digital: Topline driving growth

May 13, 2003

Digital Globalsoft, one of the leading software services companies in the country has reported a healthy growth in topline for FY03, however bottomline growth has been restricted due to falling margins. The company has reported a 27% growth in topline for FY03 while bottomline has grown at a lower 14%. For 4QFY03 topline growth has been 10% on a sequential basis while bottomline growth has been 11%. But in the March quarter too pressure on operating margins are apparent. For FY03 operating margins of the company have fallen by 270 basis points.

(Rs m) 3QFY03 4QFY03 Growth FY02 FY03 Growth
Net Sales 1,100 1,215 10.4% 3,317 4,224 27.4%
Other Income 33 57 69.8% 136 175 29.3%
Expenditure 759 886 16.7% 2,256 2,985 32.3%
Operating Profit (EBDIT) 341 329 -3.6% 1,061 1,240 16.9%
Operating Profit Margin (%) 31.0% 27.1% 32.0% 29.3%
Interest 1 1 1 2
Depreciation 70 56 -19.9% 157 258 64.3%
Profit before Tax 304 329 8.3% 1,038 1,155 11.2%
Extraordinary items 0 0 0 0
Tax 34 29 -16.2% 112 95 -15.0%
Profit after Tax/(Loss) 270 300 11.4% 927 1,060 14.4%
Net profit margin (%) 24.5% 24.7% 27.9% 25.1%
No. of Shares 34.2 33.0 32.7 33.2
Diluted Earnings per share* 31.6 36.4 28.3 31.9
P/E Ratio 14.0 16.0
(* annualised)

Digital's FY03 performance has been mainly led by strong growth in topline. Topline growth in turn has been mainly achieved by the growth seen in the company's non HP client business. While business from HP has grown by 19%, that from non HP clients has recorded a 72% growth in FY03. With this the company's objective to de-risk its revenues from parent HP (post demerger) is slowly showing results. De-risking has led to lower dependence on parent HP. Revenue contribution from HP and HP billed external customers now forms 79% of total revenues compared to 85% last year. During the quarter the company added of 21 new customers. Of these, 15 were for its services and 6 were for the products business.

Rs m) 3QFY03 4QFY03 Change FY02 FY03 Change
HP 786 71.5% 873 71.9% 11.1% 2,811 84.7% 3,058 72.4% 8.8%
HP external 70 6.4% 65 5.3% -7.1% 0 0.0% 298 7.1%
Total HP related 856 77.8% 938 77.2% 9.6% 2,811 84.7% 3,356 79.5% 19.4%
Non-HP 244 22.2% 277 22.8% 13.5% 506 15.3% 868 20.5% 71.5%
Total revenues 1,100 100.0% 1,215 100.0% 10.5% 3,317 100.0% 4,224 100.0% 27.3%

Among service offerings, the company has reported significant growth in revenues from its two largest offerings of e- Application and Enterprise Solutions. Due to the strong growth in the Enterprise Solutions business, its contribution to total revenues has increased from 23% to 26%. Contribution of the other two large divisions (e- Application and System Engineering) have fallen in FY03. This is in line the trend seen for the sector as a whole. Infact, software companies that have traditionally focused on the technology domain (like Wipro and HCL Technologies) have also changed their focus to tap the opportunity arising from the enterprise solutions segment. A large part of the Digitalís revenues under this services segment comes from implementation of comprehensive solutions like ERP (enterprise resource planning) and CRM (customer relationship management) systems.

Service offerings 3QFY03 4QFY03 FY02 FY03
Rs m % of
revenues
Rs m % of
revenues
Change Rs m % of
revenues
Rs m % of
revenues
Change
eApplications 452 41.1% 478 39.3% 5.8% 1,387 41.8% 1,702 40.3% 22.7%
Systems Engineering 174 15.8% 172 14.2% -1.1% 663 20.0% 711 16.8% 7.2%
Enterprise Solutions 293 26.6% 338 27.8% 15.4% 765 23.1% 1090 25.8% 42.5%
eInfrastructure 115 10.5% 125 10.3% 8.7% 379 11.4% 448 10.6% 18.2%
Telecom 29 2.6% 32 2.6% 10.3% 91 2.7% 111 2.6% 22.0%
ATG & TSCC* 23 2.1% 56 4.6% 143.5% 15 0.5% 103 2.4% 586.7%
Products 14 1.3% 14 1.2% 0.0% 17 0.5% 59 1.4% 247.1%
Total 1,100 100.0% 1,215 100.0% 10.5% 3,317 100.0% 4,224 100.0% 27.3%

While the company has seen significant growth in topline due to increased volumes, mainly due to increased offshoring, operating margins have suffered. This may have been mainly due to falling realisations. Also the company has aggressively expanded its manpower in order to cater to the demand it is expecting going forward. This has put further pressure on margins. To put things in perspective, employee costs (50% of sales) have grown by 39% in FY03. Digital's offshoring business has grown in FY03 and now contributes 36% to total revenues compared to 32% in FY02.

Digital has been successful in its endeavour to de-risk its business, but its fate still hangs in balance post the merger. One of our concerns regarding the impact of the HP-Compaq merger was its effect on Digitalís Systems Engineering services. Digitalís expertise in erstwhile Compaq platforms like OpenVMS Tru64, UNIX and Itanium gave it an edge over others. However, with the merger of HP and Compaq there has been a rationalization in areas where there are similar offerings by HP and Compaq. However, the company is also looking at developing new competencies in this domain. This includes HPís Office Server Suite and VMS-based Advanced Server Systems. Having said that we must also point out that due to the merger Digital is placed well to capture a potentially large source of revenues in the form of its parent HP-Compaq.

At the current market price of Rs 510, the stock trades at a P/E multiple of 16x its FY03 earnings. Considering the fact that the company may now be able to tap business from a larger parent, the growth potential is immense. However, investors must keep in mind that a key concern is the future status of Digital. There are concerns that it might be merged with HPís India subsidiary. Also the stock has been prone to speculation in the recent past due to this uncertainty, thus investors may want to look carefully at the risk return proposition of the stock.


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