Whetting high-risk appetites

Suresh Krishnamurthy

THE NASSCOM-MCKINSEY study suggests that the revenues of large Indian IT companies will grow at an annual compounded growth rate of 25 per cent and that the industry would grow at 41 per cent.

This implies that smaller companies would grow at a rate higher than 41 per cent. If the smaller companies outperform the larger companies in revenue growth, it is reasonable to expect the stocks of smaller companies to do the same at the bourses. This is the rationale underpinning the need to have exposures to smaller IT companies.

Yet, while there may be a number of investment-worthy mid-sized companies, not many small IT firms qualify for the same. Many fall out of contention because of their diffused focus. Of the few, the scrips of Sierra Optima and Cybertech Systems appear attractive.

These companies are essentially offshore development centres for their overseas equity partners, ensuring a high proportion of offshore revenues in the total business volumes. Since their overseas equity partners are software companies with a relatively larger presence in the US markets, these companies can work on larger projects and on leading technologies. The working alliance with their larger overseas associates also helps counter the risks that small companies face.

The flip side is that marketing costs are borne by their overseas partners, the high-value work done at their offshore development centres is not reflected in the billing rates. Technically, they have a single client _ their overseas equity partner. And if anything affects the operations of their overseas equity partner, the fortunes of Sierra Optima and Cybertech Systems will be affected, at least temporarily.

Overall, however, a strong alliance with an overseas equity partner, and operating as an offshore development centre, appears to be a workable proposition for the latter. Of these two companies, the Sierra Optima scrip appears more attractive. In the Cybertech Systems case, a few unanswered questions remain. The company's buyback offer and a delay in the merger of a 100 per cent subsidiary appear to have dented investor confidence in the stock. However, this is a good stock to keep track of.

In the software products segment, both Kale Consultants and Aftek Infosys appear attractive investment candidates. Aftek Infosys operating profile is impressive and its products have met with a reasonable degree of success at the market place. Its financial performance in the recent quarters have been in line expectations. In Kale Consultants case, this may not be the right time to acquire the scrip. They unveiled a fairly disastrous first quarter performance this year _ their profits sank by 80 per cent. However, they bounced back with the acquisition of a few products of Speedwing, a British Airways associate, strengthening their portfolio of products offered to the airlines industry. Still, it may be worthwhile to wait for the next quarter's performance before considering an exposure in the counter.

In the IT-enabled services segment, the stocks of Geometric Software and Infotech Enterprises appear worthy of investment. Geometric Software's performance has been notable in recent quarters and the company does have an impressive track record. The stock is also attractively priced at present. For Infotech Enterprises, the company's performance has been, despite bagging a relatively huge order and making an acquisition, quite unimpressive. It may be better to wait for the next quarter's performance before considering fresh exposures.

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Overall, however, making an investment appears a daunting proposition. From an investment perspective, the risk is that too much depends on the style and quality of management. These companies have to upscale their operations fairly quickly and two successive quarters of missed opportunities can set back these companies prospects. Consider the stocks of BFL Software and Tata Infotech. Despite having a critical mass in terms of business volumes, these companies have had to pay for a couple of quarters of poor marketing efforts. That seemed to have set off a vicious cycle of events from which these companies have not recovered. For the smaller IT companies the risks are even more. To maintain growth, a management with a focussed approach and strong growth management skills appear to be called for. And without being convinced of the management quality it is quite difficult to invest in these companies.

In short, investment in these stocks appears to call for a greater interaction with the management. It is perhaps only because the primary markets were so favourable to these software companies that these companies are listed. In fact, the overseas equity partner of Sierra Optima is driven by venture capital investments. If not for a benevolent capital market, most of these companies may well have been financed solely by venture capital companies.

In this backdrop, it appears that for an investor with a fairly less aggressive risk appetite, the mutual fund route is a better proposition than taking exposures to this segment. Most of the IT sector mutual funds have exposures in these small companies. The extent, however, varies between less than 5 per cent to fairly high levels. Considering the risks involved in investing in these companies, higher exposure to these stocks now appears ill-advised. Still, depending on the investor's risk appetite, investments in a particular mutual fund may be considered. Investing in these scrips is strictly for investors with high-risk appetites.