Don't be a square

First Published in the Economic Times 16 April, 2000

In a situation where all Software companies look alike, and market movements have little correlation with reality, looking at the "fundamentals" of a Software company appears senseless. Punters are only interested in immediate numbers and rosy projections - and if growth requires huge cash infusions, few care. After all the "new economy" bandwagon does not seem to believe in profitability or returns on investment.

This is all very well when we are riding the market tiger, but ultimately there will be a weeding out of good and bad. This column has featured several "bad" types in the past, and lest you think that I am biased against the new economy, I thought I'd highlight a Software company I like - even though its valuation, like that of its peers, may appear daunting. The company is Geometric Software Solutions (Geometric) which has only recently gone public.

Geometric has actually been around for quite some time. In the mid-eighties, Godrej & Boyce started a CAD/CAM division, which was spun off into Geometric in 1994, along with all relevant physical and intellectual assets. This marked a major turning point for the company. Freed from being part of a huge and ancient company, they could focus better.

Godrej used to make CAD/CAM products for drafting, solid modeling, machining and finite element analysis. Even though some of their products were good, they couldn't make headway against large international CAD/CAM vendors. Hence Geometric's business plan evolved around their strengths in CAD/C.M.CAE. New revenue sources (on-site and off-shore) were developed where they leveraged on their experience. Also, the products business was re-oriented.

Rather than selling complete CAD/CAM solutions, they started vending components and technologies. This allowed them to partner and supply major international CAD companies, rather than compete with them - a strategy which helped their services business too. For end-users they started supplying add-on or plug-in products, which complement (rather than rival) the products of competitors. Today, they are one of few Indian Software companies to enjoy a steady stream of product income - currently 41% of sales.

In the present situation, when every Software company is a me-too, their approach is refreshingly different. The typical Indian Software firm is not focused, but spread wide. Companies will do ERP, Y2 work, Internet solutions, training, or whatever earns them quick revenue. Despite strengths in different areas, they are not necessarily specialists in anything. This business model may work for Infosys, since they are large enough to build decent-sized specialist Teams. But, for a small or medium sized company, trying to operate in ten different areas, it is difficult to build sufficient domain knowledge and large-project capability.

Over the long-term, low-end Software man-hour rates must drop (though it may take some time). Then, the me-too shops will suffer lower margins as competition intensifies for low-end jobs. However, companies with specialised skills will be able to protect margins better, thanks to their "knowledge" advantage.

There are two major arguments I've heard against Geometric. The first is, why has it taken 15 years to reach a turnover of Rs. 20 crores?" Especially when brand new start-ups do it in one year. The second complaint is against the "promoter" - the Godrej group. Disillusioned by the performance of other Godrej scrips, many investors tend to shun all group companies. Moreover, the story appears very similar to spin-offs by other corporate houses.

In terms of sales growth, Geometric is likely to grow slower than many others. The reason lies in their niche area of operation. They cannot suddenly start doing Y2K work, or web designing, e-commerce applications, or ERP, or the latest hot thing. In this sense, they are limited. However, to counter that, they earn higher man-hour rates than most Indian Software companies... thanks to their specialisation. This also restricts competition, as it is not easy for a competitor to suddenly encroach on their CAD/CAM space.

About the management, my personal view is that this company is completely run by professionals. In fact, employees own a significant chunk of equity, as do two strategic investors. MacNeal Schwendler Corporation, USA - a leader in the CAE market holds nearly 10%. Moldflow Pty. Ltd., Australia, a leader in solutions for "plastic flow analysis" holds 5% (they sold some stake during the IPO). Besides, VCs Draper and ICICI venture own nearly 13%. Also, the spin-off from Godrej happened way back in 1994 - so it is definitely not a "let's cash in on the boom" story.

For the year ended March 2000, expected sales are Rs. 34 crores (62% growth), while the bottom-line is estimated at Rs. 6.95 crores, giving an EPS of 14. At the current market price of Rs. 717, the P/E is 51 and the market cap is 15 times sales. This is no doubt high, but given the mad valuations that junk Software stocks command, this seems reasonable.

Within "techie" circles in Mumbai and Pune, they have a very strong reputation in terms of skills-base and the quality of work they're doing. From my point of view, if I'd like a longer-term investment, this counts for more than the fact that another "hot" scrip may have significant operator interest and may zoom up faster in the near term.