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Digital: Parental blues

Oct 1, 2002

In FY02, the software sector clocked a subdued 22% growth. However, Digital closed the fiscal with a steep 79% growth in topline. This was due to the strong growth in revenues (73%) from its parent Compaq (now new HP). However, with the merger for Compaq and HP, what was one of the biggest strength for Digital, became one of the biggest concerns. While the merger created a US$ 87 bn giant parent (compared to US$ 47 bn Compaq), the apprehensions stemmed from the fact that HP already had a 100% subsidiary in the country, HP India. To list a few of the concerns, will the parent want two subsidiaries in a country? What if the two entities are merged? Will the merger ratio in case of a merger be favourable to minority stakeholders?

But Digitalís management has taken a more optimistic stand on the course of events. The management feels that it has a now a larger parent to get business from. Infact, it has already started getting business from the parentís clients and leveraging on new HPís sales force. The apprehensions regarding the merger were strengthened as Digital saw the weakest growth in revenues from its parent in 1QFY03. The revenues from new HP that account for 83% of the companyís revenues grew by 1% sequentially (QoQ). This was immediately after the merger. Digitalís counter to this is that the lower growth in revenues from the parent is due to the fact the things are in a state of flux as the two companies are sorting out merger related issues.

However, going by what the management has indicated a lot could be expected from the company since this allays fears regarding loss of business from HP in the future. When it comes to positives, Digital has quite a few. Firstly, the companyís past performance. It has swiftly managed to transition from a hardware company to an IT services company, almost without any glitches. The second strong investment argument in favour of the company is its portfolio of offerings. Digital has a well-diversified revenue stream that spans across development, migration, re-engineering, IT-infrastructure services, implementation services and systems engineering. The company has also forayed into the call centre business. Finally, the company has been aggressively looking to de-risk its revenue concentration from its parent. Infact, the non-Compaq revenues grew by 138% in FY02. In 1QFY03, the company added 28 new clients (excluding 20 annual maintenance contracts that the company bagged).

At the current market price of Rs 552, the stock is trading at a P/E multiple of 17x its FY03 estimated earnings. The uncertainty regarding the future prospects will continue to depress the valuations in the near future. However, the company has proved itself and performed excellently in the past. Therefore, if the impact of the merger is positive, then the stock could see a significant improvement in valuations. However, the element of risk is significant.

We have recently updated our research report on Digital. The investment arguments and concerns are discussed more elaborately in the report and are supported by three-year forward financials. (Read Digitalís research report)

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