Persistent Systems (India) IPO Analysis

Focused on outsourced software product development services

The company has good track record, except for the past few quarters, and holds good growth potential

Persistent Systems (India), promoted by technocrat, Dr Anand Deshpande, is one of the leading players in outsourced software product development services. The company designs, develops and maintains software systems and solutions, creates new applications and enhance the functionality of its customers' existing software products. Currently, the company is present in the telecom & wireless, life sciences & healthcare and infrastructure & systems space. It has been working on new technologies like cloud computing, analytics, enterprise mobility and enterprise collaboration. Along with services, the company has been acquiring intellectual property (IP) from its customers, sharing revenue with the clients. Currently, this stream contributes to about 7% of the revenue.

As of December 31, 2009, the company had added 251 new customers (net) since April 1, 2007, excluding one-time customers for license sales with a number of active clients at 270 clients. Top client contributed 9.98% and top 10 clients contributed 41.27% of the revenue for the nine months ended December 2009. The repeat business for the company is in and around the 90% levels.

The company had 4,639 employees as of January 2010. It added 430 employees (net) in FY 2010 till January 2010. The company is operating at high offshore levels. The offshore share of revenue is at 89.63% for the quarter ended December 2009 and was at 85.79% for the year ended March 2009. Time & material (T&M) contracts contribute 76% of the revenue, fixed price contributed 17.1%, and licensing products 7% for the nine months ended December 2009. For the year ended March 2009, T&M contracts contributed 80.5% of the revenue, fixed price 14.3%, and licensing products 5.2%.

Geographically, for the nine months ended December 2009, US & Canada contributed 84% of the revenue of the company, Europe contributed 9%, and Asia Pacific (APAC) contributed 7% of revenue. For the year ended March 2009, US & Canada accounted for 87% of the revenue of the company, Europe contributed 9%, and Asia Pacific (APAC) contributed 4%.

As far as industry verticals are concerned, a major portion of the revenue accrues from independent software vendors (ISVs), which contributed 47% of the revenue, telecom contributed 24%, and practices, enterprise & solutions contributed 29% for the nine months ended December 2009.

The issue includes offer for sale of about 12.81 lakh shares by former employees of the company. Of the net proceeds of the issue, about Rs 76.02 crore would be used towards expansion of existing facilities at Nagpur and Hinjewadi, Pune, taking the total capacity at the two locations to 4,200 seats; about Rs 2.96 crore would be used towards fit-outs at the premises leased in SEZ at Hyderabad; and Rs 20.45 crore towards hardware at facilities. Post commissioning, the company would have a seat capacity of about 7,500 seats. It has facilities at Nagpur, Pune, Goa and Hyderabad.

Strengths

* International Data Corporation (IDC), a market research and analysis firm specializing in information technology, telecommunications and consumer technology markets, forecasts a five-year compound annual growth rate (CAGR) of 14% for research & development/ product engineering (R&D/PE) services, reaching an estimated US$ 65.7 billion by 2013. IDC defines R&D/PE services as the taking over of the R&D of a product in the company's value chain (in part or full) by a third-party services organization.

* Revenues have grown at a fast clip except in the nine months ended December 2009. Revenues reported a compounded annual growth rate (CAGR) of 40% in rupee terms and 38% in US dollar terms for the period FY2006 – 2009. Impacted by the slowdown, the revenues for the nine months period ended December 2009 were down 8.5% in US dollar terms and 3.4% in rupee terms.

* Along with services, the company, with expertise in developing products, is looking at growing its IP. It has been acquiring IP from its clientele and investing in them and selling on a revenue share basis. The share of revenue from IP licensing increased from 1.5% in FY2007 to 7% for the nine months ended December 2009. The margins from this segment are higher than services margins.

Weaknesses

* With the sunset clause expiring on March 31, 2011, the tax rate applicable for the company would increase to 20%– 25%, up from the current 6.5%. It would be at 9% for FY2010 and FY2011, and would move up to 20-25% post expiry of the sunset clause in FY2012. The capital expenditure that the company has undertaken is not in SEZ, except for about Rs 2.96 crore at the Hyderabad facility, currently a 200-seater expandable to 1,000 seats. This would still be only about 20% of the business.

* The outsourced product development (OPD) market is very competitive. Competition comes from OPD centric players, divisions of large IT companies (Indian & multinational), offshore providers in other low cost countries. Of the various IT services, the OPD services are highly prone to reduction in spend as companies cut down on launch of new products in times of economic slowdown.

Valuation

For the nine months ended December 2009, the company reported a dip in revenues of 8.5% in US dollar terms to US$ 89.98 million and 3.4% in rupee terms to Rs 429.41 crore mainly due to slowdown in the global economy. As per the management, the second half of FY2009 and the first half of FY2010 saw the impact of global economic slowdown and cut in billing rates. However, for the quarter ended December 2009, the company reported very good numbers, with sales of Rs 158.36 crore, operating profit margin of 24.7%, and net profit of Rs 37.01 crore (46% of the nine months net profit).

For FY2009, the company reported forex loss of Rs 87.40 crore, which included MTM losses on hedges of Rs 16.27 crore, forex loss on cancellation of forward contracts of Rs 25.87 crore, and forex loss from lower realisation of Rs 45.26 crore. The company has changed its hedging policy and is now taking hedges of about 40-60% of the net receivables for 12 months forward. It has hedges of US$ 77.75 million at Rs 48.5/US$.

At the price band of Rs 290 – Rs 310 and consolidated TTM EPS of Rs 24.7, PE works out to 11.7 – 12.6 times. Excluding MTM losses and forex loss on cancellation of forward contracts of Rs 18.87 crore, the consolidated TTM EPS moves up to Rs 29.4 and PE works out to 9.9 – 10.5 times. There is no direct comparable company. But Mindtree, which has 45% of revenue contribution from product engineering services, is trading at TTM PE of 12.2 times. Geometric, which has 37% of its revenue accruing from OPD, is trading at a consolidated TTM PE of 24 times. On nine-month annualized basis, it is trading at 8.4 times.