UPDATE ON ALLIED DIGITAL SERVICES

I have recommended allied digital ( ADSL)  around 92 levels few weeks back. stock is trading at 56 00 levels now. however one can buy this stock for following reasons in long term prospectives.

1. BUY BACK OF SHARES

The Company is Buying 20 Lakh shares from open market through renowned broker Anand Rathi at max. price 140. 2,20,000 shares have already been bought and 2 lakh warrents would be converted to shares as constituent in 20 lakh. Remaining 15,80,000 shares are yet to be bought which is likely to happen in few quantities (20,000 – 50,000) almost every day till 20 lac shares are bought altogether. Now, what’s interesting to note is that the company would buy shares in the open market, the biggies – Corporate institutions, FIIs and HNI are unlikley to sell their holdings because, If at all they wanted to offload their stake they would  done it in past 3 sessions where there was ample liquidity to absorb good quantity of shares. So, what conclusion can be bought now is that the shares that the company would be buying would be of Retailers who always tend to be loosers in panic situations. During a course of Buy-Back, when good amount of Retailer shares are Absorbed the company would face liquidity crunch and will have to buy shares at higher prices. Rembember, If so happens then at the end of the Buy-Back, The retailers would have only 25 Lac (approx.) shares and with little liquidity in the market the share price can easily be bought higher.

2. Strong Presence in Pan India and other prominient locations world-wide

ADSL has over two decades of experience in enterprise IT Infrastructure, management and implementation & consulting on complex IT Solutions for different business verticals and recently, they have startd with the cloud-compuing business which is the most innovative and future – promising product in the IT industry. The Company has about 2,265 Committed Professionals from different managerial and engineering backgrounds operating across 132 locations in India and across locations in USA, Australia and recently in Singapore too.

3. More than commensurate de-rating of valuation makes ADSL a strong value pick

We believe that the company’s fundamentals are largely in place with its continued attempts to transform itself into a high value adding services player. Also the company’s decision of considering buy-back and appointment of a reputed joint-auditor are likely to restore some credibility. With valuations cheap at 3.7x FY12 P/E (on our substantially reduced estimates) and the current stock price at significant discount to FY11 Book Value (Rs160).

4. IMS business to drive 29% revenue CAGR over next three years

The experience and expertise in system integration (SI), technological depth, wide onsite reach and sizeable remote infrastructure make ADSL a leading IMS player in the domestic market. The company has gained a strong foothold in the US market with the acquisition of EPGS in midFY09. After
struggling initially, EPGS is now on a sturdy growth path with FY12 revenue expected at US$55mn, a growth of 28% yoy despite offshoring. Overall IMS revenues of the company are expected to witness FY11-14 CAGR of 38% v/s 16% for SI segment. Resultantly, IMS revenue share would increase from 56% in FY11 to 64% in FY12.

IMS as a service line has been witnessing robust growth   Infrastructure Management Service (IMS) helps companies to optimize/improve the utilization of IT assets and simultaneously reduces the total cost of ownership (TCO). Companies outsourcing IMS save cost and are able to focus on strategic functions.

In the last decade Application Development Maintenance (ADM) and Business Process Outsourcing (BPO) dominated the Indian IT offshoring growth and this decade, IMS is touted to be one of the key growth engines.

As per the NASSCOM Strategic Review 2010, IMS was the only segment within IT services to record a double-digit growth of 10.6% in FY10 mainly driven by offshoring of value-added and more complex services. It also highlights the higher resilience of this service line as compared other IT services in a macro downturn. Another trend that emphasizes on the high growth of IMS is the significant increase in its share in revenues of large companies, Infosys, Wipro and HCL Tech.  Indian IMS industry has reached a size of US$4.3bn, having witnessed a CAGR of 39% over FY07-10.

Within IMS, Remote IMS (RIMS) has witnessed increased traction. In RIMS, the services are provided from remote (not onsite) low cost locations like India NOC to provide a cost advantage to the clients while maintaining/improving the service levels.

As per NASSCOM-Mckinsey, global offshore IMS market would grow to US$26-28bn by 2013. India’s share of the above opportunity is projected to reach US$13-15bn. Domestically, system integration and infrastructure outsourcing segments are expected to grow at 15%pa each.

Drivers of IMS & RIMS

a) Increasing complexity of IT systems A strong technology focus of enterprises in the last decade has led to increasingly complex IT systems with host of business applications, which if not maintained, can lead to operational bottlenecks. Complex IT systems demand more resources to maintain existing service levels and thus become less responsive to the business.   Global studies show that a substantial portion of IT budgets now goes towards maintaining current IT systems. Dependency of businesses on technology to become competitive has made it a necessary investment. The key challenge for an enterprise today is to evolve an IT infrastructure management strategy that leverages the existing investments and achieves increased service levels for the end customers, improved end-user response time through proactive management and reduced costs and increased flexibility.

b) Labour, the largest addressable cost  As hardware costs fall, labor becomes the most addressable cost in infrastructure. As per McKinsey, the costs of non-labour components – hardware, software, maintenance (for instance, software updates and hardware replacement) and facilities – declined by ~44% between 2000 and 2008 as competitive pressures, innovation, and tougher negotiations with vendors brought prices down. Between 2008 and 2011, these costs have been estimated to fall further by 54%, thanks to innovations such as ‘virtualization’ (explained below). Thus the labour cost becomes one of the biggest addressable costs in infrastructure management.

c) Rising demand for ‘virtualization’  Typically in buoyant market conditions, enterprises tend to invest in new hardware (servers, etc) even if the existing infrastructure is not being optimally utilized. The focus is on grabbing maximum business and sustaining the growth momentum through buoyant capex. Resultantly, there is a build-up of buffer asset capacity. As per experts, the server utilization is not more than 60% even for the most efficiently run company during a business bull run.  In a bearish scenario, companies intend to utilize their IT infrastructure optimally and avoid new investments. The phenomenon of ‘virtualization’ is gets increasing importance. Virtualization means optimally utilizing (through cross-utilization, etc) IT infrastructure (servers, storage, computing infra, etc) across multiple locations (offices, branches, etc) by treating them as one common infrastructure.

d) Increasing realization about economic viability of RIM  To a great extent, the robust growth witnessed in the RIM over the past few years has been driven by increasing realization of the economic viability behind offshoring IMS. Enterprises have realized that majority (90-95%) of their technology infrastructure problems could be resolved remotely from an offshore issue resolution/management center by a third party vendor. Further, through RIM, companies avail a significant reduction in problem resolution time (1/4th-1/5th compared to onsite) which ensures higher uptime of the infrastructure. By offshoring, they enjoy significant cost savings for a better level of service (through higher uptime of assets, access to more skilled resources than onsite, 24*7 service, etc).

Most of the IMS players out of India provide SLA-based RIM services to clients. The SLA (service level agreement) clearly underlies the scope of work i.e. the level of service chosen, variety of assets, number of assets, service window (24*7, 8 or 12 hours, etc), uptime required, response time of assets/applications, etc. The variety of assets includes servers, network, desktops, security, applications, database, storage, mails, etc. The customers are less concerned about the number of resources deployed by vendors and its onsite:remote mix and are more concerned about the availability of their IT infrastructure ie uptime  Further, pricing in remote IMS services is more resilient than for other commoditized IT services. Typically, pricing is tied to the level of service and uptime. Generally, no enterprise would like to save cost by taking a lower uptime and lower level of service for its business critical IT systems and infrastructure.

Globally IT spends are being  prioritized in favour of IMS/RIMS as enterprises try to optimally utilize and increase efficiency of their existing IT infrastructure.

ADSL is a strong IMS player

ADSL is an IT infrastructure management and technical support service outsourcing company. It has over two decades of experience in technology and enterprise infrastructure implementation, management and consulting on complex IT and business systems. The company operates across a network of 132 locations across India with a team of ~2,700 employees from different managerial and engineering backgrounds. ADSL has a wholly owned subsidiary in the state of Delaware, USA, by the name of Allied Digital Inc and liasioning offices in Sydney, Australia and New Jersey, USA. EPGS, LLC USA and Digicomp Complete Solutions Ltd are two newly acquired subsidiaries of ADSL. EPGS operates out of 27 locations in the US with ~340 employees.

ADSL enables large and medium enterprises and service providers to reduce their total cost of ownership of IT infrastructure by using a combination of onsite and remote services. The company has been a preferred choice for outsourced technical support for large corporate customers in India.

The experience and expertise in system integration (SI), wide onsite reach, sizeable remote infrastructure and technological depth make ADSL a very competitive IMS player. Company’s IMS clientele includes large domestic corporates. The IMS offering of the company comprises FMS (onsite proactive management), AMC (need-based reactive management) and RIMS (remote proactive management). Company typically signs three-year contracts with customers for providing IMS services.

ADSL provides SLA-based IMS services. Key elements of a SLA are the infrastructure/assets to be managed (network, servers, desktops, storage, security, applications, etc) and the required uptime (availability) of these assets/applications. ADSL commits to a particular uptime level based on its own assessment of the client’s infrastructure. Company then decides on the onsite:remote mix of resources to provide the committed uptime level. The customers are less concerned about the number of resources deployed by ADSL and its onsite:remote mix but are more concerned about the availability of their IT infrastructure.

ADSL’s IMS services are significantly cost-competitive than some of the large Indian offshore vendors who provide onsite IMS services based on people-billing model. By shifting infrastructure maintenance to ADSL from these vendors, clients could save 20-40% for a similar or higher uptime service levels. For IMS contracts, company has a technology–process–people approach unlike competitors which have a reverse approach

5. EBIDTA to expand 200bps over FY11-13; to reach 22% in FY13

ADSL’s margin improved significantly by 200bps in FY10 driven by implementation of hybrid delivery model in EPGS, cross-selling of value added services to EPGS clients, revenue mix shift in the domestic business towards high-margin IMS segment and towards RIM within. As per the management, EPGS operating margin has improved to 7% from near 0% when
acquired. We expect ADSL’s OPM to expand by 100bps each in FY12 and FY13 on further expansion in EPGS OPM (to 17-18% over next two years), continued revenue mix shift towards IMS/RIM and contribution from recently entered Lenovo deal.

6. To turn FCF positive in FY11; growth without dilution/leverage

We estimate ADSL to have turned CFO positive in FY11 and become FCF positive in FY12. Augmentation in CFO and FCF over FY11-13 would be driven by robust revenue growth, margin expansion, reduction in working capital intensity (due to decline in SI revenue share) and no significant capex (current NOC/SOC utilization is low). This and the robust Cash balance (Rs2.2bn, 20% of m-cap) eliminate the need for equity issuance and balance sheet leverage to fund growth over the next 3-4 years. Another pleasant feature about ADSL is its pure RoE of 20%+ (driven by high RoA) as the company has negligible leverage. The utilization of significant C&E would only improve RoE in the coming years.

7. En Pointe Global Services (EPGS) gaining traction

ADSL had acquired 80.5% stake in En Pointe Global Services (EPGS) in July 2008 for equity valuation of US$30mn. The rationale was to gain access to marquee clients in US, up-sell/cross-sell incumbent offerings and to improve margins by remote transitioning of delivery. However, due to shadow costs and additional S&M costs in US, the margin expansion could not be realized immediately after. Now with integration issues ironed out, EPGS operations have reached a steady state. Going forward, we expect EPGS to show good traction in client addition, revenues and margin. Since the acquisition, the company has added many marquee clients such as Washington Mutual (US$4mn client), JP Morgan, City of Sandiego, Lam Research, etc.

When acquired, EPGS was providing low value-added services like desktop management, help desk services, etc and had a 100% onsite business model. Post acquisition, ADSL has introduced onsiteoffshore (hybrid) model and has started providing high value-adding services like complete data center management, managed services and innovative servicing deals like the one with Lenovo (explained later).

With the adoption of hybrid model, the pricing of services to clients has reduced by 20-30% as compared to the 100% onsite model. Despite offshoring, EPGS has had a decent revenue growth from US$30mn when acquired to US$43mn in FY11. The management expects to cross revenue mark of US$55mn in FY12, implying a strong growth of 28%.The current order book for EPGS stands at US$60mn. On the other hand, margin has expanded due to upselling/cross-selling and remote transitioning. From a break-even at the time of acquisition, the operating margin has expanded
to ~7% currently. Management expects margin to further improve to 1718% over the next two years.

8.Lenovo Deal to start contributing from Q1 FY12; to add materially in FY13

ADSL has entered into a deal with Lenovo to service all its client’s laptops and desktops for 3 years in the US. There are 3 levels of services involved from zero human intervention in Level 1 to onsite service engineer support in Level 3. Level 1 has automated resolution where issues are automatically sent to NOC in India and are resolved by pushing solutions through the network without any human intervention. Level 2 consists of relatively heavier updates and in Level 3 a service engineer is sent for onsite support. Though the deal is not exclusive with ADSL, its experience and knowledge base due to long incumbency in this field gives it a strong competitive advantage. The company is currently in negotiations to enter into a similar tie-up with Lenovo in Europe.

Advantage to consumers:

The costs of servicing laptops are quite high in the US markets as
a result such a provision helps to save on these costs for the length of the maintenance period.

The experience of ADSL in solving such issues has led to an automatic resolution of majority of the issues thus saving a lot of time and increasing uptime.

Advantage to ADSL:

The technology leveraged approach of ADSL effectively leads to
non–linear revenue stream (most issues being resolved automatically ie without human intervention)

ADSL accrues 30-35% margins per device per customer from the revenues emanating out of such services.

Possibility of similar deals with other OEM manufacturers will help ADSL scale-up non-linear revenue component.
Revenues from this arrangement are expected to trickle from the current quarter. As per the company, full-year revenues could be ~US$3mn in FY11 and US$15mn in FY12

9. Recent Developments and orders in pipeline

The company has recently made a complete networking deal with India’s one of the largest PSU.

It has made a 5-year deal with India’s largest retail chain.

It has made a cracking services deal and end-user networking deal  with India’s one of the largest Auto component Manufacturer.

Closes the first VDI Deal with fast growing educational Institute in India.

Obtains a large networking order from Indian renowned Family Business Group.

Allied Digital receives ‘Channel World Premier 100′ Award for displayiing dynamic business practises in a challenging business environment.

Forbes Asia awarded ADSL as ‘Best Under a Billion Dollar Company’ for three consecutive years.

Conclusion : Going forward for the next two quarters I personally don’t see significant rise in the turnover or net profits but going further the growth would be exponential. I feel all the negatives in the stock has already factored in and the stock has already seen the worst for ADSL! Any positive news from the management side can trigger a strong rise in the stock price remember, the 13 cr loss from one of its clients in the quarter 4 is still going negotiations and any amount that comes in through the negotiations would actually add to the Q4 net profit which most of them are unaware of.

Some HNI group is anticipated for posting negative comments  in prominent blogs and forums like Moneycontrol, Rediff Money etc.. to create panic among the retail investors, they are absorbing the shares that are sold out in panic. Do not be influenced by any such commentators, do your own research. Let us take the worst case scenario. Say, the company is a fraud just like in the case of satyam -  ADSL holds around 700 crores of reserves with just over 50 crore of loan which amounts to around 650 crore of valuation for a market-cap of around 270 crore. Even if the ADSL’s CEO – Nitin shah comes out to be a fraud, Some big IT company would easily take over it and utilize the infrastructure and its strong presence in India and also in Prominent countries world-wide, as the company is too small for take-over target.

I expect the stock price to gradually move towards the 3-digit mark till the end of the Buy-back which  I expect it to be completed before the F12 Q1 result and as time follows the stock should consolidate near Rs.150. In a decade’s time, the stock could quote in four digits..