Hidden Bargains

Contrary to opinion, some infotech stocks are still worth a look-in. A simple valuation model shows why

Are infotech (IT) stocks still worth buying at current levels? This is one of the most frequently asked questions in the market today. The Indian stock market has completed yet another cycle. The rally, led by IT stocks, started at the beginning of the calendar year 1999 with the Sensex at around 2,800 points, and it peaked at 6,151 on February 14, 2000. By April this year, the Sensex had crashed to 3,200 points.

The question is whether IT stocks have reached the bottom too. To find out, The Smart Investor selects several stocks that have a higher upside potential compared to the downside risks.

Companies that are susceptible to market risk have been avoided carefully -- though this does not mean that they do not have upside potentials.

The basic tool

Our valuation model is on the PE ratio (Price /Earnings per share or EPS), which we have modified a bit. What we plan to focus on is earnings yield. What is this? Take the example of a stock that has a PE of seven. Now suppose it shows no growth in EPS.

In this case, the stock will show yield of 14 per cent (Re 1/Rs 7 * 100). This 14 per cent is called the earnings yield. Thus, higher the PE the lower the earnings yield and vice versa.

Now, the expected growth rate in EPS is a crucial factor in determining the PE. Because of the varying growth rates coupled with other factors like replacement value of assets and business risks different companies show varying PE.

This is why, the popular practice of comparing the PE with an industry average does not make sense. Ideally, no company with even a slightest and definite positive growth rate should be traded at a PE that is equivalent to an earnings yield of more than the required rate of return of the market.

If we consider 14 per cent is a decent return, a PE of seven for any growing company should be a strong support and the probability of the company's trading below the PE is very low. (It happens quite often during bad times giving the long-term investors a good opportunity to buy.)

The model

With the help of PE and the expected growth rate we try to work out the expected return from the investment. First we compound the EPS with the projected annual growth rate.

And based on a PE of seven, we extrapolated the possible market price to work out the return from the investment. We considered a PE of seven because, we think this is the minimum PE any company with positive earnings must enjoy.

Here's an example. Suppose a company has a current PE of 18, and suppose the company is expected to grow at an annual growth rate of 95 per cent per annum. A PE of 18 is equivalent to a market price of Rs 18 against an EPS of Rs one. The EPS will grow from Rs one to Rs 1.95 and Rs 3.80 in the first and second year respectively.

Let us consider that the PE can go down to seven. In that case the price of the share will become Rs 13.65 and Rs 26.62 in the first and second years respectively.

Thus, in the first year the investor will make a loss of around 24 per cent, but if he holds the share, in the next year he will be able to book a return of around 22 per cent.

The choice is the investor's. Any upward movement of the PE from the projected level yields bonus to the investors. The return could be worked out for different probable PEs and different expected growth rates. The model obviates the use of actual price and actual EPS.

Why this model?

This model helps picking up undervalued stocks, which are disparaged by the market. A good reason to use this model is that it safeguards the investors from investing in companies with very high PE coupled with not-so-high growth rate.

Such companies possess very high downside risks. At the same time it helps identifying the companies with good upside potential. Of course, like any other model this model is also not foolproof. Sometimes even the stocks rejected by the model may show good appreciation.

Different analysts project different growth rates for the companies. In order to minimise the projection risks, we decide to consider the consensus growth rate estimated by wow-india.com. These are consensus of growth rates projected by various research houses in India.

The PE is worked out by the Business Standard Research Bureau based on the prices of six June 2001.

Word of caution

The crucial input of the model is the expected EPS growth rate. Thus, this model is subject to the risk associated with the projection. If the projection fails, investors may end up getting a return less than the estimated one.

Moreover, projected bottomline growth may not be the projected EPS growth. If the company goes for a fresh equity issue that will result in a drop in EPS and a rise in PE without any price appreciation.

Moser Baer

Moser Baer India Ltd (MBIL) produces and sells floppy diskettes of 3 1/2" size and optical media including recordable CDs (CD-R) and digital versatile disks (DVD). The company sells its products as an original equipment manufacturer (OEM) to companies like Emtec, LG and Mitsubishi.

The company also sells its products under the brand name of Xydan, MMore, Prostore, MB Media and BASF. Except BASF all the brands are international brands. Combining branded and OEM, optical media contributes around 68 per cent of the total revenue of MBI and floppy diskettes contribute the rests.

It annually produces around 13 crore pieces of floppy diskettes. It plans to produce around 45 crore pieces of CD-R for the financial ending March 2002. For the fiscal ending March 2003 the company is expected to produce around 68 crore to 76 crore pieces.

The management is hopeful that the company won't be affected much by the US slowdown, as there is no fear of any order cancellation. MBIL, with its order book position exceeding its available capacity, is poised for a bottomline growth of more than 100 per cent over the current fiscal. The projected growth rate over the next fiscal is more than 65 per cent.

The company seems to be traded cheap at a PE of around 10. Even if the share slides to a PE of five, over the year the investors will be able to book a return of 17 per cent. The same will become around 40 per cent per annum over two years.

Even if the market batters down the PE further to four, the investments will return around 24 per cent per annum over a period of two years.

Mascot Systems

Mascot Systems is a subsidiary of Mastech System Corporation, which in turn is a 100 per cent subsidiary of the NASDAQ listed iGate Capital, US.

The company was in the business of providing offshore software delivery services to the clients of iGate Capital. Towards the end of 1999, following a major restructuring exercise of iGate Capital, the global software solution business in North America and UK of iGate Capital and Mastech System's entire business in Netherlands and Asia comes to Mascot.

Currently Mascot has 31 Fortune 500 clients. Its top 10 customers provide around 70 per cent of its total revenue. GE is one of the largest customers of the company that contributes around 38 per cent of its total revenue.

The company enjoys a billing rate of $1 million (around Rs 4.5 crore) with 15 customers. According to a Mumbai-based broker there is no indication of any kind of alteration of outsourcing schedule from the customers of the company so far.

The company has been battered badly by the market. The analysts have projected a very impressive 113 per cent bottomline growth for the company over the current fiscal. The same for the following fiscal 2002-03 is 73 per cent.

Against these impressive numbers the current PE is only 6.5. Even if the PE goes down to four, the investors will be able to book a decent return of 30 per cent over the first year, and around 50 per cent per annum if remain invested for one more year. For those who are ready to hold the investment for two years, they will be able to enjoy a handsome return of 30 per cent even if the PE falls to three.

Aptech

The IT education major Aptech sources around 81 per cent of its revenue from its training business and the rest comes from software services. It has over 2,150 education centres across the world out of which around 2,000 are in India.

The company has an alliance with major IT players like IBM, Microsoft and Oracle. This enables the company to offer training on latest technology.

In the software segment the company has around 150 clients including Schlumberger, Aramco, Irtron and Intermec. The company caters to businesses like healthcare, financial services and oil engineering.

With an aim to expand its client base, the company has already acquired Specsoft Inc, US, for a consideration of around Rs 44 crore. Aptech plans to hive off its software business and merge Hexaware with it. Hexaware is a group company involved in the software service business.

The company is being traded at a PE of around five. The bottomline of the company is expected to grow at 42 per cent and 32 per cent respectively over the coming two years. The chances of the company's PE falling any lower is quite bleak.

Thus, in all likelihood the projected growth rate will be translated as a return to the investor, which is a handsome 40 per cent over a year. If the PE goes down to four, the return over the year will be around 16 per cent and the same will be around 24 per cent per annum over a holding period of two years.

SSI

SSI is involved in the IT training business. It is also into consulting services. Around 60 per cent of its revenue comes from the training business, and the rest comes from software business. The company has around 650 centers across the country.

Though the company is mainly dominant in southern part of the country, it is gradually expanding its reach to other parts also. The analysts have contradictory view on the impact of the IT slowdown on the company's training business.

But they unanimous believe that the company's the short-term high-end courses will be affected adversely. In its technology segment NASDAQ is believed to be the only loyal customer. Thus there is very high probability that in the wake of the US slow down the company will lose a numbers of customers. Along with the declining numbers of employees, the billing rate of the company is also coming down gradually.

In order to reduce its fixed costs the company intends to source a part of its software assignments from smaller companies. The profit margin may suffer due to increase in variable costs when the business volume increases.

With the PE of 5.9, the training house's stock is traded at its bottom. Analysts have projected a bottomline growth of 46 per cent for the fiscal June 2001-02 and 57 per cent for the following year.

The stock will be able to yield a handsome return of around 24 per cent even if the PE goes down to five. If the PE moves down to four the investment will yield a negative return for the first year but if remain invested for the next year, it will fetch a return of around 25 per cent per annum.

Sonata Software

Sonata software has changed its focus from software reselling to software development and IT consulting. The company's client list includes companies like Smithkline Beecham, Bayer, Singapore Telecom and SBT of USA. The company is also a vendor for the companies like Microsoft, IBM, Oracle and Lotus.

In order to increase its export revenue, the company has acquired 26 per cent in a US consulting firm Spinway for a consideration of $ five million (around Rs 23 crore). Of this amount, $ 2 million is being paid upfront and the remaining will be paid over three years. USA contributes around 60 per cent and Europe contributes around 40 per cent to the company's turnover.

Against the projected bottomline growth of 42 per cent, the company is currently traded at a PE of 6.5. There is no projection available for the next fiscal. If the valuation of the company drops further to 5.5, the investors will be able to make a decent return of around 20 per cent over the year.

Of course, if the stock drops by another one point to 4.5, investors won't be able to book a positive return over the period.