Persistent Systems seems a good buy in the mid-cap IT space now. With a large IP (intellectual property) business, capability in SMAC (social media, mobility, analytics and cloud), which is driving growth in the services segment, and a foot in IoT (internet of things) now, the company’s future looks promising.

The stock’s valuation has corrected in the last year from 20 times to about 17 times (at ₹733) now on one-year forward earnings due to some challenges in its business. However, over the last two quarters, the strong growth in IP-led business and an improved traction in the enterprises segment are encouraging.

Persistent, which started out by developing software for database companies, slowly moved to become an outsourced product development company. When serving independent software vendors (ISVs) such as Microsoft and IBM, it got access to enterprise clients. So, now, while on the one hand, it does product development with ISVs, on the other, it helps their customers deploy that product in the business.

Additionally, Persistent helps these enterprises in digital transformation too. Further, over the last few years, the company has also developed an IP product portfolio. It has among the largest IP portfolios compared with any company of its size in the domestic market.

In February, Persistent signed a deal with IBM Watson to offer solutions to customers on Watson’s IoT platform. This partnership should drive growth for the company in the next few years.

What numbers say Persistent Systems has two revenue streams — IP (28 per cent of total revenue) and services. The services business is split into ISVs (46 per cent) and enterprises (26 per cent). In 2015-16, while the IP business grew 25.9 per cent, the services segment grew only 11 per cent due to a sluggish growth of 1.9 per cent in the ISV business. The segment may see a revival in growth over the next few quarters as ISVs begin to invest in cloud offerings.

In the March 2016 quarter, Persistent’s dollar revenue growth at 12 per cent sequentially was better than expected and up from 8 per cent in the December quarter. This was led by a jump in IP revenue (up 57 per cent sequentially).

The enterprises segment grew 1.8 per cent (after a strong double-digit growth in the previous quarter) while the ISV business saw flat growth. The disappointment was the drop in operating margins — down by 289 basis points sequentially, attributable largely to the expenses related to the partnership with IBM. But margins may improve over the next one year, as operations are integrated. In the full year 2015-16, the company’s dollar revenue grew by 14 per cent, higher from the previous year’s 12.6 per cent.

IP business gaining traction In the IP business, Persistent acquires products nearing their end-of-life from software vendors and improves upon them. In May 2014, it launched the brand ‘Accelerite’, and put all its acquired IP products under it. In 2015-16 alone, the company acquired five IPs.

The revenue for the company in this business is mainly from licence renewal fees. Margin contribution is higher relative to other segments; in the initial years, though, margins are low because of high R&D and related costs. Revenue from the IBM Watson partnership struck in February this year is also going into the IP segment.

The management expects this partnership to bring an additional $50 million in revenue (full year overall company revenue in 2015-16 was $352 million) in 2016-17.

However, margins may be weak due to the additional investments required.

Led by enterprises The list of platform vendors that Persistent serves has been growing and includes Oracle, Salesforce, SAP, Appian and Dassault Systemes.

Though the ISV business has been going through a rough patch for the last three to four quarters with many of them shrinking spends on legacy products, their partnership has helped Persistent acquire enterprise clients, many of which are among the Fortune 500 companies.

With more companies globally adopting platforms to differentiate their offerings from competition, the outlook for the enterprise segment and opportunity for Persistent, as a provider of technological support, seems bright.

Near-term margin pressure The operating profit margin in the March 2016 quarter was 15.9 per cent, sharply lower both sequentially (2.9 percentage points) as also year-on-year (4.3 percentage points). A key reason for the margin contraction was the new business from IBM Watson.

The company has indicated that there may be a two percentage point decline in 2016-17 margins due to the alliance with IBM.

However, the company has indicated that the IBM partnership will start yielding better margins gradually as most costs are incurred in the initial few years.

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