RS Software (India) Ltd

RS Software (India) Ltd

My attention was drawn to a company called RS Software (India) Ltd; it showed up on my screen as a potential deep value situation. It had all the characteristics I look for in a deep value opportunity:
- a low P/E @ just 5.06 (indicating cheapness);
- a high ROIC @ over 25% consistently for the last four years (indicating quality);
- 39% of the equity held by promoters (indicating skin in the game);
- a tremendous, c. 60%, fall in price in the last one year (indicating it is hated by the majority).                                                                                                                                                                     

So the initial screen looked good. But, as any value investor knows, that is just the beginning; the hard work only really starts now – digging into the detail, building a narrative, determining intrinsic value, checking if there is a good enough margin of safety, exploring catalyst, and, last but not the least, marrying everything together.

Having done the work, RS Software ended up being a pass. But, it was well worth the effort. I will definitely be keeping an eye on this situation; it may produce an investible opportunity down the line; or at very least, throw up some valuable business lessons.

Investment Snapshot
R S Software (India) Ltd
Business
RS Software India Ltd is an India based company that primarily deals in customized software solutions for the electronic payments industry. It is a "pure outsourcer", with ambitions to diversify revenues into recurring products/services. It has offices in US, UK, and India; most of the work gets done by software engineers based out of India, with a few hundred engineers based out of client location in the US. Presence in the UK looks minimal.
Share information					Valuation Metrics
(@ 20/10/2015)					(@ 20/10/2015)
		INR	USD		Trailing P/E		5.06
Price		135.5	2.08		Return on equity		33.71%
52-week range		121.50 - 348.70			Return on investment		33%
Dividend yield		2.04%			Cash flow per share		28.28 INR
MarketCap		3.41bln	52.5m		Book value per share		87.22 INR
Financials (TTM)		INR	USD		Shareholding pattern
Revenue		3764m	57.8m		Promoters		39%
Revenue growth		-1.44%			Institutions		5.32%
Operating profit margin (after tax)		23%			Others (individuals, corporates)		55.60%
Net profit margin		18%
Debt:Equity		0
Revenue for quarter ending Sep15 is down 34.7% YOY
THE BOTTOM LINE
The company has some positives - it is a service provider to players in a super growth industry; has a strong balance sheet; and, promoters have significant skin in the game. But, it has experienced alarming drop in revenues of late. This is chiefly due to its reliance on a single client - VISA - which contributes ~ 84% of the revenue. VISA has recently opened a large technology development center in Bangalore to move technology/development in-house, and, signed a USD200m contract with another large softward provider - Infosys. Both developments are alarming and coorelate to the fall in revenues. Worryingly, management so far seems to be in denial, has been lethargic in diversifying client base, and unsuccessful in growing topline.

Detailed analysis

Pros

Operates in a super growth industry that has immense potential

The company operates in an industry with immense growth potential. The electronic payments industry is large, growing, and — thanks to its relatively stable and predictable transaction volumes combined with low capital intensity — it should be profitable. As more and more people across the world transact online and over mobile, the payments industry is set to take-off. It is amazing what one can do with a mobile now-a-days – being a Londoner, by simply taping my smart phone, I can pay for train tickets, buy my coffee, and pay for my lunch. Although RS Software is not a front-line provider of electronic payments services; its business, to provide software services to the front-line operators in the industry, is not a bad place to be. Providers of service to a growth industry can be much better bets than players within a growth industry.
Strong balance sheet
The company has zero debt; and quite a bit of surplus cash @ c. INR 1,470m (USD 22.6m) as at March 15. However, management has recently announced that the cash is earmarked for acquisitions; therefore, I would discount the cash factor. But zero debt is good.
Management has skin in the game: promoter and management own c. 39% of the company
Unloved and out of favour. There is hardly any analyst coverage and the company is currently out of favour. Both these are positive factors for a contrarian strategy, provided the investment thesis stacks up.

Cons

Client concentration
Majority of the revenues (c. 84%) come from one client – Visa. Having VISA has the main client is not a bad thing - Visa is one of the two largest players in the electronic payments industry (VISA and MasterCard account for 88% the market). But, this is only a positive if the revenues from VISA are secure and bankable. At this point, I should note that the fact that VISA was the main client, and the share of revenues from VISA, was not disclosed in the financials. It is only upon further research online that one learns of this fact (see more under the disclosure heading below).
VISA seems to be moving on
My research threw up two alarming facts that don’t appear to be good news for RS
a) VISA has just recently opened a new technology development center in Bangalore, India (http://www.businesswire.com/news/home/20150805005526/en/Visa-Opens-Technology-Center-Bangalore-Accelerates-Digital). The center’s objective is to accelerate the development of next generation payment solutions. It will hire over 1000 software engineers. This cannot be good news for RS Software.
b) VISA has signed a $200mln contract with Infosys, a major Indian software house, in late 2014 (http://timesofindia.indiatimes.com/tech/it-services/Visa-signs-200-million-contract-with-Infosys/articleshow/45240663.cms). The contract is for application development, testing, and infrastructure management. Again, bad news for RS. Based on the above, the revenue’s from VISA seem to be anything but bankable.
Alarming decline in top line
For a company servicing an industry that is growing exponentially, and, which counts one of the biggest players in the industry as its main client, this should be a period of double digit growth in revenues. But alarmingly for RS, revenues have started declining. After showing consistently high revenue growth up to FY14 (revenues for period from FY11 – FY14 were 17% CAGR), revenue for FY15 feel by c. 1.5%. Even more alarming is the fact that net sales for quarter ending Sep15 were down 34.7% YOY. There appears a correlation between what’s happening at VISA front in the last year and RS’ revenue trend.
No apparent success in growing the client base
RS claims in its financial statements that it is working on diversifying its client base, and its revenue base – it wants diversify its revenues from a “pure outsourcer” to a regular product/service offering. But there is no clear insight of progress on this front. The financials are full of fluff and provide nothing concrete. Having checked out recent statements and interviews given by the CEO, I am none the wiser. My assumption is that the company enjoyed a cosy relationship VISA all these years – it has been in existence since 1991 – and has suddenly been jolted by rapid changes in its industry. Its complacency for all these years may be coming back to bite it. I hope that I am wrong here, I hope that the talented engineers at RS are beavering away at a revolutionary new product; or, the sales folks are about to close a deal on a major new client. But, value investing doesn't invest in hope.
Poor disclosures and ambiguous management
Financial statements that have too many pictures, colour, and fluff, are suspicious; financials that are in black & white, and to the point, is normally a good sign. RS’ financials, at 174 pages, have too much fluff. Even after weeding through all those pages, one is none the wiser on key points - what concreate steps is the company taking to stabilise revenues and grow?, what progress has it made to diversify its client and revenue base?. There is page after page devoted facts and figures on how great and wonderful the electronic payments industry is, but there is only a fleeting mention of the company’s desire to mitigate client concentration risk.
Flight of talent
If I were an ambitious engineer working at RS today, would my head not be turned by developments at my largest client - VISA? What stops me from shooting off my CV to VISA, a client who has just opened a center in India, and who probably knows and appreciates me. And, with poor results, I am probably finding my bonus pool shrinking, and pay rise being cut.

Intrinsic value estimate

I am reminded of a famous quote, often attributed to Einstein (although I am aware of attributions to William Bruce Cameron): “Not everything that can be counted counts. Not everything that counts can be counted.”

Normally, I would do a DCF to estimate my intrinsic value. But for RS, I have decided that doing a DCF at this stage is a fool’s errand. I have all the historic information I need to do a DCF, and I have laid it all out in my valuation model. But, what assumptions do I make for key inputs? E.g. what do I input for revenue growth for a company that seems to be at an inflection point?; Is it even worth forecasting?

If I claim to be able to forecast what direction RS will take over the next few years, I will be fooling myself. And, by any chance, if my forecast ends up being true, I will be fooling myself even more with my false sense of my forecasting ability. The best course of action with this situation is to keep a close watch; and, as a true Bayesian, update my beliefs as things progress.

Conclusion

To paraphrase from Mohnish Pabrai’s excellent book – The Dhandho Investor - Mohnish lists 9 characteristics of a good value investment opportunity; two of which are are: look for simple business in industries with ultra-slow rate of change; and, look for distressed businesses in distressed industries. RS at present seems to be a deadly combination of the above – A distressed business in an industry that is experiencing rapid change.

That said, I think that this is a really interesting situation. It is clearly not an investment at present, but it could well become one soon. It could either end up being a great shorting opportunity, or turn out to be a great long-term investment. At the very least, following this situation ought to teach me some valuable business and life lessons – for one, how not to get complacent when things feel comfortable; and, to always keep on learning/developing.