Kale Consultants: Hold/Buy on declines

Recommendation: Hold/Buy on declines

Suresh Krishnamurthy

SMALL software companies are making acquisitions by the day to increase their customer base.

The acquisitions appear to hold the potential to change the company's operational and risk profile. One such company is Kale Consultants which is looking at acquisitions to jumpstart growth. While shareholders can hold on to their exposures, fresh investments can be contemplated after the second quarter performance is announced.

Kale Consultants' stock price has been on a relentless downtrend since June. Though the stock recovered from lows of less than Rs 100 to trade at Rs 160, its performance has been poor since February compared to other software scrips. The reason for this is the company's insipid financial performance in the first quarter ended June 2000. While revenues grew to Rs 6.80 crore, profits declined 80 per cent to Rs 36 lakh. The doubling of wages and software delivery expenses, and a modest topline growth were mainly responsible for the declining profitability. The company indicated that it had increased employee strength anticipating growth and spent more on marketing. This suggests that the decline in profits may be a one-time affair and the employee contribution to revenues would improve profitability.

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However, assuming this happens, a higher volatility in the revenues and profits is only to be expected because Kale Consultants is one of the few companies in India focussed exclusively on software products. And the software products business has more inherent risks than the software services. For example, the revenues from the banking segment for Kale Consultants began tapering in 1999, indicating the potential downside.

Indeed, Kale Consultants deployed most of the 394 software engineers in product development. Till such time the products start generating revenues, the profitability is likely to be dragged down by employee costs, increasing the volatility in profitability.

Operational profile

Kale Consultants is focussed on developing products for the airlines, banking and the healthcare industries. It has been developing application softwares for these three industries and marketing them as products. It is not altogether out of the customised software development services segment. Similar to other software companies, it does offer services but may restrict it only to its product customers.

In products, Kale has enjoyed considerable success in the airlines segment and has a host of customers abroad. This is the company's most profitable division. Its initial public offer (September 1999) document indicated that the airlines business, employing about 15 per cent of its total employee strength, contributed 40 per cent of its revenues.

In the healthcare and software development services, there has seen strong growth since the base revenues are small. Kale's clients for its customised services include Citibank India, JP Morgan and a few Asia-Pacific governments. But only one customer is a software development company. As such, the services offered are unlikely to be in the areas of the latest technologies. In 1999, however, the banking products division started showing receding revenues. It is not yet known if the trend has reversed. However, the decline in profits in the first quarter may also be partly due to the poor performance of the banking products division.

Welcome developments

It is in this backdrop that the developments of the past few months appear welcome. Kale has in the past few months:

*Acquired three products of Speedwing, the independent operating division of British Airways Plc.

*Entered into a strategic alliance with Atraxis, an associate of Swissair to market its products.

*Entered into a 60:40 joint venture with a Malaysia-based company to market Kale's products and services to Malaysia and the surrounding regions.

*Entered into a partnership with Jade of New Zealand to develop enterprise solutions for e-commerce and migration from legacy systems to Internet technologies.

The focus on the airlines business is quite welcome as the company has proven expertise in the field. Also, the Speedwing acquisition can become a major development for the company. According to Kale Consultants, the acquisition cost Rs 5 crore and has the potential to generate revenues of Rs 50 crore over the next three years. This is likely to be reflected in Kale's revenues after December.

The acquisition means addition of another 20 clients to the company clientele. This is important as it will provide the company a platform to hawk other products and services. The other two ventures, though minor in comparison, also appear necessary from the long-term perspective. However, the impact on revenues appears unclear as of now. The Malaysian joint venture, involving a Rs 1 crore outlay, is expected to break-even in 18 months.

Investment prospects

The stock now trades at Rs 160, at a price earnings multiple of 28 times the per share earnings for the year ended March 2000. While the stock's valuation appears similar to its peers, the asset acquisition from Speedwing has altered expectations in terms of revenue and profit growth. Its strong presence in the airlines segment is a positive factor. Also, the prospect of higher volatility in profits, compared to a software service provider, also needs to be considered.

Overall, can shareholders retain their exposures. Fresh investments can be contemplated after the announcement of the performance of the second quarter ending September 2000. That would indicate if the decline in profitability in the first quarter was a one-time affair or the slowdown in a major business segment is also posing concerns. A re-evaluation of holdings may also be necessary if the poor performance continues.