This is a post with a difference. For the first time on this site, I’ve tried to articulate my thesis for a specific stock. Note that this is not a recommendation to buy or sell this stock but more a look into the various aspects to consider when identifying your stock picks, which I described conceptually in my post on investment checklists. The sources for financial data are the annual reports and screener.in, those for the industry analysis are various reports available online.
Disclaimer: I currently own the stock and therefore more than likely to be biased.
This is an oft-repeated graphic on the internet, since it was published in a tech crunch article by Tom Goodwin in Mar, 2015. Below, a short excerpt:
“The value is in the software interface, not the products. It’s not just the smart home. Uber provides average cars in a premium way; Seamless makes the most disgusting of greasy kebab joints appealing and makes its margin from both sides. iTunes for many years took virtually all the profit made in the entire music industry by being just the thin software between the hard work making tunes and the money selling them.”
Persistent Systems is looking to capitalize on this need, for every business to digitally transform the way it interfaces with its stakeholders.
Persistent: Strong player in a niche segment
Unlike the outsourced IT services market worth over USD 500 BN of which IBM, Accenture along with Indian IT majors like TCS, Infosys, Wipro, are well known competitors, outsourced software product development is a niche segment with a 2016 global market estimate of USD 15 BN, growing at a steady rate of 4 – 5% annually.
Difference between traditional IT Services and Outsourced Product Development:
Product development needs a different set of operational skills to be successful. Established in 1990, Persistent has a demonstrated track record of it’s operational capability in outsourced product development.
In Q4 2016, Forrester classified the company as a “Leader” in the BPM Service Provider space, rated better than much larger overall competition like Accenture, Capgemini, TCS and Cognizant.
Part 1 – The Fundamentals
Strong growth track record
Since listing in 2007, Persistent has delivered double-digit revenue growth every year barring 2008-09. Overall 10 year revenue CAGR of 22% and 18% Operating Profit growth.
Growth on its own matters little if it does not generate a return sufficiently above the opportunity cost of other less uncertain investments. Persistent has maintained ROCE of above 20% over 10 years
Comparing Persistent’s Cash Flow from Operations with Profit Before Tax shows a favourable relationship between the two. The recent decline in CFO as percentage of PBT bears watching to ensure earnings quality does not deteriorate.
(Largely) consistent growth
Tracking year-on-year growth rates of key metrics provides a sense of the consistency delivered as an indicator of how likely or unlikely a company will continue to deliver over the next 3 – 5 years.
Persistent has shown some volatility in the last two years after a fairly stable growth trajectory.
Not a borrower
Persistent has negligible debt (INR 3 Cr) compared to 2016 EBIT of INR 317 Cr
Consistent dividends = (Some) cash yield
A consistent dividend paid out of operational earnings provides the reassurance of an Order to Cash mechanism that works. Persistent has paid out a “reasonable” payout policy (Dividend / Net Profit) over the years with a largely upward trend.
Applying a rudimentary scoring mechanism to bring together all facets of the fundamentals, Persistent scores 38.5 out of a possible 50
Above table compares Persistent with the three largest India IT majors and one mid-sized IT Services company of comparable revenue (Persistent: INR 23.12B, NIIT Tech: INR 26.82B)
Compared to its peers (no comparable pure product development companies are listed in India), Persistent compares favourably on fundamentals:
- TCS does better on growth and consistency
- NIIT Tech does better on earnings quality
- Overall Persistent scores high on Earnings Quality and Yield
Part 2 – Price v/s Value
“High quality assets can be risky, and low quality assets can be safe. It’s just a matter of the price paid for them” – Howard Marks (OakTree Capital)
Establishing that a company is fundamentally strong is critical to the investment process. Determining whether it is a good buy at the prevalent price is equally, if not more important. Doing the first, but not the second often results in overpaying for assets, therefore putting future returns and in extreme cases, even the capital at risk.
Safe Price (Or Idiot’s Valuation)
What is “Safe Price”? A conservative valuation of the company as a function of free cash flows generated over the last six years adjusted for a conservative growth rate into the future
Step 1: Average Free Cash Flow generated by the business over the last 6 years
Step 2: Assume the firm can maintain this average FCF over the long term. Value of the company is PV of this perpetuity adjusted for a conservative growth rate. This is “Safe” Share price
Step 3: Compare the per Share price versus market price to determine how optimistic / pessimistic the market is about future prospects
Chart shows Persistent stock price plotted against a theoretical “Safe Price” revised annually, computed on the basis of rolling 6 year financial performance. It indicates Persistent would not have been a good buy in April 2015, at INR 900 because of the divergence from safe price of INR 500 at the time but as of Jan 20th 2017, at INR 630, is much closer to its safe price of INR 540.
How does this delta between Current and Safe Price compare with other IT stocks?
General rule of thumb is to eliminate stocks where the ratio (Current Stock Price / Safe Stock Price) is > 3. The decline in IT stocks over the last year means most companies in this sector are under this threshold.
Persistent is currently conservatively valued versus Indian IT majors and similar-sized companies:
- While all IT stocks are at conservative valuations, Persistent is still favourably priced in comparison
- Better priced compared to NIIT Technologies, which has comparable revenue and fundamentals
Future Prospects (not considered for valuation) – Can it outperform the Base Case?
Chart shows increasing % of revenue from IP-led offerings; 22% to 27% over the last three years. This implies decreasing reliance on the linear FTE-based revenue model.
In FY2016, Persistent re-organized itself into four market-facing SBUs:
- Services: The bread and butter outsourced product development business
- Digital: Help customers become software-driven businesses
- IBM Alliance Unit: The IoT play, developing IBM’s engineering lifecycle management suite of products
- Accelerite: Buy IP for non-strategic products from software product companies and monetize
The IBM Alliance Unit, is an exclusive partnership where 1,000 Persistent engineers will work to help IBM’s customers develop solutions on the Watson IoT (Internet of Things) platform using the IoT continuous engineering solution. The potential impact of IoT on technology is estimated at $11 Trillion by 2025.
Units 2 (Digital) and 4 (Accelerite) are currently nascent, they offer significant potential for growth in emerging focus areas that could enable Persistent to move beyond the FTE-based billing model to more non-linear revenue streams based on intellectual property with higher operating margins.
Under Founder Director Dr. Anand Deshpande, who continues to own a significant part of the company, Persistent has the potential accelerate its trajectory with it’s new focus on IoT and solutions for Smart Cities. If this effort is successful, the possibilities for profitable growth could increase significantly.