Polaris Software Lab: Buy on declines

Recommendation:Buy on declines

Krishnan Thiagarajan

``BUSINESS conditions have not changed much.

It is the mood of investors that has changed, and their mood makes a huge difference if you are missing expectations by a penny, or if your growth is merely 90 per cent a year vs. 120 per cent a year. They magnify the differences and punish stocks that do not meet the upper expectations. Investors are in a manic-depressive state of mind. In the manic mood, no matter what the analysts write and what the companies do, every glass is seen as half full, and in the depressive mood, those same things are seen as a glass half empty.''

Inside the different sectors (in the hi-tech sector) some companies gain and some lose. One would think that investment analysis would look at not only sector fundamentals but company fundamentals. Instead, investors are overly concerned with whether the Nasdaq is up today or down today. And when it is down, all companies that are remotely associated with the Nasdaq -- whether they are on it or on the New York Stock Exchange -- get punished.

``For now, then, I am philosophical about the market swings. Nowhere does it say that a normal P/E will be 100. P/E ratios of 100 are not a God-given parameter of any industry. But if you really think about it, what other part of the economy would you want to be invested in? Over any period of time, this hi-tech megasector has rewarded investors pretty well. The fundamentals favour it.

Andy Grove, Chairman, Intel, in the Fortune issue ``Will Tech boom again'' on the state of the US tech markets. A comment which is equally valid to the software services market in India and, here, Polaris Software Lab looks a fairly good option from a medium-to-long-term perspective.

Following the furore over the breakdown of its acquisition of the New Jersey-based software firm Data Inc. in mid-October, the Polaris Software Lab stock was hammered quite sharply. The apprehension over a long drawn out litigation with Data Inc. and the probable decline in the scorching growth rates (of over 100 per cent recorded in practically every quarter since its IPO in August 1999) appears to have clouded the investment prospects of the company.

But these fears seem exaggerated. Given the new initiatives launched by Polaris in the banking segments, strong tie-ups/projects in the insurance, financial services and e-commerce segments, organic growth initiatives through investments in infrastructure and manpower and the strong first-half performance, the Polaris stock has reasonable upside potential from the current price levels.

At the current market price, the stock trades at a price-earnings multiple of 35 times its annualised 2000-01 per share earnings. Although the stock has recovered some lost ground over the past couple of weeks, at the current PEM, investors can contemplate building up exposures in this stock at declines. Any market weakness can be used as an opportunity to gain entry into this stock.

Strong focus on banking: Polaris has built its domain expertise in banking and finance by executing projects for Citigroup, the world's largest banking group for well over a decade. Using this domain expertise, it has chosen to consciously broadbase its client profile.

In 1999-2000 first half, Polaris was selected as one of the partners in a global alliance for developing the ``New Millennium'' banking software for the Japanese giant, NEC. This project is being executed as a team consisting of four independent companies other than Polaris at San Jose, US. By 2000-01 first quarter, it has become a megaproject for Polaris with more than 50 per cent of the new product development effort being parcelled offshore to Polaris.

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In the first quarter, Polaris entered into the field of banking software product by forging an alliance with Marshall and Ilsley Corporation (M&I), a US-based banking software major. Using this alliance, Polaris developed PolarisPoint, an international version of M&I Eastpoint (a software product developed by it in the US) and held the IPRs for this product. Using PolarisPoint -- a comprehensive banking product with modules such as Anytime, Anywhere Banking, Mobile Banking and Internet Banking -- Polaris is making a foray into the European and Asia Pacific region (excluding US). Besides this, it also plans to target the domestic markets.

Carrying this banking product initiative forward, in the second quarter, Polaris has created BankWare, a suite of relationship-oriented banking products and services as a separate strategic business unit. BankWare has basically been packaged and integrated using the base of PolarisPoint and other components available with Polaris. This suite of products and services are expected to give Polaris a strong and steady market presence in the banking and finance segment, one of the high growth areas in the future.

Supplemented by insurance/e-commerce: In the area of insurance, the company has entered into a tie-up with Deloitte Consulting, one of the dominant players in the global insurance market, for developing insurance solutions for its clients in the US and around the world.

Similarly, to expand its footprint in the e-commerce domain, Polaris has executed a string of projects in the second quarter-ended September 30, 2000. In the second quarter, nearly 28 per cent of its revenues accrued from its thrust on e-commerce, up from 24 per cent in the first quarter-ended June 30, 2000. The projects ranged from developing online stock trading links for a Middle East customer, legal portal for a Hong Kong-based corporate group, waste management-cum-auction portal and e-wallet system over the Internet for the European branches of a MNC bank.

Recently, it has also announced the formation of its new initiative, the Polaris WebLab, which is expected to strengthen its focus on the emerging Web space. This initiative will create Web interactive architects and designers who are expected to work closely with strategic business units on live projects for global clients. This is also likely to strengthen its initiatives in the Enterprise Application Integration and Enterprise Knowledge Management Space.

Robust infrastructure support: After inaugurating its software development campus at Navalur in Chennai in 2000-01 first quarter, Polaris proposes to continue making investments in infrastructure. It plans to invest Rs 33 crore in a 2,00,000 sq ft development centre at Navalur, Chennai and Rs 20 crore in a 90,000 sq ft. centre at Gurgaon, New Delhi. While the Chennai project will house around 1,200 employees and be completed by June 2001, the Gurgaon project is expected to house around 700 employees and is likely to be operational by September 2001. This investment in infrastructure is in line with its enhancement of employee strength. It has added nearly 730 employees for the first half ended September 30, 2000. The employee strength stands at 2,165 as of the second quarter.

Although this investment in infrastructure and employees sends positive signals on growth potential and are indispensable for a `scalable' growth model, it also enhances the risk for Polaris substantially. The entire infrastructure is to be put up using the cash reserves of around Rs 58 crore, as of September 30, 2000. Polaris appears to be following the high-risk-high-return model employed by its frontline peers in the industry.

The success of this strategy will hinge on the management quality, the strength of its core internal processes, high revenue growth (as its operating margins are significantly lower at 23 per cent relative to its frontline peers (33-37 per cent) and sustained growth of its target market segments. If Polaris were to experience any slowdown in its overall revenues/employee productivity, it may have a sharp backlash on profitability. Investors may have to closely monitor this risk on an ongoing basis as the markets, in general, have a low tolerance for earnings disappointment of growth stocks.