By Nirmal Bang

Background

Persistent Systems Limited (PSL) was incorporated in 1990 in Pune as a private limited company. Currently PSL is one of the market leaders in outsourced software product development space. PSL design, develop and maintain software systems and solutions, create new applications and enhance the functionality of the customers’ existing software products. As an Outsourced Software Product Development (OPD) specialty company, PSL provide its customers the benefit of offshore delivery. The company delivers services across all stages of the product life-cycle, works with a wide-range of customers and develops, enhances and deploys the customers’ software products. Persistent Systems’ outsourced software product development services allow its customers to release management bandwidth, to reduce time-to-market, improve the quality of their products, reduce risk of failure during the engineering development process, and improve predictability and reliability of the engineering process. The company has compet ency centers in Telecommunications and Wireless, Life Sciences and Healthcare and Infrastructure and Systems. Their customers range from numerous global software companies to early-stage companies. As of 31 December 2009, the company has over 37 customers that have annual revenue of more than US$1 bn. PSL has a presence in three continents across the globe. It has nine development centers in Europe, America and Asia. In India, along with three development facilities in Pune, which is the company’s hub; PSL has development centers in Nagpur, Goa and Hyderabad. As of January 31, 2010, the company had 4,639 employees of which over 3,700 are software professionals. PSL believes that the ability to maintain growth depends on attracting, training, motivating and retaining skilled employees. The attrition rate for the company was 8.56% and 13.75% for the nine months ended Dec. 31, 2009 and fiscal 2009 respectively.

Persistent Systems Limited (PSL) was incorporated in 1990 in Pune as a private limited company. Currently PSL is one of the market leaders in outsourced software product development space. PSL design, develop and maintain software systems and solutions, create new applications and enhance the functionality of the customers’ existing software products. As an Outsourced Software Product Development (OPD) specialty company, PSL provide its customers the benefit of offshore delivery. The company delivers services across all stages of the product life-cycle, works with a wide-range of customers and develops, enhances and deploys the customers’ software products.

Persistent Systems’ outsourced software product development services allow its customers to release management bandwidth, to reduce time-to-market, improve the quality of their products, reduce risk of failure during the engineering development process, and improve predictability and reliability of the engineering process. The company has competency centers in Telecommunications and Wireless, Life Sciences and Healthcare and Infrastructure and Systems. Their customers range from numerous global software companies to early-stage companies. As of 31 December 2009, the company has over 37 customers that have annual revenue of more than US$1 bn.

Services across the Product Engineering Lifecycle

PSL provide a comprehensive range of services for its customers across all phases of the Product Engineering life-cycle. It designs, develops, tests, provides quality assurance, deploys, supports and maintains software systems and solutions for the customers. It also creates new custom applications, enhances the functionality of customers’ existing software products, and participates in the release of new product versions. Over the past five years, the company has contributed to more than 3,000 product releases for its customers.

Domain Capabilities

PSL has significant domain expertise in telecommunications, in life sciences and healthcare and in infrastructure and systems. The teams in these domains are focused on harnessing and leveraging their experience and tools across product companies within each focus industry.

Telecom and Wireless

The company offers software solutions to telecom product development companies and carriers across handset, wireless and wireline industries. Their team is equipped with in-depth knowledge and expertise of existing and emerging telecom technologies and business practices.

Life Sciences and Healthcare

The company’s life sciences team focuses on systems biology, translational medicine, bioinformatics, laboratory informatics/automation and clinical research in informatics. Its core technological expertise of the life sciences competency center includes: data management, integration and warehousing; data analysis – algorithms and visualisation; data curation (automaton of pipeline); workflow, automation – Laboratory Information Management System; webbased portals and web services.

Infrastructure and Systems

Its analytics and data infrastructure competency center develops applications and technologies that are used to gather, provide access to, and analyse data and information about, company operations. The company offers customers complete analytics and data infrastructure solutions or components that can be adapted to current platforms.

New Initiatives focused on growth

PSL dedicates four percent to six percent of its engineering staff for exploring new technologies and building capabilities in new technology areas. Some of the crucial initiatives of the company keeping in mind the market needs are: Cloud Computing Cloud Computing enables the customers to pay-per-use on services consumed and it leads to lower costs by better resource utilization through resource sharing. PSL partners with leading cloud platform vendors to enable software product companies to migrate their products to the cloud platform. Analytics This initiative of the company helps its clients to make effective decisions by analzing the voluminous data. The company provides data mining, statistical analysis and visualization services. It works with customers who build tools and other infrastructure for analytics. Enterprise Mobility The increasing penetration of smart phones, notebooks and mobile internet devices has caused them to be managed as enterprise resource. The company works with customers such as and-set manufacturers, wireless network equipment companies, telecommunication infrastructure companies building point solutions for these companies.New Initiatives focused on growth PSL dedicates four percent to six percent of its engineering staff for exploring new technologies and building capabilities in new technology areas. Some of the crucial initiatives of the company keeping in mind the market needs are:

Cloud Computing

Cloud Computing enables the customers to pay-per-use on services consumed and it leads to lower costs by better resource utilization through resource sharing. PSL partners with leading cloud platform vendors to enable software product companies to migrate their products to the cloud platform.

Analytics

This initiative of the company helps its clients to make effective decisions by analzing the voluminous data. The company provides data mining, statistical analysis and visualization services. It works with customers who build tools and other infrastructure for analytics.

Enterprise Mobility

The increasing penetration of smart phones, notebooks and mobile internet devices has caused them to be managed as enterprise resource. The company works with customers such as hand-set manufacturers, wireless network equipment companies, telecommunication infrastructure companies building point solutions for these companies.

Enterprise Collaboration

The company works with product companies to build products that leverage technologies across search, email and messaging, text mining and analytics. While deploying these products multiple customizations are required. The company has built frameworks to integrate diverse and available collaboration tools within the enterprise.

Flexible pricing models

PSL provides flexible engagement and pricing models depending on whether the customer is a start up or mature organization, the phase of the product in the product maturity lifecycle, technology and domain requirements for building the product and the requirement during the various stages of the product development life-cycle. Pricing models could be variable based on the resources required such as time and expenses or cost plus or fixed like based on service level agreement or royalty streams.

Objects of the Issue

The issue compromises of issue of 0.54 Crs equity shares of face value of Rs.10 within a price band of Rs.290 and Rs.310. The issue size is Rs.156.6 Crs at the lower price band and Rs.167.4 Crs at the upper price band. In the IPO, PSL will issue 0.41 Crs fresh shares while the remaining 0.13 Crs shares will be offered for sale by Dr. Shridhar Bhalchandra Shukla and Ashutosh Vinayak Joshi. Dr. Shridhar Shukla who holds 0.17 Crs shares jointly with Vijayalaxmi Shukla will be offering 0.06 Crs shares for sale. While 0.06 Crs shares will be offered for sale by Ashutosh Joshi who holds 0.17 Crs shares. Post issue the holding of promoter will reduce to 38.85% from the current holding of 43.34%.

Proceeds of the issue will be used for:

- PSL will use Rs. 119.0 Crs towards the expansion of the facility at Rajiv Gandhi IT Park, Hinjawadi, Pune and approximately Rs. 55.9 Crs to revamp its campus at the IT Park, Parsodi, Nagpur.

- Rs.20.4 Crs will be spent to procure additional hardware required to carry out software development.

- Rs. 2.9 Crs towards interior and fit out expenses of the incubation space in the Sundew Properties Private Limited SEZ, situated at Madhapur, Hyderabad.

Investment Thesis

Robust CAGR over last 4 years with stable margins

Over the last few years PSL has displayed healthy performance despite economic concerns and downward pressure on volumes and pricing. PSL has witnessed a robust CAGR of 42.2% during FY 2005 - FY 2009 in revenues from sale of software services and products which is significantly higher than the industry growth rate during the same period. Despite facing a tough time in 2H 2009, owing the global slowdown, the company has managed to register 33.3% growth in revenues from sale of software services and products. The increase in top-line reflects that company has enhanced its range of services to obtain additional business from existing customers apart from constantly adding new clients every year. We expect the top-line growth to remain strong going forward after expecting a flattish decline in top-line in FY 2010.

Company has also maintained stable EBITDA margins in the range of 20%-24% over last 4-5 years. EBITDA margin in FY 2009 declined mainly on account of cancellation of certain forward contracts due to lack of volumes which resulted in one time charge of Rs 25 Crs.

Increase in offshoring to help OPD players like Persistent

PSL is one of the market leaders in OPD services. PSL design, develop and maintain software systems and solutions, create new applications and enhance the functionality of its customers’ existing software products. Over last 20 years company has developed strong expertise in this space. Company’s OPD services allow customers to reduce time-to-market, improve the quality of their products, reduce risk of failure during the engineering development process, improve predictability and reliability of the engineering process, while helping them lower their over-all PE costs. IDC has forecasted that worldwide R&D/PE spending to grow at a CAGR of 14% during 2009-2013 to reach US$65.7 bn by 2013 (Source: Company Data). We believe that PSL being a niche player in this segment will be able to capitalize on these opportunities.

Wide spectrum of services enhancing future growth prospect

PSL provides a broad range of services to its customers that support their software products throughout the full product life-cycle. Company offers end to end services in order to address the customers’ specific needs as products move from different stages of maturity across early to end-of-life. PSL’s services offerings range from research and prototyping, development and testing, consulting services and deployment, and support and maintenance. PSL’s services focus with capability to manage smaller products, serve customers globally and its offshore delivery model makes its product sustenance offering very attractive. Company also provides new life to products that are either end-of-life or orphaned because of lack of management attention.

Large customer base

Over the years company has developed a large customer base. PSL has consistently increased its client base and has currently more than 200 active clients of which more than 37 customers have an annual revenue of more than US$1 bn which gives PSL ample opportunities to expand its business with existing customers. PSL has added 59 new customers (excluding one-time customers to license sales) during nine months ended December 2009. While company has added 110, 82 and 77 new customers (excluding one-time customers to license sales) in FY 2009, FY 2008 and FY 2007 respectively. We believe that constant client addition will help the company to grow its business. Moreover, PSL has demonstrated a good history in retaining its customers which is reflected by the fact that company has garnered around 88.5% and 91.6% of its revenue from repeat business in FY 2009 and 9M 2010. Repeat business from clients ensures steady cash flows and enables the company to grow along with the growth in client’s business.

Investment in new initiatives to propel top-line growth

PSL has taken initiatives to invest in new technologies such as cloud computing, analytics, enterprise mobility and enterprise collaboration. These initiatives allow the company to establish thought leadership and deliver specialized services to its customers. Cloud computing is an emerging computing technology that uses the internet and central remote servers to maintain data and applications. Cloud computing allows costumers and businesses to use applications without installation and access their personal files at any computer with internet access.

Cloud computing could have a significant positive impact on the OPD market as the product companies will have to re-invent themselves for the new business models, inter compatibility and cost efficiencies. Over the next five years, IDC expects spending on IT cloud services to grow almost threefold, reaching US$42.2 billion by 2013 and accounting for some 10% of all IT spending worldwide. (Source: IDC, Company Filings).

Development of IP capabilities will further boost company’s business

PSL intends to regularly invest in the creation of new intellectual property. It plans to focus on three main areas of innovation: platform innovation, PE process innovation and domain specific innovation. Company’s efforts have resulted in the development of value-added products and services including time-to-market accelerators, connectors and integration services and other technology-based components. PSL seek further growth by leveraging its software development capabilities through designing, developing and marketing proprietary niche software solutions in select international markets.

Investment Concerns

Risk of dilution in earnings post the removal of STPI benefits

The major development facilities of the company are located in the cities of Pune, Nagpur and Goa where it operates through various software technology parks. The tax holiday enjoyed by PSL will cease to exist if the government decides not to extend the tax benefits granted for the export of IT Services from specially designated software technology parks post FY11. In such scenarios, there will be dilution in earnings due to increased tax liabilities.

Revenues highly dependent on customers located in United States

The company derives over 80% of its revenues from sale of software services and products from customers located in the United States. In the event of economic downturn in US economy or curbs on outsourcing to India, its business will be negatively affected due to reduced demand by customers or postponement of IT spending.

Appreciation of INR can dampen profitability

Major chunk of the revenues of the company is denominated in US dollars. The INR has appreciated from the levels of USD/INR 48-49 to USD/INR 46-47 over last couple of quarters. This INR appreciation is expected to negatively impact the company’s top-line growth and margins.

Valuation:

Peer Comparison

PSL does not have a direct competitor in OPD space. Therefore, we have compared PSL with Sasken Communications Technologies Ltd (Sasken), MindTree Ltd and KPIT Cummins as they operate in similar kind of business (product engineering and product life cycle management) and have decent exposure to telecom vertical. PSL’s top-line growth has been much higher as compared to its peers over last 3-4 years. Moreover, PSL’s EBITDA margin is also towards the higher end in the peer group.

Recommendation

Based on price of Rs 310 (upper end of the price band) and company’s annualized earnings (on 9M 2010 results) the company will trade at a P/E multiple of 11.68x which is higher than its peers. However, considering that company’s business is superior as compared to its peer group, we believe that it should command a premium and therefore trade well above the P/E multiple of its peers. PSL has recorded strong growth in top-line and profitability in Q3 FY 2010 while its peer has witnessed a muted growth after excluding the impact of acquisitions. PSL’s Sales was Rs 158 Crs and EPS was Rs.7.72 in Q3 FY 2010. Assuming that PSL registers similar top-line and margins in Q4 FY 2010 as we saw in Q3 FY 2010, its 2H FY 2010 results would be better than its 1H FY 2010 top-line of Rs 271 Crs and EPS 11.13 indicating that company is recovering rapidly from the downturn. Also, company looks attractive in terms of P/BV and EV/Sales multiple given that company is expected to grow at a rapid pace as compared to its peers. Therefore, we recommend SUBSCRIBE to this issue.