On the Growth Track

Zylog Systems is a technology solutions provider to clients across verticals like banking, insurance, telecom, manufacturing, retail and pharmaceuticals. The company provides a portfolio of IT products and services, which it has expanded through a combination of organic and inorganic growth. It offers both onsite and offshore services depending on the client’s requirements and the nature of the project.

Strengths
Niche player. The company is a niche player with specialisation in field service automation, mobile solutions, inventory management, radio frequency identification (RFID) applications, banking, insurance solutions and replacement technologies.
Zylog derives around 65 per cent of its revenue from IT services and the balance 35 per cent from products and solutions. It executes most of its projects onsite. It earns 85.3 per cent of its revenue through onsite work and 14.7 per cent through work done offshore.
Profitable acquisitions. Between FY08 and FY10, the company made a few acquisitions that have helped it achieve growth and also widened its portfolio of service offerings. In the past, most of the acquisitions made by the company were small-sized (except the Brainhunter acquisition in FY10). These acquisitions were in the IT solutions and products space. And they were financed mostly through internal accruals with only a small proportion of debt funding.
While some of these acquisitions have opened up opportunities in new markets and verticals, others have strengthened the company’s position in certain business lines. For instance, the acquisition of UK-based Anados Software in FY08 gave Zylog an end-to-end insurance solution. The acquisition of Ducont in FY09 marked its foray into Middle-East markets. Fairfex Consulting’s acquisition in FY09 strengthened the company’s position in the pharma and healthcare sector.

Growth opportunities
Brainhunter acquisition to open up new opportunities. In February 2010, through its wholly-owned subsidiary, Zylog Systems (Canada), the company acquired the assets and business of Brainhunter Inc., Canada, and its wholly-owned subsidiaries. Brainhunter is a consulting and engineering services company in Canada with a major presence in verticals such as government, telecom, BFSI and oil and gas. It was a loss-making company when Zylog acquired it. Brainhunter is also one of Canada’s largest staffing companies. It has a wide-spread client base of over 400 blue-chip organisations across the sectors mentioned above. Around 35 per cent of the services it renders are to the various agencies and departments of the federal government of Canada. This acquisition has facilitated Zylog’s entry into the Canadian market. It will also provide it with the opportunity to cross-sell its products and services to Brainhunter’s marquee clients.
Expansion in WiFi services. The company has rolled out an offering in internet services wherein it leases bandwidth from an integrated telecom company and offers last-mile connectivity to its customers through Wifi technology in relatively under-penetrated cities and towns. According to a recent report by Anand Rathi, the company has earmarked capital expenditure of US $50 million for the first phase of this venture in which it will unwire Southern cities and towns and provide wireless solutions.
The company is also in discussions with the government to provide wireless solutions to it.
E-governance projects in India. In FY10, Zylog started executing projects in the e-governance space related to road transport organisation (RTO), agriculture and below-poverty-line population. A common feature of these projects is that information has to be collected at the grassroots level, database has to be created, and smart cards bearing relevant information of individuals have to be issued. Most of these projects (except RTO) are being funded by the central government. Zylog has successfully implemented RTO projects in Karnataka and Gujarat. The governments of Tamil Nadu and Haryana have also approached Zylog for submitting proof of concept (PoC). According to the Anand Rathi report, some of the state governments have made it mandatory for all their citizens to convert to smart card-based driving licences over the next two years. If more states implement this concept, it is sure to boost Zylog’s revenue further.

Concerns
E-governance segment largely dependent on ability to win deals. A company requires good connections within the government and experience in executing similar projects in order to bag government projects. Since Zylog is a new player in the e-governance space, some state governments could be reluctant to award projects to the company.
Smaller players vulnerable to vendor consolidation. Enterprises are always looking out for ways to reduce their expenditure on the solutions and services they need. After the recent financial crisis, there is an increasing trend among clients to work with fewer vendors, as this enables them to negotiate for better billing rates.
Any vendor consolidation could adversely impact mid-tier players such as Zylog who could end up losing some of their existing client accounts.
Zylog faces competition from both ends of the spectrum: in some projects it faces competition from local vendors while in others it faces competition from the large Indian players.
Currency fluctuation. The company derives its revenue largely from export of products and services, which renders it vulnerable to currency fluctuation.
Integration of Brainhunter. Although the management has successfully integrated its past acquisitions, the integration of Brainhunter will present a unique set of challenges. One, in terms of revenue Brainhunter is a larger company than Zylog. Two, it is into staffing solutions. By contrast, Zylog’s other acquisitions have been fairly small sized companies and all were in the IT solutions space, a similar line of business.
What will render Brainhunter’s integration more challenging is the fact that it had filed for Companies’ Creditors Arrangement Act to avoid bankruptcy. Therefore, the successful integration of this acquisition is one aspect that investors need to monitor closely.
Competition may affect long-term growth and margins. Zylog’s Wi-Fi segment is expected to grow significantly over the next two-three years as the company is targeting under-penetrated areas. However, it may face cut-throat competition from integrated telecom operators who are currently facing significant downward pressure on average revenue per user in the voice segment.

Financials
Good growth. Over a period of five years, the company has registered a compounded annual growth rate (CAGR) of 47.97 per cent in sales. Its profit after tax has grown at a five-year CAGR of 30.54 per cent. Free cash flow, which represents the cash that the company is able to generate after laying out the money required to maintain or expand its assets, of Zylog registered a five-year CAGR growth of 55.61 per cent.
Declining profitability ratios. Over the last five years Zylog’s return on capital employed (RoCE) has averaged 22.64 per cent. Over the same period its return on net worth (RoNW) has averaged 24.2 per cent. In FY11 its RoCE stood at 21.54 per cent while its RoNW stood at 22.58 per cent. Although these are decent numbers, they represent a decline of about 7.35 percentage points and 11.43 percentage points in RoCE and RoNW respectively over the last five years.
Stable margins. Over a period of five years, the company has maintained a stable operating profit margin in the range of 16-18 per cent. Its operating profit margin has averaged 17.14 per cent over the last five years. Similarly, its net profit margin has registered a five-year average of 11.05 per cent.

Valuations
The stock is currently trading at a consolidated price-to-earnings ratio (P/E) of 4.65. This is below its three-year median P/E of 5.49. Its earnings per share (EPS) registered a three-year CAGR of 13.81 per cent. Based on this EPS growth, its price-to-earnings to growth ratio (PEG) comes at 0.3 times. The company has good growth potential and could be a part of your long-term portfolio.