Silverline's acquisitions: Hold

Recommendations: Hold

Suresh Krishnamurthy

FRESH investments need not be contemplated in Silverline Technologies for now.

Shareholders can hold on to their exposures considering that the impact of its acquisitions will be felt only after 2001 first quarter.

The company's acquisitions have substantially raised its risk profile. Given the staid revenue growth and a largely legacy-based client profile, Silverline had to look for acquisitions to boost margins and volume growth. However, acquisitions come with risk _ in Silverline's case, the companies acquired need to be turned around.

The crucial factor for their turnaround is revenue growth. In fact, if the turnover over the next few quarters is not encouraging, shareholders may offload their holdings. Shareholders uncomfortable with the company's enhanced risk profile too can contemplate a phased offloading of equity.

Focussed plan

Silverline Technologies (STL) mobilised close to $90 million through American Depository Shares in June, and used a large part of this for acquisitions in the next three months.

In October, STL acquired Sky Capital International (SCI), one of STL's largest customers, and SeraNova, a Nasdaq-listed company based in the US. Combined, these two acquisitions would warrant a cash outlay of $42 million. In addition, the issue of stocks to SeraNova shareholders would expand STL's equity by 14 per cent.

Together the two deals is valued at around $120 million (Rs 552 crore). In addition, Silverline has invested over $30 million (Rs 140 crore) in its US subsidiary, Silverline Technologies Incorporated. With these acquisitions, STL now has a revenue base of $200 million (Rs 900 crore).

The SeraNova's acquisition offers STL a place in e-business services. Given that SeraNova derives all its revenue from Internet-based services, the acquisition should improve the e-business contribution to STL's total turnover. Since SeraNova's growth has been faster than Silverline's, the e-business contribution should increase.

Acquisition gamble

However, as much as these acquisitions represent opportunities, they have significantly enhanced STL's risk profile. The acquisition of SCI and SeraNova are likely to accrue to earnings in financial 2001. However, whether the accretion to earnings will be commensurate with the equity expansion and the investment is the moot point. As of now, they appear unlikely to add to the per share earnings, at least in the next few quarters.

SeraNova is a loss-making company and in the case of a SCI, a Silverline press release said that its acquisition would add to the earnings in FY 2001. Contrast this with Silverline Technologies's 26 per cent net margin for the quarter ended September. So, even if SeraNova and SCI start earning profits, it is likely that they would drag down the overall profitability in the near-term.

To improve the profitability of SCI and SeraNova's operations, STL needs to transfer the bulk of the work done onsite now to offshore development centres in India. This integration may take a while. This is because Silverline has close to 920 software professionals in India, in addition to SeraNova's 550 employees. The integration would have been quicker if SeraNova did not have an employee base in India. However, with a massive employee base of 1,500 in India, maintaining high capacity utilisation in its development centres in India is a challenge for STL.

It is also crucial for STL to retain SCI and SeraNova's employees abroad, as the high-end strategic consultancy activities would be executed there. For STL to retain its overseas employees and also shift work offshore, the revenues have to grow rapidly. Strong revenue growth has become critical for STL. Without this the company's ability to retain employees and bolster profitability may be affected.

Hazy issues

One area where acquisitions are normally expected to produce significant benefits to an acquirer is in reducing `client concentration' risks. However, there is the possibility that STL's acquisitions may not deliver on that count. Consider this. One of STL's major clients is First Data Corporation, which accounts for close to 18 per cent of the company's revenues. In SeraNova's case, American Express contributes 40 per cent of the revenues.

Both First Data Corporation and American Express are also clients of SCI. STL has, however, not disclosed the contribution of these two entities to SCI's revenues. But, it appears reasonable to conclude that in the combined organisation, client concentration, especially that of First Data Corporation and American Express, will be high. And a limited number of clients may expose STL to greater risks.

The valuation of the two deals also raises a few issues. STL acquired SCI, which has revenues of $24 million, at a revenue multiple of 0.9. The revenue multiple for SeraNova, on the other hand, at 1.2 appears relatively stiff, considering that the value of the stock swap would be more or less equal to the market capitalisation of SeraNova on Nasdaq _ around $70 million. Also, there is the cash outflow in the SeraNova deal because of the assumption of the company's debts. Besides, SeraNova, which reported cash outflows from operations of $13 million in the quarter ended June, may require cash flow support at least for a while. In this backdrop, the valuations do appear stiff. It remains to be seen if the human resource acquired compensates for the stiff valuation in the time to come.

Silverline's valuation

STL's revenue and earnings growth has traditionally been lower than the industry average. The growth rate has, however, risen in recent quarters. For the quarter ended September 2000, the combined revenues of STL and its subsidiaries rose 48 per cent. Excluding the income earned from the amounts raised from the ADS issue, the profit growth in the quarter was 54 per cent.

The growth rate is, however, still much lower than that recorded by industry majors. Taking into account the prospective equity expansion of 14 per cent and not including the ADS proceeds, the per share earnings on an annualised basis works out to Rs 26. On this basis, the stock trades at a price-earnings multiple of around 13 times.

However, it is here that the acquisitions cast a shadow. How much would the two acquisitions drag down the per share earnings? SeraNova recorded loss of $2.6 million or around Rs 12 crore in the quarter ended June. Losses in September are likely to be less and SeraNova is likely to declare its financial performance on November 6. Per share loss estimates by analysts for SeraNova are pegged at 0.045. On this basis, SeraNova's losses would decline to around Rs 6 crore. The per share earnings of the combined entity would then be around Rs 22. Again, adjustments also need to be made for the earnings of SCI. If it is also making losses, then the per share earnings would come down further. However, even at a per share earnings figure of Rs 20, the stock's price earnings multiple works out to only around 15. Given the growth prospects, the valuation does look attractive.

On the other hand, the prospects of an improvement in the stock's valuation would hinge on how these two acquisitions shape up. Has the company paid more than it should have or has it bitten off more than it can chew? The answers to these questions lie in the company's 2001 revenue growth. Fresh investments can be contemplated then. For now, it may be better to sit on the fence and watch keenly.

Pic.: The Silverline Technologies office in Chennai... Recent acquisitions signal opportunities and risks.

Picture by Shaju John