No Mass Appeal

Despite the compelling valuations, Mascot Systems' disappointing performance has kept the investors away

If the last-quarter results are any indication, there has been a marked improvement in the performance of domestic software companies. The recovery has been largely driven by the sharp upsurge in volumes, with tapering of pressure on billing rates. Though the upturn has been more prominent in the frontline stocks, many mid-and-small sized players have also shown some distinct signs of recovery in business.

However, some of the small companies still seems to be struggling to ramp up their operations. The case in point is the Bangalore-based Mascot Systems which continued to show a declining trend in the last two quarter. For the first half year ended September 30, 2002, the company's revenues plummeted by 18 per cent to Rs 181.12 crore.

 

More concerning is the steep drop in the company's margins which, anyway, were one of the lowest in the industry. Operating margins declined to a dismal level of 8.7 per cent, down from 13.5 per cent in the corresponding period last year. The company's net profits slumped by 46 per cent to Rs 14.55 crore during the first half of this fiscal.

It's not that the management hasn't made efforts to bring in new business by further strengthening the marketing and sales infrastructure. It has set up offices in all the key markets, with Germany and Australia being added in the last quarter.

The benefits are also reflected in terms of robust new client additions, with 11 customers added in the last quarter alone. But unfortunately, it has not been able to substantially scale up the business from its new engagement.

In case of profitability, the company is believed to suffer due to its dependence on a single client, GE, for more than half (or 55 per cent) of its business. GE is known for aggressively negotiating on billing rates, even with large vendors like Satyam and Wipro. Besides, margins are lower as the company generates about 69 per cent of its total turnover from the low-margin onsite business.

A blended approach: As part of its strategy to acquire large contracts and build long-term relationships, the company has entered into blended rate contracts with some of the clients.

It is a version of fixed price projects, where the service providers agrees to operate at a fixed rate regardless of whether its offshore or onsite part of the project. For instance, blended rate of $38 per hour is something between the offshore rates of about $20-22 per hour and onsite rates of $45-50 per hour.

Blended rate contracts could be quite advantageous in the long term. To begin with, these contracts are normally spread over a longer duration (about 3-4 years plus) and generally involves huge volumes with opportunity to employ 100 plus professionals on the engagement. Thus, such deals result in a stable and long term customer relationship.

On the flip side, the company has to make large investments, with practically no return in the initial phase of the contract. The reason being that initially most of the work is onsite which is a low margin business even on normal onsite rates.

So, at blended rates which are generally lower than onsite rates, the company could actually end up losing money during the initial period of contract. But it is the other way round when the major portion of the business shifts to offshore where the company accrues super-normal margins. Thus, it is important to quickly scale up the offshore portion of the business.

"The break even for a typical blended project is achieved when about 40 per cent of revenues starts following from offshore work, which could take as much as two quarters," explain Gerhard Watzinger, chief executive officer, Mascot Systems in a recently held earnings conference call.

Blended rate contracts contributed to about 30 per cent of the company's revenues in the last quarter. But it was largely (about 93 per cent) from the onsite business of the blended contracts, thereby further adding to the pressure on the company's margins.

Valuations: At the current price of Rs 137, the scrip is trading at 12.5 times its FY03 earnings which seems to be quite reasonable. But the stock is expected to remain muted as the company is not expected to show any significant improvement in its performance in the second half also.

Moreover, the scrip has already seen some upside on the back of the recent announcement to acquire US-based eJiva, which is one of the group companies of its parent iGate Corporation. Even this is also not expected to result in any tangible benefits in near future.