Internal risk factors

Krishnan Thiagarajan

FROM AN investment standpoint, an evaluation of the risk-return calls for a conscious understanding of the following risks at the micro level for medium-sized companies vis-a-vis frontline firms. Clearly, at this level, the business derisking issue is handled much better by the latter because of their larger client base, revenue growth and spread of business.

Client concentration and credit risk: The risks associated with client concentration is significantly higher in the medium-sized companies as excessive exposure to a few large clients can impact on the profitability and increase the credit risk. But, at the same time, large clients help scale up revenues quickly and repeat-business contribute to higher margins through lower marketing costs. From an investors' standpoint, the comfort level will be high only in respect of companies able to strike a judicious balance.

Take the case of Silverline Technologies. According to the American Depository Shares (ADS) offer made in June 2000, approximately 45 per cent of its revenue came from two corporate clients in 1998 and 1999. In the first three months of 2000 and for the whole of 1999 and 1998, various business units of First Data Corp., accounted for approximately 18 per cent, 30 per cent and 29 per cent respectively of Silverline's revenues. In addition, over the same period, Silverline's second biggest client, Sky Capital International (Hong Kong), accounted for 19 per cent, 15 per cent and 16 per cent of the revenues.

Or, take Polaris Software, in which Citibank -- its largest client -- contributed 29.3 per cent of revenues in 1999-2000 compared to 35 per cent in 1998-99. Though both Silverline and Polaris (to give only two examples) are broadbasing their client profile and minimising the volatility associated with limited clients on profitability, it still is too high when one compares it with Infosys Technologies. For 1999-2000 and 1998-99, Infosys' largest two clients accounted for 7.2 per cent and 6.4 per cent of the company's total revenues.

The risks of client concentration include:

* loss of major clients

* significant reduction in the volume of business

* cancellation or deferral of significant projects

* work is moved by client in-house

* loss of business to competitors

Besides the client concentration risk, even the credit risk is higher for medium-sized companies. For instance, in the case of both Silverline and Polaris, the accounts receivable was at around 90 days (on an average) in 1999-2000 compared to 61 days for Infosys Technologies.

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Geographic concentration: Given the rapid change in technology (say, wireless Internet on which Nokia and Ericsson are working or third generation wireless systems to be launched by NTT DoCoMo of Japan or Samsung Electronics of South Korea) and political volatility associated with different markets, a diverse spread of revenues from the US, Europe and South-East Asia is desirable from a long-term perspective.

As late entrants in the software sweepstakes and with different affiliations (say, PSI Data Systems' affiliation with Groupe Bull of France), quite a few medium-sized companies targeted aggressively the non-US markets early enough to achieve a better geographic spread. Even companies such as Silverline Technologies and Digital Equipment (India), which had US-centric operations, are extending their reach to Europe and Asia Pacific.

Play on wage differentials: Caught between lower billing rates compared to their frontline peers and rising labour costs, medium-sized companies need to reorient their focus either by moving up the value chain or acquiring premium customers and reorienting faster than the competitor to survive.

Clearly, Indian software companies can no longer play on wage differentials as can be seen from the experience of Silverline Technologies. According to a October 1999 study by Software Productivity Research, the average annual wage rate for software professionals in India was approximately 10 per cent of the average annual US rate. But labour costs in India for IT professionals employed by Silverline Technologies increased by 27 per cent and 42 per cent from 1998 to 1999 and 1997 to 1998 respectively, while during the same period labour costs for comparable Silverline professionals employed in the US increased only by 10 per cent in total. This shows that increased labour costs may have an adverse impact on the profit margin and erode India's competitive edge in the long run.

Put differently, going forward, the human resource valuation metrics, such as revenue per employee, attrition rate and success of the ESOP plans (tied as it were to the company's stock price), will assume greater importance. To put this issue in perspective, consider the revenue per employee of Infosys Technologies with that of Polaris Software. Considering an overall technical employee strength of 4,742 (including technical support employees), the revenue per employee for Infosys worked out to Rs. 18.60 lakhs. For Polaris, for an technical employee strength of 1,249, the revenue per employee worked out to Rs. 11.69 lakhs.

This effectively means that for say, x dollars of revenue, any medium-sized company will have to employ 1.5 employees against one by the frontline firms. To that extent, the comfort level of revenue per employee is an important parameter which will dictate the operating profit margin of medium-sized companies.

Manage scalability: The key to the future growth of medium-sized companies hinges upon a composite strategy to `manage scalability'. Companies such as DSQ Software with revenues of Rs. 220 crores -- annualised for 15 months ended June 30, 1999 -- Silverline Technologies (Rs. 195 crores for 1999-2000) or Polaris Software (Rs. 146 crores for 1999-2000) have reached the critical mass for `ramp up' to the next rung of the software revenue ladder. To handle the two-pronged objective of scaling up on the revenue front and, at the same time, improving the margins, the medium-sized companies will have to work on several fronts simultaneously, including:

-- the enhancement of offshore and offsite infrastructure for rapid ramp-up in operations

-- setting up of marketing offices worldwide, recruitment/continuous training of quality manpower

-- realignment of the management systems and quality processes to handle a mix of highly repetitive projects in, say, legacy or client-server based environment as well as highly innovative projects in the field of e-commerce or ERP, the entire company has to scale up seamlessly to a tight and transparent deadline.

Reacting to an observation on `scalability', Mr. Vineet Nayar, Vice-Chairman, HCL Technologies, in a recent interview to Business Line said: ``I still believe that quality systems and process to be able to consistently deliver quality to the customers and at a scaled level is a credible challenge. Ultimately it comes down to people. Can you deliver quality services to your customers at 1,000 people, 10,000 people or 100,000 people. That to my mind is the bigger challenge. The internal processes, training and quality delivery to the customer which is consistent in nature. Because on the one side, companies want to move up the value chain and on the other, we want to grow. These two objectives are not necessarily converging, they are diverging models. To try and converge these two objectives more and more at an optimum growth level is the challenge for growth. Otherwise, if you grow too fast, you will fall dead as your quality will suffer. Or you grow too slow and you are quality sensitive, the competitor will kill you. There has to be an optimum model to growth.''

For frontline companies, which have already managed this transition, moving up the software value-chain remains the major challenge. Whereas, for medium-sized companies, the need to arrive at an optimum growth strategy balancing the progression up the value chain alongwith scalability poses a big challenge. To that extent, managing risks from the financial, technical, managerial and operational side holds the key to the transition from a medium-sized company to its frontline peers in the industry.