Digital Equipment (India): Buy on declines

Recommendation: Buy on declines

Krishnan Thiagarajan

THE third quarter financial performance of Digital Equipment (India) has highlighted three crucial growth drivers for the future:

*Scalability: Despite a difficult quarter for the technology industry in the US, Digital Equipment (India) has shown that it has the ability to scale-up revenues and profit before tax in the third quarter-ended December 31, 2000. Although the growth in revenues and profit before tax in the third quarter is lower than the second quarter, it still reiterates the fact that Digital is on the right growth trajectory.

Digital recorded a 30 per cent growth in revenues in the third quarter over the corresponding previous quarter-ended September 30, 2000 vis-a-vis a 41 per cent growth in the second quarter over the corresponding first quarter-ended June 30, 2000. Similarly, the company recorded a 56 per cent growth in profit before tax compared to a 64 per cent growth over the same period.

*Rising operating margins: The operating profit margins of Digital improved by nearly 6.35 percentage points to 31.41 per cent in the third quarter-ended December 31, 2000. After a 9.73 percentage point rise in operating profit margins to 25.03 per cent in the second quarter, Digital's operational contours are showing signs of moving in the right direction. Much of this jump in OPM is attributed to a rise in the contribution of onsite revenues over the past three quarters.

The onsite revenues in the third quarter were 68 per cent of total revenues, up from 65 per cent in the second quarter and 52 per cent in the first quarter. Even in the third quarter, the growth of onsite revenues at 35 per cent was significantly higher than the offshore revenue growth of 20 per cent. This growth is even more creditable as Digital has continued to enhance its manpower strength by 21 per cent to 1,059 employees by 2000-01 third quarter.

*Non-Compaq business/geographic diversity: Digital appears to have achieved some success in broadbasing its client base and in 2000-01 third quarter. The contribution of non-Compaq client revenues of Digital jumped to 13 per cent in the third quarter vis-a-vis 10 per cent in 2000-01 second quarter. That along with the rise in the contribution from Europe to 17 per cent of total revenues from 13 per cent in the second quarter is a healthy sign for the future.

However, from an investment standpoint, the following areas may turn out to be a cause for concern and need to be closely monitored in future :

*Dependence on Compaq: With Compaq, the parent of Digital accounting for 87 per cent of total revenues in the third quarter, (although down from 90 per cent in the second quarter, the huge dependence on a single client continues to be a cause for concern. If Digital has to achieve its stated intention of reducing the dependence on Compaq to 50 per cent by 2003, probably the pace of growth of non-Compaq revenues needs to be watched much more closely in future.

If the US tech slowdown were to intensify in the following months, the dependence on Compaq may turn out to be a liability for Digital. In addition, Compaq's worldwide strategy of weaving its fortunes around the Internet and Internet appliances also deserves a close watch for a possible effect of a slowdown.

*Onsite-offshore mix: Digital's onsite-offshore mix has been rising steadily over the past three quarters. Although the enhanced percentage of onsite revenues may probably offer much higher value-added projects and enhance the domain expertise of Digital employees, it may not be an ideal strategy for enhancing/protecting the margins in the long run.

In the medium term, the offshore delivery model appears best-suited for absorbing the higher wage bill (due to rapid manpower additions) and supporting a higher bench (employees waiting for the next project). Unless Digital consistently manages to bring work offshore, the high proportion of onsite revenues may start taking a toll on the operating profit margins.

*Low revenue per employee: Although the average revenue per employee has been steadily moving up from Rs 4.20 lakhs per annum in the first quarter to Rs 4.60 lakh in the second and Rs. 4.97 lakh in the third quarter, it is significantly lower than the levels recorded by the frontline companies. Unless the offshore revenues move up sharply over the next few quarters, the investments being made in ramping up offshore infrastructure, manpower and marketing, selling and support staff, may begin to depress the operating profit per employee and the operating margins of the company.

From an investment perspective, the continued support and patronage from Compaq, the relatively successful efforts at scalability and steady improvement in operational parameters continue to inspire confidence. In this backdrop, investors aiming to broadbase their tech portfolio may contemplate buying the Digital stock on declines. However, going forward, the operational parameters may bear a close watch.