Independent Research Report Zylog Systems Limited Independent - - PDF document

CRISIL Equities

Zylog Systems Limited

1

Independent Research Report – Zylog Systems Limited Independent Research Report – Zylog Systems Limited

Chasing diversified growth opportunities

Industry: Information Technology Date: May 7, 2010 Zylog Systems Ltd (Zylog), headquartered in Chennai, is a niche IT services player with a focus on products, solutions and mobile technologies. We assign Zylog a fundamental grade

• f ‘3/5’ indicating that its fundamentals are ‘Good’ relative to other listed securities in India.

We also assign a valuation grade of ‘4/5’ indicating an ‘Upside’ to the current market price. Chasing diversified growth opportunities Zylog is currently pursuing various new initiatives for growth in the IT services and telecom

• space. These include: (a) the recent acquisition of Brainhunter, one of the leading Canadian

staffing companies; (b) various e-governance projects in the transportation, healthcare, agriculture sectors, and related to below poverty line population; (c) Wi-Fi-based internet service offerings in the tier-I and tier-II cities in southern India, where it has a deep-rooted

• presence. We believe that these initiatives position Zylog well for strong growth. We expect

Wi-Fi revenues to grow to Rs 1.2 bn by FY15 and e-governance revenues to touch Rs 0.8 bn, a 9% revenue contribution from zero contribution currently. Inorganic growth strategy has strengthened its offering and client base Zylog, a niche IT services player, has strengthened its offerings and reach through strategic acquisitions made over the past three years. Zylog has successfully integrated the acquired products, solutions and services into its suite of offerings. These acquisitions have helped Zylog penetrate the market deeper and cross-sell its newly-acquired offerings to complementary markets. Key challenges include integration of Brainhunter and competition in Wi-Fi (a) Brainhunter is a larger company (in revenues terms) than Zylog and is into staffing solutions, while other acquisitions were small in size and in the IT solutions space. Also, Brainhunter had filed for Companies' Creditors Arrangement Act to avoid bankruptcy. Hence, successful integration is a key monitorable. (b) In the longer term, the Wi-Fi business is expected to face significant competition from the telecom majors, resulting in margin erosion. Revenues to grow at three-year CAGR of 37% due to Brainhunter acquisition We expect consolidated revenues to grow 37% over FY10-13 to Rs 23 bn on account of the Brainhunter acquisition, while the standalone revenues are set to register a CAGR of 22% in rupee terms. However, EBITDA margins are estimated to decline to 11% in FY13 on account

• f (a) 400 bps impact of Brainhunter acquisition; (b) 300 bps reduction in offshore utilisation

rates and rupee appreciation. We have assumed Brainhunter revenues to be flat over FY09- 13 and any out-performance by Brainhunter remains an upside to our estimates. EPS to grow at three-year CAGR of 21% Despite 37% growth in revenues, EPS is set to grow at a CAGR of 21% due to falling EBITDA margins and increasing tax rates of Zylog (ex-Brainhunter), and we project 2.5% PAT margin for Brainhunter. We expect EPS to touch Rs 95 in FY13 from an estimated Rs 54 in FY10. We project RoE to touch 17.2% in FY13 from around 16.8% in FY10. Valuation: Upside from current market price We have valued Zylog based on ‘Sum of the Parts’ approach. We have used discounted cash flow method to value both Zylog (standalone) and Brainhunter. Based on above valuation method, we arrive at the Fundamental value of Rs 530 per share for Zylog. We initiate coverage on Zylog with a Valuation Grade of ‘4/5’ indicating an ‘Upside’ to the current market price of Rs 456. Key forecast(consolidated financials) (Rs Mn) FY09 FY10E FY11E FY12E FY13E Operating income 7,511 9,035 18,638 20,690 23,323 EBITDA 744 1,419 2,085 2,307 2,628 Adj Net income 846 889 1,328 1,372 1,585 EPS with forex impact (Rs) 51.6 54.2 80.7 82.6 95.4 EPS growth (%) 20.3 5.1 48.9 2.3 15.5 EPS without forex impact (Rs) 23.7 54.2 80.7 82.6 95.4 EPS growth (%) (58.3) 128.4 48.9 2.3 15.5 PE (x) 3.9 8.4 5.6 5.5 4.8 P/BV (x) 0.3 1.3 1.1 0.9 0.8 RoCE(%) 9.6 15.2 19.0 18.7 19.6 RoE(%) 8.7 16.8 20.9 17.7 17.2 EV/EBITDA (x) 1.3 5.8 3.8 3.1 2.4 Source: Company, CRISIL Equities Estimate CFV Matrix

Fundamental grade of 3/5 indicates good fundamentals Valuation grade of 4/5 indicates an upside 1 2 3 4 5 1 2 3 4 5

Valuation Grade Fundamental Grade

Poor Fundamentals Excellent Fundamentals

Strong Downside Strong Upside

Key stock statistics

BSE/NSE Ticker Zylog Fundamental Value (Face Value Rs10) 530 Current market price (Rs per share)* 456 Shares outstanding (Mn) 16.4 Market cap (Rs Mn) 7,494 Enterprise value (Rs Mn) 8,241 52-week range (Rs) (H/L) 487 / 138 P/E on EPS estimate (FY11E) 5.6 Beta 1.3 Free float (%) 63.98% Average daily volumes (30-day average) 141,242 * as on the report date

Share price movement

50 100 150 200 250 300 Apr-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Zylog Sytems Nifty

• Indexed to 100

Analytical contact

Chetan Majithia (Head, Equities) +91 22 3342 4148 Suresh Guruprasad +91 22 3342 3531 Pranav Master +91 22 3342 3566 Email: clientservicing@crisil.com +91 22 3342 3561

CRISIL Equities

Zylog Systems Limited

2 Zylog: Business environment

Parameter IT offerings (excluding e-governance) New initiatives: E-Governance and Internet services Brainhunter Consolidated % Revenue contribution (FY09) 100.0% 0% 0% % Revenue contribution (FY13) 56.4% 6.2% 37.4% Managed services Insurance products: Phoenix, Claim Point E-Governance Staffing solutions Product / service offering Data warehousing and Business Intelligence Banking: RTGS Paymanager, Cheque truncation Smart card solutions (95% of revenues) Mobile computing Telecom: Field Power, Z*Connect, SMS.Companion Internet services Replacement technology Pharma: Vesalius, Sales Rxcelerator Wi 5 IT solutions Web 2.0 Manufacturing: Infor Syteline (ERP solution) (5% of revenues) QA and testing Inventory management: Silvanus Geographic Presence North America, Western Europe, APAC, Middle East North America, Western Europe, APAC, Middle East India Largely Canada Current market position Relatively small-size player Among the top 3 staffing solutions company E-governance: Government of India IT and engineering services company, End market BFSI, Telecom, Pharma, Retail and Manufacturing BFSI, Telecom, Pharma, Retail and Manufacturing Wi-Fi: Residences in cities and towns including the government of Canada Global: MTM Technologies and RWD Technologies Global: Covansys Corp, Syntel Inc and Trizetto Group E-governance: TCS, Wipro, Oracle CGI Group, EDS Canada Key competitors Offshore: Infosys Technologies, Tata Consultancy Services, Wipro and HCL Technologies Offshore: Infosys Technologies, Tata Consultancy Services, Wipro and HCL Technologies Wi-Fi: All integrated telecom operators (in particular BSNL due to its wide presence) and

• ther local / national ISPs

Sales growth forecast 22% CAGR over FY10-13 1.1% CAGR in rupee terms over FY11-13 Higher IT spend in North America, Asia-Pacific and Middle-eastern regions E-Governance: Replication of similar projects in other states and recurring maintenance revenues Revival in global IT spends Capitalising on cross-selling opportunities in the Canadian market Wi-Fi: Attractive tariffs and coverage in underpenetrated towns Demand drivers Growth in its niche offerings of replacement technology and consumer electronics New opportunities, if any Higher offshore component would improve operating margins Cross-sell offerings to complementary markets Source: Company reports and CRISIL Equities

CRISIL Equities

Zylog Systems Limited

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Grading Rationale

Niche player in IT services and products

Zylog (ex-Brainhunter) derives around 60% revenues from IT services, 40% from products business, of which one-fourth is from product sale and balance from

• implementation. It is a niche player with specialisation in field service automation,

mobile solutions, inventory management, RFID applications, banking and insurance solutions, and replacement technologies. We expect the company to continue offering niche services where the Indian IT giants lack focus. The key competition for Zylog is local vendors and some of the large Indian players in few projects. Zylog operates largely on an onsite-based model with an effort mix of 65:35 in favour of onsite, which is significantly higher than other Indian IT companies. While this results in high employee and other project costs such as visa processing and travel, it leads to better client servicing. The company’s IT services segment has grown at a 40% CAGR over the past three years due to organic and inorganic initiatives, and 90% of its revenues are dependent

• n the US geography. We expect this business to grow at 18% CAGR over the next

three years. Figure 1: Projected revenues for the IT services segment

8.0 9.6 1 1 .3 1 3.2 6% 1 9% 1 8% 1 7% 0.0 3.0 6.0 9.0 1 2.0 1 5.0 FY1 0E FY1 1 E FY1 2E FY1 3E ( Rs B n) 0% 4% 8% 1 2% 1 6% 20% Revenues Revenue growth Driven by revival in key markets and verticals

Source: CRISIL Equities Estimate

Figure 2: Effort mix comparison (2008-09)

24 29 65 37 25 71 35 63 75 76 1 20 30 40 50 60 70 80 Infosys Patni Zylog Hexaware M astek ( Per cent ) Onsite Offshore

Source: Company reports and CRISIL Equities

Presence in niche segments with an onsite-based model

CRISIL Equities

Zylog Systems Limited

4 Table 1: Key assumptions (Zylog ex-Brainhunter)

FY05 FY06 FY07 FY08 FY09 FY10F FY11E FY12E FY13E Total employees 553 719 968 1,938 2,045 2,443 2,919 3,488 4,099

• Net additions

166 249 970 107 398 476 569 611 Technical employees 490 615 841 1,587 1,648 2,027 2,432 2,919 3,444

• Net additions

125 226 746 61 379 405 486 525 Support employees 63 104 127 351 397 416 486 569 654

• Net additions

41 23 224 46 19 71 83 85 Utilisation rate (%)

• Onsite

90.0% 94.9% 85.3% 92.6% 85.0% 92.0% 94.0% 95.0%

• Offshore

0.0% 91.8% 74.5% 89.5% 85% 80% 78% 77% Billed Manhours per month

• Onsite

93,462 150,845 171,026 176,822 233,762 281,584 323,811

• Offshore

55,794 92,710 114,669 151,774 167,520 200,556 244,241 Billing rate (US$)

• Onsite

59.2 65.5 68.8 64.2 61.0 61.0 61.6 62.2

• Offshore

23.4 24.9 23.9 22.9 21.5 21.5 21.7 22.0 Source: CRISIL Equities Estimate

Inorganic growth strategy has strengthened its offerings

Zylog has made few acquisitions over FY08-FY10, which has helped it achieve robust growth and increase its service offering. Except for the acquisition of Brainhunter in February 2010, Zylog has made small-sized acquisitions in the IT solutions and products space in the range of US$ 3mn to US$ 8 mn. These acquisitions have mainly been financed through internal accruals and a small proportion of debt funding. While some deals have opened up opportunities in new markets and verticals, others have strengthened the company’s position in certain business lines. For instance, acquisition of UK-based Anados Software gave Zylog an end-to-end insurance solution, while that of Ducont and Brainhunter marked its foray into the Middle-Eastern and Canadian markets, respectively. Our interactions with the management indicate that Zylog is unlikely to look at acquisitions in the near to medium term, especially because

• f the time and procedures required to ensure the smooth integration of Brainhunter.

Table 2: Profile of acquisitions

Source: Company and CRISIL Equities Year Name of the entity Geography Nature of Business Deal Value (USD mn) Price to Sales Multiple Impact 2007-08 Anodas Software U.K Insurance software solutions and Third Party Administration (TPA) services 2.3 na Enabled Zylog to offer an end-to-end core insurance solutions Fairfax Consulting Inc. U.S Content management services firm with focus on the pharmaceutical and healthcare verticals 7.5 1.4x Opened up more opportunities in the U.S. and European markets as well as strengthened presence in the pharmaceutical space 2008-09 Ducont FZ LLC Dubai Application provider in wireless applications space. It has number of banks, telecom operators and government bodies as its clients 7.5 2.0x Expanded presence across the Middle- East market and also strengthened partnership ties with GBM, Microsoft, Oracle, Reuters, Captaris and others 2009-10 Brainhunter Inc. Canada Staffing (90% of revenues), consulting and engineering services provider with Government of Canada being a key client 33 0.2x Enabled to get a foothold in the Canadian

• market. Expanded presence in telecom,

BFSI, and oil and pipeline verticals.

Acquisition-led strategy has

• pened up several opportunities

CRISIL Equities

Zylog Systems Limited

5

Harnessing synergies through successful integration of acquisitions

Zylog’s success in integrating its target companies can be largely attributed to its ability to assimilate products and services into its suite of offerings and cross-sell them to complementary markets. For instance, Ducont, which was acquired in September 2008 for US$ 7.5 mn, clocked revenues of around US$ 9.3 mn in FY09 (ended December) from US$ 3.8 mn in FY08.

Brainhunter acquisition to open newer opportunities

In February 2010, Zylog acquired the loss-making Brainhunter, one of the largest staffing company in Canada for US$ 33 mn through Company’s Creditors Arrangement Act (CCAA). As per the CCAA arrangement, Zylog is obligated to repay all of Brainhunter’s outstanding debt for US$ 33 mn to acquire the company. Further, Brainhunter’s equity shareholders are not entitled for any compensation. Brainhunter filed for bankruptcy protection in 2009 as it invested significantly in IT solutions R&D at a time when global economic downturn was at its peak. The R&D investments, which typically yield results over longer periods of time, were ironically funded through short-term borrowings. It also de-listed its stock in November 2009. Zylog funded the acquisition through US$ 10 mn cash and the balance through debt. Table 3: Brainhunter – Key financials (in US$)

Sept ‘06 Sept ‘07 Sept ‘08 Sept ‘09 Revenue 153 203 217 194

• YoY change

33% 7%

• 10%

Gross margin 16.6% 14.7% 14.3% 15.0% Operating margin 1.8% 3.1% 1.1% 2.5% PAT margin (ex-goodwill impairment)

• 2.5%
• 0.8%
• 2.6%

1.3% PAT margin

• 3.2%
• 1.7%
• 8.7%

0.1% Shareholders’ funds 16.6 13.1 0.3 Na Debt 13.8 42.8 32.1 Na Current liabilities 23.5 23.7 21.7 Na Goodwill 20.2 20.2 6.6 Na Source: Company data Note: year ending September

Brainhunter specialises in the provision of staffing solutions (contingent staffing, managed staffing, permanent staffing and staffing software solutions). In FY09, around 95% of its business was derived from providing IT and engineering staffing consultants

• n a contract basis to its clients. The company also sells recruiting-related software

including applicant tracking systems (ATS), vendor management software (VMS), and job board software. As of September 2009, Brainhunter deployed 1,400 contractors with an internal staff of over 170. Brainhunter has a wide-spread client base of over 400 blue-chip organisations across various sectors including BFSI, information technology, telecom, government and oil and pipeline. Around 35% of the services rendered are to various Federal Government of Canada agencies and departments. We believe with the following synergies playing out, Zylog is poised to turn the acquisition around within the next two-three years. Currently, Brainhunter partners with other software vendors such as EDS and Fujitsu to complete its suite of offerings. With Zylog coming into the picture, all its IT-related work can be carried out in-house. Also, the company will enjoy cost savings if the projects are executed offshore. Brainhunter’s brand coupled with Zylog’s presence in IT services to

• ffer synergistic opportunities

Brainhunter witnessed reasonable revenue growth before the global crisis, but margins declined on account of investments in R&D and increase in interest costs Ability to cross-sell offerings, key to successful integration of acquisitions

CRISIL Equities

Zylog Systems Limited

6 So far, Brainhunter was present only in Canada. However, with Zylog’s reach across the US, Europe, Asia-Pacific and the Middle-East, Brainhunter’s services can now be made available in all these regions. This acquisition gives Zylog a much awaited entry into the Canadian market. Given that it is present in similar verticals, we believe Zylog could leverage Brainhunter’s customer base to cross-sell its own products and services as it has done in the previous acquisitions. Based on our discussions with the management, Brainhunter’s clients including the Federal Government of Canada continue to give repeat business and are expected to renew contracts. Brainhunter witnessed a revenue degrowth of 8% in FY09. With turn around in the global IT services industry, we expect the revenue growth to bounce back post

• FY10. As per the management, the company has achieved breakeven at PAT

levels in 2QFY10 (September year-end) and is EPS neutral for Zylog. The management expects a payback period of three-four years on the acquisition. Figure 3: Brainhunter – PAT to turn positive

1 85 1 90 1 95 200 205 FY09 FY1 FY1 1 FY1 2 FY1 3 US$ mn

• 1
• 8
• 6
• 4
• 2

2 4 6 (% ) Revenue (LHS) EBITDA M argin PAT M argin

Source: Company data, CRISIL Equities Estimate

While we agree that the management has successfully integrated its past acquisitions, we believe that the integration of Brainhunter would have its own challenges and thus remains a key monitorable. Brainhunter is larger than Zylog in revenue terms and is primarily a staffing company. In contrast, each of its prior acquisitions were in similar business lines and fairly small in size. Accordingly, we have factored in a low revenue growth of 3-4% and PAT margin of 2.5-3%.

E-governance to provide significant impetus to growth

In FY10, Zylog proactively initiated projects in the e-governance space related to road transport (RTO), agriculture and below poverty line (BPL) population. A common feature across these initiatives is the collection of grassroot level information, creation

• f a database and issue of smart cards with relevant information about the individual.

Most of these projects (except RTO) would be funded from the budgetary allocation by the central government. According to the management, with the successful implementation of the Karnataka and Gujarat RTO projects, Tamil Nadu and Haryana governments have approached Zylog for submitting a proof of concept (POC). Some of the state governments have made it mandatory for all their citizens to convert to a smart card over the next two years. If this is implemented across states in an effective manner, it would further boost Zylog’s revenues. Growth to emanate from replication of projects for other states along with maintenance revenues As per the management, Brainhunter has already achieved PAT breakeven in the quarter ended March 2010

CRISIL Equities

Zylog Systems Limited

7 Table 4: Zylog’s e-governance initiatives in India

Particulars Status Expected cumulative revenues

• ver the next 5 year

Road transport project Already implemented in Karnataka and Gujarat, while Tamil Nadu and Haryana are in the RFP stage. Rs 930 mn BPL initiative In the POC stage with Karnataka, Kerala, Bihar, and Haryana Governments No revenues considered since the project is in the POC stage Healthcare: Telemedicine To be implemented in Karnataka, Bihar and Haryana Rs 1,803 mn Agriculture initiative In the POC stage with Karnataka state government No revenues considered since the project is in the POC stage Source: Company and CRISIL Equities Estimate

We expect e-governance revenues to grow from Rs 282 mn in FY11 to Rs 821 mn in FY15 driven by replication of similar projects in different states along with maintenance

• revenues. EBITDA margins for this segment are expected to be in the range of 7% to

8% in the initial phase. Margins would improve if Zylog wins similar projects in other states due to economies of scale.

Details of projects to be executed by Zylog in the e-governance space

Road transport: It involves implementation and issuance of smart card for driving licences and vehicle registration books across all regional transport offices. This project is structured

• n a revenue share basis with the state government. It is Zylog’s responsibility to collect

revenues from individuals. Zylog retains around 25-30% of revenues collected while the balance is shared with the respective state government. Agriculture: Zylog’s initiative targets creation of a centralised database for farmers across various states of India capturing their personal details, land holding, farming infrastructure, soil health and crop history. With this information being made available online, farmers can avail of amenities as per their eligibility and the Department of Agriculture could reduce misuse of government subsidies. The funding for this project would be received from the Agriculture Ministry of India. Initiative for BPL population: The main objective of this project is to provide smart cards to BPL families to cover health insurance of a pre-decided amount. While 75% of the funding would come from the central government, the state government would give the balance. Healthcare initiative: This project involves two aspects – installation of telemedicine kits and setting up of an information management system for hospitals. The interactive telemedicine kiosks would be installed across sub-centres in towns and villages. The other initiative involves building a central management and monitoring systems by linking all hospitals in the state. This would not only help maintain patient information but also ensure suitable inventory (drugs and non-drugs) disbursement.

Wi-Fi services - good prospects over the medium term

Zylog has chalked out an offering in internet services wherein it leases out backbone bandwidth from integrated telecom operators and offers last mile connectivity to its customers through Wi-Fi technology in relatively under-penetrated cities and towns. Zylog has earmarked a capex of Rs 2 bn, 25% of which has already been invested to roll out the network in Hyderabad, some areas of Chennai and select towns of Tamil

• Nadu. It has not only set up its own distribution network but also adopted the franchisee

route to serve clients. Cut-throat competition and limitations

• f Wi-Fi technology to impede growth

in the segment

CRISIL Equities

Zylog Systems Limited

8 Having commenced operations in December 2009, Zylog has garnered 8,000 retail subscribers with average revenue per user (ARPU) of Rs 550 per month and nine corporate clients with about 175 users per corporate, at an ARPU of Rs 200 per month. We expect the retail subscriber base to grow at a swift pace to 520,000 in FY15 driven by expansion of service coverage and increased content being made available online. However, with high decibel competition coming into play, we anticipate subscriber additions to come at the lower rung of the ARPU ladder. Consequently, we expect retail ARPU to decline at 16% CAGR over the next five years.

Long-term growth and margins to get affected by competition

We expect the Wi-Fi segment to grow significantly over the next two-three years as the company is targeting under-penetrated areas. However, we anticipate cut-throat competition from integrated telecom operators who are facing significant downward pressure on their voice ARPU. With proliferation of USB dongles for internet access, especially post 3G and Wimax service launch, and likelihood of BSNL unbundling its local loop, the landscape in the broadband segment is set to change. Also, Wi-Fi as a technology has limitations in terms of distance and speed compared to other wireless

• platforms. Moreover, being a relatively old technology, Wi-Fi faces the risk of
• bsolescence.

Table 5: Key assumptions

Particulars FY11E FY12E FY13E FY14E FY15E Retail subscribers ('000) 73 149 243 360 517 Retail ARPU (Rs) 479 407 334 267 227 Source: Company, CRISIL Equities Estimate

Figure 4: Wi-Fi services: Projected revenues and EBITDA margins

263 583 832 1 ,01 8 1 ,250 29.7% 29.2% 1 9.8% 1 5.7% 1 5.3%

• 200

400 600 800 1 ,000 1 ,200 1 ,400 FY1 1 E FY1 2E FY1 3E FY1 4E FY1 5E ( Rs M n) 0.0% 1 0.0% 20.0% 30.0% 40.0% Revenues M argins

Source: CRISIL Equities Estimate

CRISIL Equities

Zylog Systems Limited

9

Industry outlook

IT industry export revenues to grow at two-year CAGR of 15%

The first half of 2009 witnessed a slowdown precipitated by the economic downturn, thereby adversely impacting global IT spends. However, with an improvement in the global scenario, especially in the US market, we are upbeat on the growth outlook for the sector. CRISIL Research expects the IT industry’s export revenues to expand at a two-year CAGR of 15.5% to Rs 35 bn in 2011-12. Given Zylog’s new initiatives (ex- Brainhunter), we expect its revenues to grow at a faster rate of 24% over the same period. Our view on the sector is driven by a revival in key verticals such as BFSI and telecom, easing pressure on billing rates, and Indian IT vendors increasingly developing capabilities in high value chain service-lines and focusing on exploring new markets. Figure 5: Projected export revenues for the IT services segment

8.0 9.6 11.3 13.2 6% 19% 18% 17% 0% 4% 8% 12% 16% 20% 0.0 3.0 6.0 9.0 12.0 15.0 FY10E FY11E FY12E FY13E (Rs Bn) Revenues Revenue growth Driven by revival in key markets and verticals

Source: CRISIL Research

Improved outlook in IT industry exports

CRISIL Equities

Zylog Systems Limited

10

Key risks

Volatility in global economic environment could impact revenues

In FY09, Zylog (ex-Brainhunter) derived around 90% of its revenues from US-based

• clients. Consequently, in the event of any economic slowdown in the country, Zylog’s

clients could reduce or postpone their IT spends, which would have a cascading impact

• n Zylog’s revenues. Moreover, since the company derives its revenues from export of

products and services, it remains vulnerable to currency fluctuation. However, the currency impact would be lesser as compared to the other players in the IT industry as Zylog has higher onsite presence, which provides a natural hedge. Hence, the company does not hedge its open position.

E-governance segment largely dependent on ability to win deals

In order to bag government projects, a company requires a good network and experience in executing similar projects. Since Zylog is a new player, there could be some dithering from the government’s end to award projects to the company. However, according to the management, Zylog has a good network, especially in few Southern

• States. Also, typically, government projects have a long payment cycle.

Smaller players vulnerable to vendor consolidation

Enterprises are always on the lookout for solutions and services without wanting to incur limited expenditure. Coupled with the recent global slowdown, there is an increasing trend among clients to work with fewer vendors, enabling them to successfully negotiate billing rates. We believe any kind of vendor consolidation could adversely impact mid-tier players such as Zylog; they may lose their existing client accounts.

Improvement in job market may lead to high employee cost

Improvement in the outlook for the IT industry is expected to result in Indian IT companies planning large-scale recruitment. Consequently, attrition rates would be adversely impacted by the improvement in the same during the previous year. This could put pressure on Zylog’s plans to add around 500 (net) employees in FY11. We forecast employee cost as a percentage of revenues to increase marginally to 65.6% in FY11 from 65.2% in FY10. This could increase if the company faces higher pressure on the recruitment front. Global economic environment - a key monitorable Lack of experience and revenue collection could impact e- governance Mid-tier companies such as Zylog to get impacted by vendor consolidation Industry to witness higher attrition in FY11 with improvement in the job market

CRISIL Equities

Zylog Systems Limited

11

Financial Outlook

Revenues to grow at CAGR of 37% over the next three years

We expect Zylog’s consolidated revenues to clock a three-year CAGR of 37% to touch Rs 23.3 bn in FY13 from an estimated Rs 9 bn in FY10, driven by the Brainhunter

• acquisition. During the same period, we estimate Zylog’s revenues (ex-Brainhunter) will

likely register a CAGR of 22% in rupee terms to reach Rs 14.6 bn in FY13 due to the following factors: We expect the IT services segment to grow at an 18% CAGR over FY10-13 with revival in key markets coupled with further capitalising on cross-selling

• pportunities.

The new business initiatives of Wi-Fi and e-governance services are expected to gather steam and contribute around 6% to the top line in FY13. Figure 6: Projected consolidated revenues and its growth trend Figure 7: Consolidated revenue-mix

23.3 20.7 1 8.6 9.0 1 2.7% 1 1 .0% 1 06.2% 20.3% 0.0 3.0 6.0 9.0 1 2.0 1 5.0 1 8.0 21 .0 24.0 FY1 0E FY1 1 E FY1 2E FY1 3E ( R s Bn) 0.0% 20.0% 40.0% 60.0% 80.0% 1 00.0% 1 20.0% Revenues Revenue growth 56.4% 3.6% 2.6% 37.4% Revenues: Rs 23.3 bn (FY13E)

IT services and solutions Wi Fi services E-governance Brainhunter

Source: Company, CRISIL Equities Estimate

EBITDA margins to decline

In FY07 and FY08, Zylog (ex-Brainhunter) maintained stable margins of around 18%. However, margins plummeted in FY09 to 10% on account of global slump in IT spend leading to an increase in project expenses (includes all other direct costs related to projects like travel expenses and software packages). Although we do not expect this trend to continue, margins are expected to be under pressure over FY10-13 primarily

• n account of:

Reduction in offshore utilisation rates: We believe it is necessary if the company is looking at scaling up its business. Brainhunter to depress margins: The Canada-based company is estimated to have low margins in the range of 3-5% over our forecast period. This we believe would have a ~ 400 bps impact on a consolidated basis. Rupee appreciation: We expect ~100 bps impact on margins on account of rupee appreciation to Rs 43/ $ in FY13 from Rs 47.3 in FY10. As a result of all these factors, EBITDA margins are expected to dip from 16% in FY10 to 11% in FY13. However, if Zylog increases the offshore effort higher than estimated or is IT services and e-governance segments to pull down margins

CRISIL Equities

Zylog Systems Limited

12 able to turn around Brainhunter faster than we anticipate, the margins could witness an upside to our estimates. Figure 8: Projected consolidated EBITDA margins

1 ,41 9 2,085 2,307 2,628 1 5.7% 1 1 .3% 1 1 .2% 1 1 .2%

• 500

1 ,000 1 ,500 2,000 2,500 3,000 FY1 0E FY1 1 E FY1 2E FY1 3E ( Rs mn) 0.0% 4.0% 8.0% 1 2.0% 1 6.0% 20.0% EBITDA EBITDA margin

Source: CRISIL Equities Estimate

EPS to touch Rs 95 in FY13

Despite 37% growth in revenues, EPS is set to grow at a CAGR of 21% over the next three years due to falling EBITDA margins and increasing tax rates of Zylog (ex- Brainhunter). Also, Brainhunter is estimated to report PAT margins of 2.5-3% over FY11-13. We expect EPS (including Brainhunter) to touch Rs 95 in FY13 from an estimated Rs 54 in FY10. We project RoE to touch 17.2% in FY13 from around 16.8% in FY10. Figure 9:EPS forecast (including Brainhunter) Figure 10:PAT and ROE forecast

54 81 83 95 2% 48.9% 2.3% 15.5% 0% 10% 20% 30% 40% 50% 60% 20 40 60 80 100 FY10E FY11E FY12E FY13E (Rs) EPS EPS growth 889 1,328 1,372 1,585 16.8 20.9 17.7 17.2 0.0 5.0 10.0 15.0 20.0 25.0

• 200

400 600 800 1,000 1,200 1,400 1,600 1,800 FY10E FY11E FY12E FY13E (%) (Rs mn) PAT ROE

Source: CRISIL Equities Estimate Source: CRISIL Equities Estimate

m

CRISIL Equities

Zylog Systems Limited

13

Management Overview

CRISIL’s fundamental grading methodology includes a broad assessment of management quality, apart from other key factors such as industry and business prospects, and financial performance. Overall, we believe that the management has strong experience, implementation capability and track record of integrating acquisitions, which would take the company forward on the growth path.

Management missed out on the high growth phase

Despite starting operations during 1996, the company is relatively small compared to the peers who started during the same period. Over 1996-2000, Zylog’s management focussed on niche offerings largely in the telecom space, while the industry was focussing on high growth areas such as Y2K and manpower outsourcing. However, post 2002-03, Zylog focussed on inorganic activities to ramp up its service portfolio and geographic footprint. For the next phase of growth, the management has set a challenging target of scaling up its Wi-Fi and e-governance businesses, and integrating Brainhunter with Zylog. Since the management has not executed such an aggressive plan in the past, successful execution is the key for future growth.

Business spearheaded by promoters

Mr Sudarshan Venkatraman, Chairman, and Mr Ramanujan Sesharathnam, Managing Director, are first-generation entrepreneurs and have close to two decades of experience in the IT industry. Their insight has enabled the company to diversify its product and service portfolio. The promoters have been instrumental to the strong growth achieved by the company through organic and inorganic expansion. We believe they have a fair degree of risk appetite given the acquisition of Brainhunter, which is larger than Zylog, and is currently loss-making. Although, we gain comfort from the fact that the management has successfully integrated its prior acquisitions.

Ability to identify and integrate acquisitions

Over 2005-09, Zylog acquired few companies with each one aimed at either adding to the product portfolio or diversifying the geographic risk. The management has set up a specialised merger and acquisition (M&A) team, which focuses on identifying targets for acquisition as per its M&A criteria. The top management’s acumen is reflected from its most recent acquisition of Brainhunter, which was awarded through CCAA proceedings, where Zylog was competing with several IT firms. Moreover, the management has not

• nly integrated its acquisition well but has also managed to grow its targeted

companies manifold with Ducont being the best example.

Strong second line of management

Operationally, each region and function has a head managing the overall delivery and business development of the unit. As far as its new businesses – Wi-Fi and e- governance – are concerned, individuals heading the businesses have relevant past

• experience. Based on our interactions, we believe the second line of management is

equipped with domain expertise and has been given fair degree of autonomy in decision making. In each of its acquired companies, Zylog has allowed the existing management to run the operations. Experienced and capable management to spearhead growth

CRISIL Equities

Zylog Systems Limited

14

Corporate Governance

CRISIL’s fundamental grading methodology includes a broad assessment of corporate governance and management quality, apart from other key factors such as industry and business prospects, and financial performance. CRISIL Equities also analysed the company’s shareholding structure, board composition, typical board processes, disclosure standards and related-party transactions. Any qualifications by regulators or auditors also served as useful inputs while assessing corporate governance. Overall, corporate governance at Zylog presents good practices supported by a strong and fairly independent board. The board has relevant experience in the industry. We feel that the company's corporate governance practices are adequate and meet minimum required levels.

Board composition

Zylog's board comprises eight members, of whom four are independent, which is in accordance with the stipulated SEBI listing guidelines. Most of the independent directors have been on the board for four-five years. Mr Ajay Mittal, a nominee director from investor UTI Ventures, has recently been replaced by Mr Vasant Kumar due to the restructuring at UTI Ventures. Given the background of directors, we believe the board is fairly diversified.

Board processes

The balance sheet disclosures are sufficient to gauge the involvement of board members in meetings. The company has various committees in place to support corporate governance practices. The roles of chairman and MD have been segregated in the company. We believe the company's disclosures are sufficient to analyse various business aspects. CRISIL Equities assesses from its interactions with independent directors that the quality of agenda papers and the level of discussions at the board meetings are good.

Other governance aspects

We feel that the independent directors are well aware of the business and are fairly engaged in all the major decisions reflecting positively on the company's corporate governance practices. Further, we assess that the audit committee is chaired by an independent director, and it meets at timely and regular intervals. Corporate governance practices are adequate and meet the minimum required levels

CRISIL Equities

Zylog Systems Limited

15

Valuation Grading Grade:4/5

We have valued Zylog based on the discounted cash flow (DCF) method after consolidating the Brainhunter acquisition. Based on the DCF, our one-year fundamental value is Rs 530 per share. This implies a P/E of 6.6x FY11 and 6.4x FY12, which is at a significant discount to mid-tier Indian IT companies. We believe that there is a scope for PE expansion, when the company is able to generate cash flows from its new business initiatives, and turn around Brainhunter successfully. We initiate coverage on Zylog with a valuation grade of 4/5, indicating a potential upside to the current market price (CMP) of Rs 456 as on May 7, 2010.

Key components of our valuation

We have considered the discounted value of the firm’s estimated free cash flows from FY11 to FY15. We have factored in a relatively high beta for the company at 1.3 for the entire period. Table 6: WACC calculation

FY11-15 Terminal value Risk-free rate of return 7.00% 7.00% Beta 1.3 1.3 Equity risk premium 6.00% 6.00% Cost of equity 14.80% 14.80% Cost of debt (post tax) 8.60% 7.40% WACC 12.70% 14.10% Terminal growth rate 4.00%

We have arrived at the fundamental value of Rs 530 by assuming a terminal growth rate of 4% and an equity risk premium of 6%. Table 7: Sensitivity analysis

Terminal growth rate 530 2.0% 3.0% 4.0% 5.0% 6.0% 12.1% 558 608 670 750 856 13.1% 504 544 592 652 729 14.1% 460 492 530 577 635 15.1% 424 450 481 517 562 Terminal WACC 16.1% 393 415 440 470 505 Source: CRISIL Equities

Since August 2007, Zylog has traded at an average one-year rolling forward PER of 6.2x. At Rs 530, implied PER is 6.6x FY11 and 6.4x FY12 We value Zylog at Rs 530 per share as against its CMP of Rs 456

CRISIL Equities

Zylog Systems Limited

16 Figure 11: One-year rolling forward PER trend Figure 12: One-year rolling forward PER trend

0.0 1 50.0 300.0 450.0 600.0 750.0 ( Rs) Zylog Sytems 5 7.5 1 3 6 9 1 2 1 5 1 yr forward rolling PER ( x)

Source: Prowess, CRISIL Equities Source: Prowess, CRISIL Equities

Table 8: Peer comparison

Market Cap. PER (x) Price / Book (x) ROE (%) Companies (Rs mn) FY09 FY10E FY11E FY09 FY10E FY11E FY09 FY10E FY11E Zylog Systems 6,462 3.9 8.4 5.6 0.3 1.3 1.1 8.7 16.8 20.9 (CRISIL Equities estimates) Consensus estimates Infosys Technologies Ltd 1,556,472 26.1 25.1 22.3 8.5 6.9 5.7 37.4 29.6 27.7 Tata Consultancy Services Ltd 1,536,419 29.3 23 20.1 9.8 7.5 6 37.8 36.4 32.6 Wipro Ltd 1,035,089 26.3 22.6 19.9 7.6 5.7 4.6 30.8 27.4 25 HCL Technologies Ltd 252,938 19 19.9 14.8 5.1 3.8 3.2 28.9 21 23.6 Cognizant (in US$) 15,736 29.7 24.8 22.5 5.9 4.8 4.7 23.2 22 19.7 Patni Computer Systems Ltd 72,695 12.3 14 13.4

• 1.9

1.7

• 14.8

13.8 Mindtree Ltd 25,824 47 13.1 12.7 4.5 3.8 3 9.7 32.2 26.8 Nucleus Software Ltd 5,299 16.4 13.4 11.5 2.2 2 1.8 14.1 15.4 15.9 Oracle Financial 185,429 25.1 22 18.6 5.3 4.4 3.7 23.5 22.6 21.4 Mastek 8,083 5.7 8.5 7.8 1.6 1.4 1.2 31.3 17.3 16.9 Source: Company, CRISIL Equities

CRISIL Equities

Zylog Systems Limited

17

Company Overview

Incorporated in 1995, Zylog is a technology solutions provider to clients across multiple verticals like banking, insurance, telecom, manufacturing, retail and pharmaceuticals. The company offers a combination of onsite and offshore services depending on the client’s requirements and the nature of the project. Its offshore development centre is located in Chennai and is registered with the Software Technology Parks of India (STPI) scheme in India. Zylog has a geographic footprint across the US, Canada, Europe, Asia-Pacific and the Middle-East. In FY09, it had 189 clients; the top 10 clients accounted for around 27% of total revenues in that year. As of March 2009, the company employed around 1,650 employees with 75% being technical staff strength. Zylog got listed on the Bombay Stock Exchange and the National Stock Exchange in 2007. The promoters and promoter group hold 35.41% of the total outstanding equity and have pledged 8 lakh shares (amounting to 4.86% of equity capital) in 2009. Table 9: Major milestones

Year Events 1995 Incorporation of the Company First offshore contract obtained from Rand Software Corporation, Vermont in Mobile and Wireless space to provide data synchronization between server and hand -held device 1996 Opened our first Offshore Development Center (ODC) in Chennai 1998 Started our SI / VAR partnership practice. 1999 Certified as ISO 9001:2000 for software development process by Det Norske Veritas (DNV) 2000 Launched our products Z*Connect and Z*PRISM in the mobile and wireless space in Las Vegas International convention of VAR Partnerships Acquired three businesses namely Silver Spring Technologies (MD), Schumacher Consulting (MA) and Schmidt Systems (VA) primarily expanding

• ur Business Intelligence, Data Warehousing and Application Integration

solutions 2002 Incorporated a 100% wholly owned subsidiary Zylog Systems (UK) Limited. 2003 Strategic partnership with BCSIS (subsidiary of OCBC, Singapore) to market and implement their banking products in India 2004 Two more businesses acquired namely Impeksoft, Inc and JDAN Systems, Inc Revenue crosses Rs. 1,000 million 2005 Incorporated a 100% wholly owned subsidiary, Zylog Systems (India) Limited to cater to domestic business 2006 Incorporated a 100% wholly owned subsidiary in Singapore to cater to APAC region 2007 Preferential allotment to Unit Trust of India Investment Advisory Services Limited A/c Ascent India Fund and Argonaut Ventures Inaugurated its own development centre in Sholinganallur, Chennai 2008 Acquired UK based Anodas Software and Chennai based Ewak Creative Compusoft Pilot projects executed in the e-governance space and rollout of internet services in Tamil Nadu through the Wi Fi technology 2009 Acquired Dubai based Ducont FZ LLC (mobile wireless space), US based FairFax (Content processing) and Malaysia based Nova Berhad, a healthcare content management company 2010 Acquired Canada based consulting and engineering services firm Brainhunter Source: Company reports and CRISIL Equities

CRISIL Equities

Zylog Systems Limited

18

Business Overview

Zylog is a well-diversified company and provides a portfolio of IT products and services, which it has expanded through a combination of organic and inorganic growth. In FY09, the company also ventured into the e-governance and internet services space. In order have a focus on different geographies, the company has promoted subsidiaries in Europe, Asia-Pacific and India.

Product development highest contributor to revenues

Unlike other Indian companies, which generate a large proportion of revenues from IT services, Zylog derives around 48% of its revenues from product development with the balance coming from IT services. Although it is a high-margin business, a high onsite presence has adversely affected its EBITDA margins. However, any rise in the offshore component would lead to significant cost savings. High focus on product development has reduced focus on the consulting business, the contribution of which has halved since FY06 to 18% in FY09. Package implementation is another service line in which the company is aggressively channelling its efforts, which is reflected from the rising share of the service line in total revenues to 14% in FY09 from 9% in FY06. Figure 13: Revenue mix by service-line

36.0 22.7 1 9.6 1 8.4 34.6 44.9 46.7 47.9 8.8 1 3.4 1 4.5 1 4.4 7.7 6.6 7.4 8.1 5.2 3.6 3.3 2.8 7.7 8.8 8.5 8.4 0% 20% 40% 60% 80% 1 00% 2006 2007 2008 2009 Consulting Development Package implementation M aintenance Testing Others

Source: Company and CRISIL Equities

Revenue mix gradually moving towards the telecom segment

The traditional BFSI segment dominates the revenue mix and contributed 29% in FY09 to total revenues. However, the overall share of BFSI segment in the revenue pie is gradually declining with the telecom vertical rapidly gaining ground. Given the company’s expertise in the mobile technologies space, each of its solutions across verticals has a ‘mobility’ factor to

• it. Zylog is also increasingly focusing on the pharmaceuticals industry, especially with the

acquisition of Nova Berhad in FY10. Differentiated model with focus on product development Telecom contributed 27% to total revenues in FY09

CRISIL Equities

Zylog Systems Limited

19 Figure 14: Revenue mix by end user segment

39.9 34.1 32.6 29.1 21 .0 22.0 24.9 26.8 5.3 8.2 9.7 9.2 1 2.2 7.3 6.5 8.8 5.3 7.8 7.9 9.4 1 6.3 20.5 1 8.4 1 6.7 0% 20% 40% 60% 80% 1 00% 2006 2007 2008 2009 Banking & BFSI services Telecom industries Retail market M anufacturing Pharma/Healthcare Other services

Source: Company and CRISIL Equities

Client concentration at par with the industry

Zylog has successfully managed to increase its client base year-on-year. At the end of FY09, it had 189 active clients. Zylog has long-standing relationships with multi-national corporations built on successful prior engagements, which is reflected from the fact that repeat business contributes 91% to total revenues. While its top client, MCI, accounts for 5.3% of revenues, its top 10 customers contribute 27% to total revenues, which is at par with the industry. However, being a relatively small player in the industry, Zylog is exposed to the risk of vendor consolidation. Figure 15: Trend in client concentration and repeat business

27.4 26.8 25.5 1 8.3 21 .6 91 .1 90.1 88.6 71 .3 64.2 1 1 5 20 25 30 35 2005 2006 2007 2008 2009 ( per cent ) 20 40 60 80 1 00 ( per cent ) Contribution of top 1 0 clients Repeat business

Source: Company reports and CRISIL Equities

Top 10 customers contribute 27% to total revenues

CRISIL Equities

Zylog Systems Limited

20 Table 10: Zylog’s IT Products

Products Vertical Brief description RTGS Paymanager Intra-day Liquidity (IDL) manager providing real-time position for all incoming and outgoing payments Cheque Truncation System Banking Allows banks to capture, process and transmit the cheque data and image to the clearing house via a secured communication Claims Management System Enables brokers/agents to schedule and assign tasks for employees and have a track over the

• same. It also manages all claim related processing activities

Phoenix Insurance Customisable solution to electronically manage all key processes and information related to underwriting, broking, claims, reinsurance and accounting. It also supports TPA services, which is a complementary offering Z* Connect It provides alerts and notifications over SMS and MMS. It is protocol independent and provides PushAdapters over Java messaging framework for different SMS and email protocols. SMS.companion Supporting multiple SMS formats, it offers corporates a platform to send bulk SMS with an

• bjective of increasing business.

FieldPower Telecom It schedules employees on the move by skills, location, SLA and cost thereby empowering clients to effectively manage their workforce Sales Rxcelerator It is a web-based platform that enables aggregation of marketing materials, ordering processes and feedback communication to aid pharmaceutical brand teams and their field sales

• rganization improve upon their day to day performance

Vesalius Pharma It contributes to the efficient administration of a hospital - in both inpatient and outpatient

• settings. Some key activities conducted include appointment scheduling, pharmacy, inventory

management, operation theatre management, billing & accounts receivables and counter collections. Infor Syteline Manufacturing It is an ERP solution for small-mid size enterprises in the manufacturing industry. It promotes collaboration with supply and demand partners, increases agility, reduces the time-to-market,

• ptimizes the operational efficiency and lowers the operational cost.

Source: Company and CRISIL Equities

Table 11: Zylog’s IT Services

Service offering Brief description Application services It includes Application Development (analysis, enterprise architecture design), Application Maintenance (24*7 support services, upgrades) and Application Integration (enterprise integration, web enablement, IT enabled business process re-engineering). Replacement technologies It offers specialized solutions for migrating legacy applications to the emerging platforms and architectures such as Microsoft.net, J2EE and LAMP and ensuring scalability, reliability and seamless integration with disparate systems. Mobile computing services It provides mobile workforce with remote access to work order details such as work order location, contact information, required completion date, asset history, and relevant warranties/service contracts. Data Warehousing and Business Intelligence services It delivers end to end Data Warehousing and Business Intelligence Services from requirements definition through development, deployment, and post-implementation support and ensures the availability of business-critical information Managed services It includes desktop management, security management, secure environment, server and database management and network monitoring. IT virtualisation It offers IT infrastructure consolidation and virtualization consulting, design, implementation and testing services to the enterprises. It also helps customers to implement and promote energy- efficient technologies and hardware infrastructure. Microsoft Dynamics It offers add-on solutions, customization and implementation services to other MS partners and end clients, who are looking for cost effective implementation. Enterprise 2.0 Computing Services It provides business managers access to information through a web of inter-connected applications, services and devices. It is defined as the application of Web 2.0 technologies to the enterprise. Source: Company and CRISIL Equities

CRISIL Equities

Zylog Systems Limited

21

Annexure: Financials

Table 12: Brainhunter Income statement (Year ending September)

(Rs Mn) FY08 FY09 FY10E FY11E FY12E FY13E Net sales 9,539 8,836 9,031 8,532 8,308 8,724 Operating Income 9,539 8,836 9,031 8,532 8,308 8,724 EBITDA 102 221 259 341 332 436 Depreciation 210 33 36 4 5 6 Interest 137 74 68 54 43 35 Other Income (588) (106)

• - - -

PBT (832) 7 155 284 285 396 PAT (826) 6 124 213 205 285

Table 13: Zylog Consolidated (including Brainhunter) (Year Ending March) Income Statement

(Rs Mn) FY08 FY09 FY10E FY11E FY12E FY13E Net sales 6,091 7,510 9,034 18,637 20,689 23,322 Operating Income 6,094 7,511 9,035 18,638 20,690 23,323 EBITDA 1,143 744 1,419 2,085 2,307 2,628 Depreciation 107 211 276 341 390 429 Interest 45 71 114 164 152 160 Other Income 66 47 50 63 77 91 PBT 1,057 509 1,078 1,643 1,841 2,130 PAT (with forex impact) 703 846 889 1,328 1,372 1,585 EPS (Rs) 42.9 51.6 54.2 80.7 82.6 95.4 PAT (without forex impact) 933 389 889 1,328 1,372 1,585 EPS (Rs) 56.9 23.7 54.2 80.7 82.6 95.4

Balance Sheet

(Rs Mn) FY08 FY09 FY10E FY11E FY12E FY13E Equity capital 164 164 164 164 166 166 Reserves and surplus 3,924 4,728 5,549 6,837 8,302 9,801 Debt 568 1,569 2,881 2,762 2,281 1,781 Current Liabilities and Provisions 375 685 1,472 1,564 1,752 1,982 Deferred Tax Liability/(Asset) 6 6 6 6 6 6 Capital Employed 5,038 7,152 10,073 11,333 12,507 13,736 Net Fixed Assets 585 620 952 1,111 1,189 1,219 Capital WIP 1 102 102 102 102 102 Intangible assets 284 820 1,806 1,806 1,806 1,806 Loans and advances 763 719 872 1,070 1,286 1,503 Receivables 1,926 2,795 4,227 4,809 5,418 6,037 Cash & Bank Balance 1,143 2,095 2,113 2,434 2,706 3,070 Applications of Funds 5,038 7,152 10,073 11,333 12,507 13,736 Source: Company and CRISIL Equities Estimate

CRISIL Equities

Zylog Systems Limited

22 Table 14: Zylog Consolidated (including Brainhunter) Cash Flow

(Rs Mn) FY08 FY09 FY10E FY11E FY12E FY13E Pre-tax profit 1,057 509 1,078 1,643 1,841 2,130 Total tax paid (117) (120) (189) (316) (469) (544) Depreciation 107 211 276 341 390 429 Change in working capital (1,199) (1,051) (1,784) (688) (636) (606) Cash flow from operating activities (152) (452) (619) 980 1,127 1,409 Capital expenditure (353) (346) (608) (500) (468) (459) Investments and others (135) 335

• Cash flow from investing activities

(488) (11) (608) (500) (468) (459) Equity raised/(repaid) 1,142

• 182

1 Debt raised/(repaid) (26) 1,001 1,312 (120) (480) (500) Dividend (incl. tax) (58) (58) (68) (68) (87) (87) Others (incl extraordinaries) (111) 472 28 Cash flow from financing activities 947 1,415 1,245 (160) (386) (586) Change in cash posiiton 307 952 18 320 272 364 Opening Cash 836 1,143 2,095 2,113 2,434 2,706 Closing Cash 1,143 2,095 2,113 2,434 2,706 3,070

Ratios

FY08 FY09 FY10E FY11E FY12E FY13E Growth ratios Sales growth (%) 49.6 23.3 20.3 106.3 11.0 12.7 EBITDA growth (%) 55.0 (34.9) 90.8 47.0 10.6 13.9 EPS growth (%) - with forex impact 28.2 20.3 5.1 48.9 2.3 15.5 EPS growth (%) - without forex impact 83.4 (58.3) 128.4 48.9 2.3 15.5 Profitability Ratios EBITDA Margin (%) 18.8 9.9 15.7 11.2 11.2 11.3 PAT Margin (%) 15.3 5.2 9.8 7.1 6.6 6.8 Return on Capital Employed (RoCE) (%) 27.9 9.6 15.2 19.0 18.7 19.6 Return on equity (RoE) (%) 29.8 8.7 16.8 20.9 17.7 17.2 Dividend and Earnings Dividend per share (Rs) 3.5 3.5 3.5 3.5 4.5 4.5 Dividend payout ratio (%) 8.2 6.8 6.5 4.4 5.4 4.7 Dividend yield (%) 3.6 3.8 0.8 0.8 1.0 1.0 EPS in Rs (with forex impact) 42.9 51.6 54.2 80.7 82.6 95.4 EPS in Rs (without forex impact) 56.9 23.7 54.2 80.7 82.6 95.4 Efficiency ratios Asset Turnover (Sales/GFA) 8.6x 7.6x 6.6x 9.7x 8.6x 8.1x Asset Turnover (Sales/NFA) 14.2x 12.5x 11.5x 18.1x 18.0x 19.4x Sales/Working Capital 3.4x 2.9x 2.8x 4.7x 4.5x 4.4x Financial stability Net Debt-equity

• 0.2
• 0.1

0.1 0.0

• 0.1
• 0.1

Interest Coverage 23.2 7.5 10.0 10.7 12.6 13.7 Current Ratio 11.1 8.2 4.9 5.3 5.4 5.4 Valuation Multiples Price-earnings 1.7x 3.9x 8.4x 5.6x 5.5x 4.8x Price-book 0.4x 0.3x 1.3x 1.1x 0.9x 0.8x EV/EBITDA 0.6x 1.3x 5.8x 3.8x 3.1x 2.4x Source: Company and CRISIL Equities Estimate

CRISIL Equities

Zylog Systems Limited

23

Focus Charts (Consolidated basis)

Shareholding as on March 2010 High onsite presence as compared to peers

9.8% 6.1 % 6.0% 36.0% 42.1 % Promoter and Promoter group FII Other Institutions Bodies Corporate Other Non-Institutions 24 29 65 37 25 71 35 63 75 76 1 20 30 40 50 60 70 80 Infosys Patni Zylog Hexaware M astek ( Per cent ) Onsite Offshore

Source: Prowess Source: Company reports Operating income to grow at a 3 year CAGR of 37% New initiatives to contribute 6% to revenues in FY13

9.0 1 8.6 20.7 23.3 20.3% 1 06.2% 1 1 .0% 1 2.7% 0.0 3.0 6.0 9.0 1 2.0 1 5.0 1 8.0 21 .0 24.0 FY1 0E FY1 1 E FY1 2E FY1 3E ( R s Bn) 0.0% 20.0% 40.0% 60.0% 80.0% 1 00.0% 1 20.0% Revenues Revenue growth 56.4% 3.6% 2.6% 37.4% Revenues: Rs 23.3 bn (FY13E)

IT services and solutions Wi Fi services E-governance Brainhunter

Source: Company data, CRISIL Equities Estimate Source: Company data, CRISIL Equities Estimate EBITDA margins to follow a downward trend EPS to grow at a three-year CAGR of 21%

1 ,41 9 2,085 2,307 2,628 1 5.7% 1 1 .2% 1 1 .2% 1 1 .3%

• 500

1 ,000 1 ,500 2,000 2,500 3,000 FY1 0E FY1 1 E FY1 2E FY1 3E ( Rs mn) 0.0% 4.0% 8.0% 1 2.0% 1 6.0% 20.0% EBITDA EBITDA margin 54 81 83 95 2% 48.9% 2.3% 15.5% 0% 10% 20% 30% 40% 50% 60% 20 40 60 80 100 FY10E FY11E FY12E FY13E (Rs) EPS EPS growth

Source: Company data, CRISIL Equities Estimate Source: Company data, CRISIL Equities Estimate

CRISIL Equities

Zylog Systems Limited

24

Explanation of CRISIL Fundamental and Valuation (CFV) matrix

This matrix analyses fundamentals (addressed through the fundamental grade) and returns (through the valuation grade).

Fundamental grade

CRISIL’s fundamental grade represents an overall assessment of the company’s fundamentals graded relative to other listed equity securities in India. The grade facilitates easier comparison of fundamentals between companies, irrespective of the size or the industry they operate in. The grading factors in: Business Prospects: Industry prospects and company’s future financial performance Management Evaluation Corporate Governance The grade is assigned on a five-point scale from grade 5 (indicating excellent fundamentals) to grade 1 (poor fundamentals)

CRISIL fundamental grade Assessment 5/5 Excellent fundamentals 4/5 Superior fundamentals 3/5 Good fundamentals 2/5 Moderate fundamentals 1/5 Poor fundamentals

Valuation grade

CRISIL’s valuation grade represents an assessment of the potential value in the company stock for an equity investor over a 12-month period. The grade is assigned on a five-point scale from grade 5 (indicating strong upside from the current market price (“CMP”) to grade 1 (strong downside from the CMP).

CRISIL valuation grade Assessment 5/5 Strong upside (>25% from CMP) 4/5 Upside (10–25% from CMP) 3/5 Aligned (+/- 10% from CMP) 2/5 Downside (negative 10–25% from CMP) 1/5 Strong downside (< negative 25% from CMP)

Analyst disclosure:

Each member of the team involved in the preparation of the grading report, hereby affirms that there exists no conflict of interest that can bias the grading recommendation of the company

Disclaimer:

This Company-sponsored Report (Report) is based on data publicly available or from sources considered reliable. CRISIL Ltd. (CRISIL) does not represent that the data/report is accurate or complete and hence, it should not be relied upon as such. The data / Report is subject to change without any prior notice. Opinions expressed herein are our current opinions as on the date of this Report. Nothing in this Report constitutes investment, legal, accounting or tax advice or any solicitation, whatsoever. The subscriber / user assumes the entire risk of any use made of this data / Report. CRISIL especially states that it has no financial liability, whatsoever, to the subscribers / users of this Report. This Report is for the personal information only of the authorized recipient in India only. This Report should not be reproduced or redistributed or communicated directly or indirectly in any form to any

• ther person – especially outside India or published or copied in whole or in part, for any purpose.