Digital Globalsoft: Pare exposures

Recommendation: Pare exposures

Suresh Krishnamurthy

UNCERTAINTY surrounds IT stocks. For Digital Globalsoft, this has been compounded by the proposed global-level merger between HP and Compaq; the latter holds 51 per cent stake in the company. In terms of valuation too, the stock appears pricey. In this backdrop, investors can consider paring exposure.

Suitability: The Digital Globalsoft stock belongs to the software sector, where the earnings growth rates have been volatile. The volatility, reflected in the stock price, enhances the risk of investing in the company.

Merger blues

The proposed global-level merger between HP and Compaq may have affected stock price trends. However, the Digital stock was more successful in weathering the downturn in sentiment vis-`-vis its peers for most of 2001. The superior stock price performance was thanks to the above-industry average financial numbers. Also, there was increased expectation of Digital growing rapidly to join the frontline IT companies such as Infosys.

However, the recent rally in the market has not had much of a beneficial impact on the Digital stocks compared to its peers. Justified apprehensions, on what is in store for Digital if the merger happens, could have been responsible for this. According to information provided to institutional investors by Mr Som Mittal, President and CEO, Digital Globalsoft, the company will be the only listed subsidiary for the post-merger HP-Compaq combine.

In addition, HP also has a 100 per cent subsidiary - HP India Software Operations - in India. These two factors can lead to restructuring of Digital's operations in some form, once the merger goes through.

Apprehensions stem from speculation regarding the restructuring mode.

The merger can lead to positive developments. According to information provided by Mr Mittal, the operations of Digital and HP-ISO do not overlap.

Moreover, both HP and Compaq have followed a system of multiple vendors in India for their outsourcing. In this backdrop, the value proposition offered by Digital may be relevant. Also, Digital will be eating out of a much larger pie. This can contribute positively to revenue growth.

On the other hand, the need for Digital to remain a listed entity is increasingly unclear.

The value offered by Digital can be just as well, or better, be exploited if it is wholly-owned.

As such, if the merger leads to de-listing, it will cap the potential for gains from an investment in the stock.

Even if Digital remains listed, there could be problems. The global-level merger can lead to delays in outsourcing from the HP-Compaq combine.

Such delays, in the midst of the IT industry slowdown, can affect revenue and profit growth.

Besides, what will happen to the market share of Digital in the larger outsourcing pie of HP-Compaq is relevant. If HP-ISO is thought to offer more, Digital's share could decline.

These issues, as of now, are purely speculative. Nevertheless, they are a cause for concern. Global-level restructuring has affected the performance of the stocks of many Indian affiliates and there is no reason to believe that it will not happen again.

In fact, if the global-level merger between HP and Compaq is through, it will be considered positive for the Digital stock.

Expensive valuation

Apart from the shadow of merger-related restructuring, the valuation of the stock is another factor. At Rs 460, the stock trades at 20 times its earnings for the 12-month period ended September 2001. Importantly, the stock derives a substantial portion of its present market value from the optimism over its earnings growth which is true for most growth stocks. However, the outlook for earnings growth itself is clouded. As they say, business visibility continues to be poor. As such, a PEM of 20 appears high.

There are also other factors. The company has maintained its guidance for a 50 per cent revenue growth for the year ended March 2002, translating into a revenue decline of 17 per cent in the second half ended March 2002 over the first half ended September 2001. In addition, if the revenue growth remains flat for the succeeding six months (that is, the period ending September 2002), investors will be staring at a decline in per share earnings.

On the other hand, the prospects for appreciation in price depend not only on the company being able to stem any decline in the per share earnings over the next 12 months but also on growth rates reverting to the 20 per cent levels.

Alternatively, if there is a decline in the per share earnings over the next 12 months then the growth rate from thereon - that is, the bounce back - needs to be that much more stronger.

Of course, if the US emerges out of recession rapidly in 2002 and the IT industry gets back to its high growth rates, the scene could change. In such a situation, the stock may even be considered as holding the potential for appreciation.

However there is no room for such optimism now. For Digital, the planned merger of HP and Compaq has only made things worse. As such, investors would be better off paring exposures now.

Strong fundamentals

Notwithstanding these concerns, Digital Globalsoft continues to remain one of the stocks to watch out for in the industry. The company's performance, since it exited the hardware business and started focussing on software service, has been compelling. Revenues and per share earnings grew at a rate higher than the industry average. This was also behind the superior stock price performance of Digital.

As of now, Digital continues to depend on Compaq, which contributes around 85 per cent of the former's revenues.

This raises concerns on client concentration. However, the Compaq association was useful for Digital during the slowdown.

Revenues from Compaq have been growing at a faster rate compared to non-Compaq sources. And, the Compaq association has also brought in more clients.

Importantly, the association with Compaq led to Digital's foray into products. Initially, the company purchased an EDI product along with its IPR from Compaq.

The transfer happened without any monetary consideration. Recently, Digital bought an electronic data archival product from Compaq for $2.5 million.

According to Digital, the annual revenues of this product are around $5 million. Both these products have customers who have to be serviced and, therefore, there is potential for cross-selling services. Digital Globalsoft plans to invest significantly in the enhancement of the products too. Overall, the foray into products can prove lucrative.

According to information available on the Digital Web site, revenues from the data archival product are likely to account for nearly 10 per cent of revenues for the succeeding financial year. In addition, Digital has also made progress in securing non-Compaq clients. These factors augur well for the longer-term profitability of the company.

In fact, Digital is on course to emerge as a player that can be ranked alongside Infosys and Wipro. The transition was smooth, until news of the HP-Compaq merger emerged unexpectedly. If the merger fails to go, the stock will regain its shine, when it can be considered for accumulation at price declines.