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The Citi factor

Mobis Philipose

It couldn't have worked out better for CitiGroup. For the last few months it has been common knowledge that CitiGroup wanted to dilute its stake in software company OrbiTech Solutions. The only question was how to pull it off with the minimum of fuss and bother.

That's precisely what CitiGroup has finally done. By striking a deal with Polaris Software it has tied-up with an old partner and sewn up a deal that seems to be mutually beneficial for both sides. Says Arun Jain, chairman, CEO & managing director, Polaris: "With a 16-year relationship with OrbiTech, it was a perfect business fit for us. While we have cost, quality and reliability, OrbiTech will provide us with speed and variety."

It isn't hard to figure out why CitiGroup wanted to dilute its stake in OrbiTech Solutions. The banking giant is known to prefer holding less than 50 per cent in its non-BFSI (banking, financial services and insurance) related businesses.

For example, it owns 39 per cent and 47.5 per cent in its other technology subsidiaries in India, e-Serve International and i-flex solutions. Holdings in excess of 50 per cent would obviously mean that these companies' results also get reflected in Citi's consolidated accounts.

Citi has, over the last few months, been looking for different solutions for OrbiTech. Initially, it is believed to have made an unsuccessful search for financial and strategic investors and that was made tougher because OrbiTech isn't a listed company.

Nevertheless, there was already pressure on OrbiTech to list. The company's employees own about 7 per cent shares that have been given to them as ESOPs (employee stock options). Employees holding these ESOPs would have also wanted to unlock the value of their investments. But clearly, listing OrbiTech would have been easier said than done.

One major hurdle was the fact that OrbiTech derived all of its revenues from CitiGroup. In fact, according to analysts, OrbiTech could be viewed as only a cost centre of Citi, and not as an independent organisation.

OrbiTech has also acted as a sub-contractor for CitiGroup - for instance, 38 per cent of the work Polaris does for Citi is received through OrbiTech. Such a structure surely wouldn't have helped Citi get a reasonable valuation.

Diversifying its revenue stream beyond Citi would have taken considerable time and even when it would have been IPO ready, i-flex solutions would have been already listed by then, offering a very similar play for the markets. Both are predominantly product companies in the BFSI space with a strong parent. The merger with Polaris Software, hence, serves a double purpose.

In fact, a clause in the merger agreement has it that CitiGroup Venture Capital would bring its stake below 50 per cent within three months from the date the merger becomes effective. As CVC would hold a little over 53 per cent of the merged entity, it would have to offload around 3 per cent of the equity.

Analysts expect Citi to bring down its stake to much lower levels. And unlike an IPO, where the Securities and Exchange Board of India's regulations restrict original stakeholders from offloading shares until one year after the IPO, Citi is not bound by any regulations in Polaris's case.

But why Polaris? Says Dipak Rastogi, vice chairman, CitiGroup Investments: "As financial investors, our relationship with Polaris is not a new one, and our investments into the company date back to 1997. This has given us the opportunity to understand the strategic direction and leadership of the management."

Also, since OrbiTech has hitherto been catering only to Citi entities, its sales and marketing network was negligible. Ram Bhagwat, managing director of OrbiTech Solutions, points out: "Polaris has the required sales and marketing network that will enable us to exploit the potential of our products."

Polaris and OrbiTech may seem a neat fit, but the fact that both companies are focused on the BFSI segment means that there is bound to be some overlap. For instance, there is OrbiTech's banking product, OrbiPack, which was till now seen as competing with Polaris's Bankware.

Post-merger, the management's plans are to focus on the premium segment with OrbiPack, while Bankware will be pitched at small- and medium-sized organisations. Further, according an analyst, one of the concerns post-merger is that OrbiTech employees are unlikely to be too happy with the news of their company merging with a company that was hitherto considered their vendor. Hence, there is a possibility of increased attrition, especially in the middle and upper management levels.

But Polaris's hiring binge at the senior management level should take care of any such problem. Without doubt, there will be challenges for the management of the merged entity to effect a smooth transition. From an OrbiTech shareholder's point of view, however, the merger works out as a perfect way to unlock value. But what does the merger ratio mean for them?

On the face of it, the Polaris management seems to have eked out a decent deal from CitiGroup Venture Capital, the 93 per cent owner of OrbiTech Solutions. While Polaris Software was valued at $210 million for the deal, OrbiTech was valued at $246.75 million, or about 17 per cent higher.

The merger ratio of 1:1.17 is clearly in favour of Polaris, considering that OrbiTech's post-tax earnings in fiscal 2002 were almost twice (1.83 times) that of Polaris's FY02 earnings. Viewed in terms of trailing price-earnings multiples, the values accorded to the two companies imply starkly different parameters - while Polaris has valued at 17.5 times FY02 earnings, OrbiTech's valuation is based on a much lower 11.2 times discounting.

Come to think of it, despite the relatively low merger ratio, CitiGroup Venture Capital would still be the single largest shareholder. The revenue from CitiGroup would account for over 60 per cent of the merged entity's total revenue. One would have expected CitiGroup to call the shots in the merger valuation process. For this very reason, the markets had been conservative in their merger ratio expectations, pegging it at around 1:1.5 on an average.

But that's far from saying that CitiGroup has got a raw deal. Just looking at the price-earnings multiple does not give a fair picture, since OrbiTech's high net margins of 33 per cent are unusually high and not sustainable.

The fact that OrbiTech derived all of its revenue from CitiGroup entities meant that it could practically do without a sales and marketing division. Its decision to cater to non-Citi clients late last year would have entailed some sales related expenses, but it would be fair to assume that the 2002 numbers did not include a significant amount relating to sales and marketing spend.

Besides, given the fact that OrbiTech had the freedom to sub-contract work to other vendors, it did not have to maintain any noteworthy bench like other software companies. Likewise, manpower utilisation rates were as high as 90 per cent in FY02 and are not sustainable, especially given OrbiTech's stated intention of trying to win more clients.

Since margins were clearly not sustainable, it makes more sense to look at the price-sales metric, using which OrbiTech is actually valued higher at 3.74 FY02 sales, against a discounting of 3.5 times for Polaris. And, on balance it does seem that both sides have done well from the deal.

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