Small IT companies: Big dreams, but...

Suresh Krishnamurthy

IN THE technology stock sell-off since March, those battered have typically been the those of small companies.

Some stocks are trading at prices 90 per cent off the highs touched in February. Most are down upwards of 75 per cent. Their operational profiles underline the weak fundamentals vis-a-vis the quality fast-changing industry scenario.

Most firms can only be categorised as `development stage' IT companies. They have a long way to go before their revenue streams achieve some stability. There are, however, two positive aspects. There are considerable opportunities for these companies to grow, and most have fortunately tied up their funding requirements. If these are judiciously leveraged, these companies stand a chance of graduating to the next level.

Business profile overview

The profile of the small IT companies differs considerably from those in the mid- and large-sized ones. The latter are mostly generic software service provider. Among the small firms, a number of them are niche software service providers for the export market, software product developers, training providers, having considerable focus on domestic industry, those that have floated B2B and B2C commerce portals, or predominantly providing IT-enabled services. Notably, almost all these companies have a presence in more than one segment, compared to large and mid-sized companies that are almost exclusively focussed on the software services export market.

Of the many with a turnover of less than Rs 50 crore, a large number is niche software service providers such as Sierra Optima, VJIL Consulting, Cybertech Systems, MindTeck, Goldstone Technologies, SQL Star International, Compucom Software, and Logix Microsystems. VJIL Consulting and SQL Star International also provide software training. In the software services segment, these companies are focussed on specific segments such as e-business, data warehousing, embedded systems, enterprise application solutions products and client-server projects, generally not taking projects outside their expertise.

Companies such as Zenith Infotech, Nucleus Software, Kale Consultants, and Aftek Infosys are focussed on software products. Among these, Kale Consultants and Aftek Infosys are predominantly focussed on the export market and Zenith Infotech and Nucleus Software on the domestic market. Geometric Software Services and Infotech Enterprises are mainly exporters of IT-enabled services. KLG Systel offers software services for the domestic industry, while Melstar Information Technologies has a presence in generic services -- domestic and exports -- along with a focus on software product development. KLG Systel, Eonour Software and California Software have also forayed into e-commerce.

Of the lot, Aftek Infosys, Kale Consultants among product companies; Geometric Software and Infotech Enterprises among the IT-enabled services; and Subex Systems, Melstar Information Technologies, Sierra Optima and Cybertech Systems appear better placed in terms of operational profile compared to their other peers.

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Revenue profile

Like the large- and mid-sized companies, the small-sized firms depend largely on the US for revenues. However, unlike the former, the penetration of the latter is quite low. Some companies are 100 per cent dependent on the US industry. Also, a fairly large proportion of revenues accrues from on-site consulting. Companies such as Sierra Optima and Cybertech Systems, which derive a significant proportion of revenues from their off-shore development centres, are in the minority.

Client-concentration levels are also high. The top five clients generally contribute up to half of the companies revenues. In some case, just a single client contributes up to a third of the revenues. However, these companies are presently not in a position to worry about client concentration. The focus, rightly, is on developing stronger relationships with the top clients to improve the quality of projects they receive.

Focussed high, pegged lower

Surprisingly, most small companies are working on leading technologies and not on low-end application maintenance projects. Some companies have even consciously stayed away from such low-end work. This is perhaps an offshoot of the kind of clients these companies attract. Most are overseas software product companies or software consulting houses that work on leading technologies. Due to their size, small companies cannot attract large end-users such as Fortune 500 or Fortune 1000 companies. To work on projects of large companies in the US, they need to have a large skilled-employee base which these companies do not have. Also, the penetration level of Indian software in the small- and mid-sized companies segment in the US is low. They necessarily have to work with other software product/service companies.

Another offshoot of working with other software product/software consulting houses is that they get to work only on piece-parts and are not able to offer end-to-end solutions, which is what the consulting houses themselves would offer. Though these companies work on leading technologies, they do work fairly lower in the value scale. This is not reflected in the billing rates of these companies. Normally, this should also be translated into lower operating profit margins. However, often they do not reflect the remuneration practices of these companies.

The revenue profile and the remuneration practices emerge as strong negatives for these small companies. The pre-dominant portion of on-site consulting, and working on projects for software products/services companies indicate they work more on piece-parts. This is unlikely to help them acquire the skills necessary to stay on the growth path. At the same time, the poor remuneration practices do not help in retaining skilled employees.

Acquisitions galore

A positive feature for the small companies is the work of National Association of Software and Service Companies. Nasscom has been creating a brand for Indian software services. More than any other segment, its efforts are likely to be felt in the business volumes of small companies. Apart from the efforts to pave a market for Indian companies, Nasscom, in collaboration with Mckinsey, brought out a study in 1999 on the Indian IT industry. The study underlined the importance of acquisitions and alliances for Indian companies.

It is not clear if the acquisitions of the Indian companies is the direct result of the Nasscom-Mckinsey study. However, acquisition activity has clearly spurted. Small companies have gone the acquisition route whole hog. In contrast, while large- and mid-sized companies have relied more on alliances, small companies have not been able to make headway here.

There is a strong rationale for the acquisition mania gripping the small companies. They do not work on large projects because they do not have the expertise. Though they can build expertise, in a few years the entire environment could change. Therefore, small companies look to acquisitions to move rapidly up the value chain.

The sharp increases in stock prices post-September last year and March this year also helped them achieve their goals. Most acquisitions by the small companies are cash-cum-stock deals. The relative size of the acquisitions are fairly large. In most cases, the companies acquired are as large as the acquiring companies. In short, the small companies have taken a fairly large risk by making the acquisitions, though the acquisitions do give these small companies exposure to a larger set of clients. In most cases, the acquired companies have been offering end-to-end solutions working on Web-based projects. However, the profit margins of most overseas software companies are not comparable to Indian companies. In fact, they are poor because of the higher remuneration practices in the US. How these acquisitions fare over the next few years will determine these companies fortunes in the stock market.Overall, the operational profile of Indian companies does not inspire confidence in small Indian IT companies. There is a still sizeable territory to be covered by these Indian companies before they can be placed on a par with their larger and mid-sized peers from an operational and investment perspective.