Despite a 25% jump in the market, India’s macro backdrop remains unclear, and there is no evidence yet of the investment cycle turning any time soon. Therefore, while investors should look for exposure to any recovery in the investment cycle, when it does come, the best way to build in some caution is by maintaining strict quality discipline. The only way to strike a balance is to buy high-quality mid-cap names. In general terms, we’re now finding a better quality/value balance in mid-cap stocks, as many of the large cap ‘quality’ names look fully priced. (Institutional holdings decrease substantially with the decrease in a company’s market cap, especially in terms of foreign institutional holdings — and FII flows of $20 billion this year have been a major driver of the large cap names, hence the market. On an aggregate basis, FII holdings are 4 percentage points lower in mid-caps than large caps.)
One mid-cap stock we like is Persistent Systems, standing out as a scalable IT firm, with strong competitive positioning in the outsourced product development (OPD) segment, decent entry barriers and intellectual property (IP) giving it a cushion to sustain margins. It is also the only mid-cap IT company to have grown rapidly over the past 10 years organically (with only one small acquisition), with a 40% CAGR over 10 years from $10 million to $210 million. Another sign of a quality business is one that generates more cash than it consumes and Persistent’s cash generation (operating cash flow and free cash flow) is even better than some of the tier-I IT companies in India, with its operating cash flows as a percentage of operating profit at 88% over the last seven years.
On the fast track
The Pune-headquartered Persistent is the fastest-growing OPD company and ticks the boxes of a scalable OPD business. It has deepening relationships with anchor clients, which means it gets access to the source code (after years of building trust), and increasingly strong operations and quality work allow it to attract and retain talent. While OPD, in India, has been a volatile business on a quarterly basis, on a yearly basis it has grown at a 17% CAGR over the last five years and Persistent’s market share during this period has grown from 12% to 16%.
Essentially, to drive the OPD business, you need support of large product companies and Persistent has come a long way since it got its first customer, O2 Technologies, and later Microsoft, which really helped it grow. Today, it counts IBM and Intuit among its top 10 clients. The question does arise that there are many smaller Chinese companies that do similar kind of work, so why is Persistent different from these companies? The 22-year-old company is an integral part of its customers’ product development cycle and also has access to the software code that software product companies are generally wary about sharing with third-party vendors.
Average deal sizes are increasing, which shows clients’ growing confidence. OPD starts as a low-revenue per client business, and even now Persistent only has $0.7 million average revenue per client. So, the recent $10-million deal from IBM and $7-million Openwave deals are important steps forward showing growing client confidence. Persistent has spent years getting to this point, and we think larger deals with source code and higher margins will be a feature of the future.
Secondly, IP plays an important role in scaling OPD. Companies such as Salesforce, VMWare and Citrix (all involved in virtualisation-based cloud infrastructure solutions) have average gross margins of 86% when compared with the 39% of large IT services companies (including Cognizant and Accenture). Although the bulk of the costs for these companies (Salesforce, VMWare and Citrix) are in selling, general and administrative expenses (SG&A), the fact that they have developed the IP will eventually help when it reaches a particular scale. Similarly for Persistent, IP has a gross margin of close of 60%, which helps it to manage generic industry concerns such as wage hikes (which in India are rising at around 10%).
It is equally important to spot emerging technologies ahead of peers. Persistent has done this consistently by investing in cloud, mobility, big data and analytics well ahead of peers and thereby benefited from the demand-supply mismatch in these technologies, which is evident in the sustained increase in its billing rates. At a time when the IT services industry is struggling to maintain pricing, Persistent has seen its billing rates increase by 13% from Q4FY09 to H1FY13. When compared with other tier-II IT companies that disclose billing rates, namely Hexaware and MindTree, Persistent has seen the highest jump in billing rates. It was listed in Q4FY09 and at that time its offshore billing rate was 11% lower than Hexaware’s and MindTree’s. In the past 15 quarters it has seen a 13% increase in its billing rates and is now at par with Hexaware and 10% above MindTree. Improvement in pricing could also be attributed to the fact that Persistent is contributing to a client’s revenue opportunity rather than reducing costs.
Unlike its mid-cap peers, Persistent has managed to build a strong cash pile
Lastly, it is critical to channel your sales force in the right direction and use your connections to the full. At Persistent, 25% of revenues currently come from technology start-ups and SMEs that require minimal sales effort as Persistent is very well connected amongst PEs and VCs. The model preferred by the company is to source customers from within this universe; most marquee clients have come about via a start-up or SMEs that Persistent is working with being acquired by the marquee company, which then retains Persistent’s services given its domain knowledge, history of product releases and faster time to market. As a result, smaller clients have increased from 211 to 246 in the past 12 months. Also, larger clients have increased from 10 to 15 as Persistent’s deal sizes have also increased.
Cheap yet sound
Persistent’s business relies on two particularly discretionary aspects, both of which are very sensitive to economic sentiment: a) companies spending on research and development and b) rollout of new products. If Persistent’s customers experience a slowdown, the first thing to feel the impact will be the release of new products. However, with US tech companies planning to roll out new products as per schedule and nine out of Persistent’s top 10 clients being either pure tech companies or companies in cloud computing, our confidence in Persistent’s client base has increased over time. Despite all this, it is still good value — cash and marketable investments make up 22% of market cap (₹96.5 per share), a free cash flow yield of 9%, and 9 times FY13 earnings looks compelling to us.