Software is Eating the World! Here's How to Profit from it.

'Uber and Ola are not taxi companies. They are technology companies.'
With these words, he began to answer my question. I was meeting the management of a software
company in Pune. I had asked about the kind of work the company does.
The company in question, and this month's Hidden Treasure recommendation, is in the business
of transforming other businesses with software.
This is not your typical IT company. It is a pioneer of Outsourced Product Development (OPD).
Delivering IT services and developing software products are as different as day and night. Large
Indian IT companies have mastered the former. Persistent Systems has mastered the latter.
Software Product Development is a tough business. Just look at Silicon Valley. The competition
is brutal. The technology changes constantly. Building domain knowledge is hard. Retaining
employees who have good domain knowledge is harder.
Now imagine an Indian IT firm working as an outsourcing partner in the product development
space. It would face a lot of the problems Silicon Valley firms face. In addition, it would face
many other uncertainties.
Large, long-term contracts would be rare. Cash flows would be lumpy. Employee attrition would
be a problem. Scaling up would be a challenge. It's very survival would be uncertain.
Persistent Systems has not only survived but thrived. It can provide full lifecycle product
development. Its employees think and work like those at a startup. In other words, the company
has the DNA to thrive in the digital world.
This is what he meant when he spoke about Uber and Ola. The management understands
technology inside out. More importantly, they understand their client's needs in this digital world.
It's no wonder Microsoft and HP have been loyal customers since 1991 and 1994 respectively.
This is an IT company that operates like an agile startup.
So it didn't surprise us when IBM picked Persistent as a preferred alliance partner for its big bet
for the future: The 'Watson' artificial intelligence platform. IBM has big plans for Watson. CEO
Virginia Rometty has said she wants Watson to generate US$10 billion in annual revenue within
ten years.
Under the collaboration, Persistent will invest in the Watson platform to build Internet of Things
(IoT) solutions for IBM's customers. IBM is the world leader in IoT. The company will also be
involved in the continuous software engineering projects related to Watson. The alliance opens
up major cross-selling and up-selling opportunities for Persistent. This alliance will significantly
enhance Persistent's stature and presence in the software world. It will also be a key growth
driver going forward.

So how good are the numbers?

Persistent's sales, operating profit, and net profit have all grown 21.4%, 24.1%, and 24% CAGR
respectively in the last seven years. Operating cash flow has grown 20.3% CAGR. During this
time, the return on equity and return on invested capital have averaged 18.5% and 24.3%
respectively. The dividend payout has increased from 5.4% to 21.5%. All this with almost no
debt.
So far so good. But are the valuations attractive enough? Read on to find out...

How Persistent Will Boost its Fortunes

The Agile Edge!

The digital revolution has brought with it a big challenge for Indian IT firms. The core
strength of these companies is their highly skilled employee base. Unfortunately, their
skills were developed well before this revolution came along. Digital projects are
typically of a shorter duration vis-a-vis traditional IT services work. The company's
annual report explains this quite well.
Traditional IT Services projects follow what is known as the Software Development Life
Cycle (SDLC). These projects start by clearly defining the final requirement. This is
usually fixed and known well in advance. The main objective of the project manager of
such a project is to get the optimal result using time and resources in the best possible
way.
Persistent Systems does not operate in this way.
Employees developing software products need to adhere to the Product Development
Life Cycle (PDLC). In a PDLC, the result of the project is not clearly known at the start.
What is known is the launch date. Budgets are planned only after the launch date is fixed.
However, the requirements are variable. The objective of the product manager in this case
is to build the best possible product within the given budget and time.
The best way to work under such conditions is to develop the product in iterations. It
works like this:
1. First, develop a prototype quickly.
2. Ask the client to review it.
3. The client will provide specific suggestions.
4. Implement those suggestions in their most basic form.
5. Repeat 2.

6. The client will now provide detailed suggestions.

7. Implement all of them with the most important suggestion as the highest priority.
8. Repeat 2.
9. After the client responds, repeat the process in the descending order of the client's
priorities.
Ensure highest quality standards at each step.
Over time, this process came to be known as 'Agile Development'.
Persistent Systems has implemented Agile Development across the company. This is no
mean feat. Large IT companies are yet to do this in a meaningful way. Due to their huge
employee base, it could take those companies years to do so.
The Agile DNA of the company is its primary differentiator in a highly fragmented global
software market. Over-time as more and more industries are disrupted by software; we
believe Persistent will grab an increasing share of the outsourced product development
(OPD) market.

The IBM Alliance

In February 2016, the company announced a significant collaboration with IBM. The tieup pertains to IBM's 'Watson' software platform. Watson is IBM's big bet for the future.
Watson deals with the futuristic Internet of Things (IoT) technologies. IoT is by far the
fastest growing sub-category of the new disruptive digital technologies. IBM is the world
leader in IoT.
IBM has signed-on Persistent Systems as a preferred alliance partner for the
Watson platform. Under this collaboration, Persistent will invest in the Watson platform
to build IoT solutions for IBM's customers. The company will also be involved in the
continuous software engineering projects related to Watson.
This alliance will significantly enhance Persistent's stature and presence in the software
world. Persistent will take over about 500 people over the next one year from various
IBM locations around the world.
The two companies will follow a joint go-to-market strategy. Persistent's recent
acquisition of Apeona will be aligned with the IBM alliance. The alliance also opens up
significant cross-selling and up-selling opportunities for Persistent.
The management had to re-organise the business in the wake of this development. From
1st April 2016, the business has been re-categorised into 4 divisions with a competent
individual in charge of each one.

1. The IBM alliance

2. The non-IBM digital business
3. The IT services business
4. Accelerite (Persistent's product business)
We believe this corporate structure is appropriate considering the nature of the company's
business.
In terms of the numbers, the alliance will immediately add 15%-16% to the company's
FY16 consolidated topline in FY17.
However, the alliance will cost Persistent in terms of margins, at least for FY17. This
is due to the addition of the additional onsite employees of IBM.
This is a major blow to the company's bottomline, in the short-term. However, we believe
the IBM alliance is a hugely positive long-term development for the company.

Competing successfully with the big boys with innovative marketing

The agile development model has helped the company diversify its client base as well.
Instead of competing with the big boys of Indian IT via the traditional Request for
Proposal (RFP) route to acquire large clients, Persistent has played it smart. The company
adopted multiple innovative marketing strategies.
Here are just a couple of examples.
Persistent has inexpensively acquired strong portfolio Intellectual Property (IP) assets
from global software majors. These IP are usually close to the end of their productive
lifecycle. The company extends their life cycles to generate high RoI from these assets. It
then packages them as a differentiated service offering to large enterprise clients.
Another method is called the 'sell-with' strategy. The company combines its in-house
developed IP as well as its acquired IP. Then it sells with its partner network (Salesforce,
Apigee, etc). This allows the company to get a foot in the door with a large client via a
small deal. The company later attempts to cross-sell other services to gain the customer's
wallet-share. Thus, the attempt is to position the company as a differentiated software
vendor right from the beginning.
The key question is this. Are these strategies working? The answer is yes! Revenue from
large enterprise customers has grown to about 27% of sales overall.
As one would expect, deal sizes have also grown. This is as clear an example as you can
get of a company strengthening the moat around its business.

Enterprise Segment Growing Well

Healthy Trend in Deal Sizes