Digital Equipment (India): Buy

Recommendation: Buy

Suresh Krishnamurthy

THE STOCK of Digital Equipment trades at a price-to-earnings multiple of 28 times the annualised per share earnings for the quarter ended September.

Given the earnings growth prospects, the support from the US-based parent, Compaq Computer Corporation, US, and the operational profile of Digital Equipment, the stock appears attractively valued.

After the announcement of a fairly impressive financial performance, the stock rose considerably. Still, the valuations are not demanding. In this backdrop, exposures can be initiated with a long-term perspective. The company appears to have the right credentials to make the transition into a large software company. The stock is an attractive pick in the medium-sized software companies category. As such, the stock is a suitable addition to any portfolio that has a predominant exposures to frontline companies.

With the worldwide reorganisation of Digital and Compaq, Digital Equipment India was restructured as an IT services provider in 1999. Since the start of the year, Digital has been able to ramp up the scale rapidly. Revenues from software exports increased from Rs 18.47 crore in the quarter ended March to Rs 40.47 crore for the quarter ended September. Operating profit margins also increased from 27 per cent in that quarter to 32 per cent in the latest quarter. The per share earnings for the quarter ended September 2000 is Rs 4.10.

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In terms of services, quite unlike other software service companies -- Digital Equipment has a presence in both IT and IT-enabled services. Digital's portfolio of services in IT services encompasses e-applications, platforms and middleware services and services targeting the telecom industry. In terms of IT-enabled services, Digital offers e-infrastructure services involving IT-based business management services.

In the quarter-ended September, e-applications contributed close to 52 per cent of the total revenues while platform and middleware services contributed close to 21 per cent. The telecom business unit, the only vertical industry focus for Digital, contributed 5 per cent, while IT-enabled services accounted for a little more than 22 per cent.

In terms of services rendered, though Digital Equipment is working on projects involving leading edge technologies, it is still not getting reflected in terms of per employee revenue. The per employee revenue in the quarter ended September, on an employee base of 878 employees, was around Rs 4.60 lakhs per annum. Even accounting for the number of employees who did not contribute to the revenue streams, the per employee revenue figure appears to indicate that Digital has quite a distance to travel in terms of moving up the technology value chain. The higher contribution of on-site revenues also indicates a similar situation.

Digital Equipment's major risk-factor, however, is its dependence on its parent company for its business. Compaq contributes close to 90 per cent of the company's revenues and is also growing faster than non-Compaq business. The over-dependence on a single customer (technically more than one Compaq unit across the world are Digital's customers) may work to the Digital's detriment in the event of any worldwide organisational change. However, till such time Digital broadbases its customer profile, the Compaq business not only provides a steady revenue, but the company is also gaining exposure to leading-edge technologies.

In future, improvement in the contribution of non-Compaq businesses would be a critical determinant of share price trends. Any failure to improve the proportion of non-Compaq business may lead to a weakness in share price. Overall, however, the operational profile of Digital is a strong plus factor that should enable the company to broadbase its customer profile. Investments made with a long-term perspective may deliver a fair appreciation over the long-term.