The current section of the “Analysis” series covers Sonata Software Ltd involved in providing information technology services to international clients and software distribution business in India. The company provides solutions oriented around Microsoft Dynamics 365, SAP Hybris and other platforms to travel, retail, distribution industries among others.
“Analysis” series is an attempt to share with all the readers, our inputs to the company analysis submitted by readers on the “Ask Your Queries” section of our website.
To benefit the maximum from this article, an investor should focus on the process of analysis instead of looking for good or bad aspects of the company. She should learn the interpretation of different types of data and transactions and pay attention to the parts of annual reports etc. used to get the information. This will help her in improving her stock analysis skills.
Sonata Software Ltd Research Report by Reader
Good day, Dr Malik,
Please find below my analysis for Sonata Software Ltd. I will appreciate your input in identifying gaps in my analysis; so, I can use that knowledge to get better.
Please note that I have tried to follow the framework described in your article for the analysis of IT sector companies. It might not be in the order prescribed, but I have tried to include all the relevant data in the below analysis.
Sonata Software Ltd: Company Description
Company is primarily engaged in the business of delivering IT services and software solutions to its customers across the globe including the US, Europe, Middle East, Asia- Pacific, Australia and New Zealand. Besides, the Company also distributes and re-sells products from global technology companies present in India. The Company’s consolidated results comprise operations of Indian and Overseas Subsidiaries. It operates under two distinct heads of International IT services (IITS) and Domestic Products and Services (DPS).
Size of the company, client additions & resource utilisation
The company is midcap IT company focused on the following verticals:
- ISVs (Independent Software Vendors)
- Travel and Tourism
- Consumer Packaged Goods (CPG), Distribution and Manufacturing
- Agri-Commodity Business (added via Scalable Data Systems Acquisition)
- Service Industries – Energy & Utilities (added via Sopris Systems Acquisition)
The company has been new clients consistently every year as is evident from management discussion and analysis. New client additions:
- 2017-18: 32 clients
- 2018-19: 31 clients
- 2019-20: 29 clients
However, upon going through the list of newly added customers in the management discussion for 2019-20, a customer who is a large manufacturer of mechanical control cables also figures in the list of newly added clients. It is hard to say whether it is a different customer operating in the same industry or whether the company has mentioned the same customer twice to make the list appear longer.
Resource utilisation, number of employees and employee cost as a percentage to total sales of the company is as below:
- Resource utilization: FY18: 85%, FY19: 86%, and FY20: 87%
- Employee strength: FY18: 3,476, FY19: 4,042, and FY20: 4,211
- Employee costs as a percentage of sales: FY18: 21%, FY19: 19%, and FY20: 18%
As can be seen from the above that the company keeps a sufficient number of employees on the bench in order to accommodate new inflows project inflows or to allocate more resources to an ongoing project.
It can also be seen that the employee costs are much lower than what other companies have in the same sector.
Upon checking companies of similar market cap I found that the employee cost as a % of total sales for companies such as Tata Elxsi and Nucleus software has consistently been in the late 50s or early 60s as a percentage to total sales.
I did spend quite a bit of time trying to locate the ratio between onsite and offshore employees, but I regret to say that I could not find this piece of information.
Nature of the business and type of contracts of Sonata Software Ltd:
Disaggregate revenue information:
- FY2019: Time and material: Rs.932.51cr, fixed price: Rs.140 cr
- FY2020: Time and material: 1027.18cr, fixed price: Rs.160.36 cr
As you can see both the time and material as well as fixed-price contracts do not form 100% of the revenue earned by the company.
Also, in my opinion, the company consistently focusses on time and material contracts as opposed to fixed-price contracts, which in my opinion indicates a conservative view by the management to safeguard revenue.
The company has consistently acquired other businesses like Gap-Buster Ltd, Semi-Cab Service, Scalabale Data Systems and Sopris Systems. Frequent M&As as rightly pointed out by you increases the chances of financial jugglery but the clause of contingent consideration, which is based on financial performance, does provide some comfort as far as management prudence regarding acquisitions is concerned.
Revenue per employee of Sonata Software Ltd:
- 2017-18: Rs.70.59 lakhs
- 2018-19: Rs.73.25 lakhs
- 2019-20: Rs.88.88 lakhs
As is evident the revenue per employee has been consistently increasing at a rate higher than the rate of addition of new employees.
Financial analysis of Sonata Software Ltd:
The sales of the company have been increasing consistently. However, upon comparison with companies such as Tata Elxsi, it has a much lower operating profit margin mainly because of expenditure on the raw material.
Upon checking the P&L statement, this cost can be assigned to the expenditure on the purchase of stock in trade (traded goods). Hence, apart from providing software services, the company also provides products.
A case can also be made that since the company spends so much on the stock in trade that the ratio of employees to the revenue is bound to be less.
The company has been paying its taxes at around the corporate tax rate.
Net profit margins are around 7-8% and have been stable at these levels over the last couple of years.
The cash flow from operations for the company has always been positive except for 2018-19 when the trade receivables and the number of receivable days increased but has again turned positive this year.
The company is growing at a rate lower than the SSGR. Hence, it indicates the potential for the company to grow at a faster rate.
The company also has a high amount of capital expenditure most of which is allocated towards the services segment of the business which can found in the secondary disclosure.
Because of the increased capex, the NFAT has come down which should increase again once the capex translates into revenues.
The company has been consistently paying a very healthy dividend. At current prices, it translates into more than a 6% dividend yield.
Add to the fact that the company has been able to multiply investor wealth by a respectable 5.5x for every rupee retained.
Management analysis of Sonata Software Ltd:
i) Related party disclosures:
The company has been lending to its subsidiaries on a consistent basis for their working capital management as well as corporate guarantees.
The inter-corporate deposits have been given at the prevailing bank interest rates. The corporate guarantees are also promptly released as can be seen from the release of mutual fund units, which were on lien for the loans borrowed by sonata software North America.
ii) Remuneration of key management personnel (KMP):
The remuneration of the KMP has been around 5-6% except for the year 2019-20 where the management took a haircut in view of the prevailing business conditions. What is heartening to note that despite the pay cut taken by the top management, the salaries of the employees increase by an average of 5%.
Upon going through the remuneration being paid to the promoters, from what I could see is that apart from the commission and sitting fees they do not draw anything out of the company profits except the dividends that every other shareholder is entitled to which as mentioned above is a healthy 6%.
Valuation analysis of Sonata Software Ltd:
I have not taken into account the price to book value (P/B) multiple, but when comparing the price to earnings (P/E) multiple, it is presently available at a P/E ratio of around 12, which is in line with its historical averages.
Quoting Mr Warren Buffet, “Fair price for a great business compared to a great price for a fair business.”
The company is quoting at a CMP=Rs.312 compared to its intrinsic value of Rs.315.
The company is free cash flow positive with FCF/CFO ratio of 80%. Also, note that this ratio is in line with other companies operating in the IT industry.
The company offers an earnings yield of 12.63% compared to G-Sec yield of around 5%.
As per my analysis, though the company might not be available at a discount, however, it is available at a fair price.
Finally, I would like to thank you for the resources that you share with everyone. I have been a quiet observer on your blog for quite a while and based on my present understanding of basic accounting this is the best analysis that I could have produced now.
Dr Vijay Malik’s Response
Thanks for sharing the analysis of Sonata Software Ltd with us! We appreciate the time & effort put in by you in the analysis.
While analysing the history of Sonata Software Ltd., an investor notices that over time, it has created many subsidiaries, acquired a few businesses, merged them with existing subsidiaries etc. At March 31, 2020, the company had the following subsidiaries:
- Sonata Information Technology Limited
- Sonata Software Solutions Limited
- Sonata Software North America Inc.
- Interactive Business Information Systems Inc. (a subsidiary of Sonata Software North America Inc.)
- Sopris Systems LLC (a subsidiary of Sonata Software North America Inc.)
- Sonata Software GmbH
- Sonata Europe Limited
- Sonata Software FZ LLC
- Scalable Data Systems Pty Ltd.
- Subsidiary Sonata Software (Qatar) LLC
We believe that while analysing any company, an investor should always look at the company as a whole and focus on the financials, which represent the business picture of the entire group. Consolidated financials of any company, whenever they are present, provide such a picture.
Further advised reading: Standalone vs Consolidated Financials: A Complete Guide
Therefore, in the analysis of Sonata Software Ltd, we have used consolidated financials in the assessment.
With this background, let us analyse the financial performance of the company.
Financial and Business Analysis of Sonata Software Ltd:
While analyzing the financials of Sonata Software Ltd, an investor notices that the sales of the company have grown at a pace of about 10-12% year on year from ₹1,405 cr in FY2011 to ₹3,743 cr in FY2020. During the 12-months ending June 2020, the sales of the company have increased to ₹3,821 cr.
However, when the investor analyses the trend of sales of Sonata Software Ltd year after year, then she notices that the journey of the company over the last 10 years has not been smooth. In FY2013, the company witnessed a sharp decline of about 16% in its sales from ₹1,568 cr in FY2012 to ₹1,311 cr in FY2013. Thereafter, the sales of the company have increased consistently year on year.
While analysing the profit margins of Sonata Software Ltd, an investor notices that the operating profit margin (OPM) of the company has witnessed a fluctuating trend. The OPM of the company was 11% in FY2011 and it sharply declined to 3% in FY2012. The decline in the profitability during this period was severe to the extent that Sonata Software Ltd reported net losses of ₹3 cr and ₹28 cr during FY2012 and FY2013 respectively.
Thereafter, the OPM of Sonata Software Ltd stayed at the low levels of 4% and 6% in FY2013 and FY2014 respectively. In FY2015, the OPM reached 10% and since then it is fluctuating between 11% and 8%.
In order to understand the business of Sonata Software Ltd and make any reasonable assessment, an investor needs to understand the reasons for the decline in the sale and profit margins of the company during FY2012 and FY2013. Thereafter, the investor needs to understand the reasons for the fluctuating OPM of the company.
Annual reports of Sonata Software Ltd from FY2010 onwards are available at the Bombay Stock Exchange (BSE) website. In addition, credit rating reports of the company since September 2014 are available on the website of CRISIL. An investor should read these two sets of documents to understand the challenges faced by Sonata Software Ltd over the years and the decisions taken by the company & its management to overcome those challenges.
While reading the FY2011 annual report of the company, an investor notices that Sonata Software Ltd has three key business divisions: Software Services, Domestic Products and Services, and a joint venture (JV) TUI InfoTec in Germany
FY2011 annual report, page 5:
The Consolidated financials cover the three business lines of the Company – (a) the Software Services business, (b) Domestic Products and Services and (c) our Joint venture – TUI InfoTec, Germany. The three business lines of the Company have unique business rhythms, profitability and growth trends.
While assessing the profit dynamics of these three businesses, an investor notices that the Software Services business is the most profitable and the Domestic Products and Services business is the least profitable business out of the three.
FY2011 annual report, page 5:
The Software services contribution to the profits of the Company is a massive 77% of the profits and 21% of the consolidated revenues.
The Domestic business accounts for 43% of consolidated revenues and 10% of profits.
TUI InfoTec-our German JV accounts for 36% of consolidated revenues and our share of profits in the JV (50.1%) contributes to 13% of consolidated profits.
From the above disclosure, an investor would appreciate that in FY2011, the Software Services contributed least to the revenue (21%) but the most in the profits (77%). Whereas the Domestic Products and Services business contributed the most to the revenue (43%) and the least to the profits (10%).
Therefore, an investor would appreciate that the Software Services business of Sonata Software Ltd is the most profitable and the Domestic Products and Services business of the company is the least profitable.
Even after 10 years, in FY2020, these two businesses have the same profit characteristics. In FY2020, the IT services business contributed a lower amount to the revenue (34%) but a higher amount to the profits (77%). On the contrary, the Domestic Products and Services business contributed a higher amount to the revenue (66%) and a lower amount to the profits (23%).
FY2020 annual report, page 19:
Analyzing your Company’s consolidated results by the two segments it operates in, International IT services contributed 34% of total revenues and 77% of PAT while Domestic products and services contributed to 66% of the total revenues and 23% of PAT.
In the above disclosure, an investor would notice that over the years, the business divisions of the company have reduced to two from three in FY2011. The joint venture, TUI InfoTec, Germany is no longer present as a business division.
While analysing further details of the joint venture (JV), TUI InfoTec, Germany, an investor notices that the JV was not performing as per the expectations of Sonata Software Ltd. The JV reported significant losses in FY2012, which turned out to be the primary reason for the losses of the company in FY2012.
FY2012 annual report, page 3:
On a consolidated basis the Company has incurred losses primarily on account of the TUI InfoTec GmbH, the Company’s German Joint Venture.
It turned out that by FY2012, Sonata Software Ltd had lost complete interest in the JV. As a result, it sold off its entire stake in the JV in Sept 2012 at a significant loss.
Sonata Software Ltd had bought the stake in the TUI InfoTec JV in 2006 for Euro 18 million (source), which is about ₹102 cr considering the average annual exchange rate of EURINR ₹56.84 in 2006 (source).
When Sonata Software Ltd sold its stake in the JV, then it recognized a total loss of about ₹71 cr spread across FY2012 (₹13 cr) and FY2013 (₹58 cr).
FY2013 annual report, page 54:
The loss on disposal of TUI of ₹ 580,557,355 (net off the loss of ₹ 130,502,537 recognized in the period 1 st October, 2011 to 31 st March, 2012) is included under Exceptional items in the Statement of Profit and loss.
Therefore, an investor would appreciate that the key reason for the losses reported by Sonata Software Ltd in FY2012 and FY2013 was the poor performance of its JV, TUI InfoTec. The company had entered into the JV in 2006 and by FY2012, the JV turned into a loss-making entity as a result, Sonata Software Ltd sold its stake in the JV in FY2013 at a significant loss.
Once Sonata Software Ltd sold off its loss-making JV, thereafter, the company did not report losses in any of the years. In fact, both the operating profit as well as the net profit after tax increased almost every year after FY2013.
Nevertheless, an investor notices that the operating profit margin of the company kept on fluctuating from 8% to 11% during FY2015-2020. Let us now try to understand the reasons for the fluctuating profit margins from the publicly available information about the company.
From the above discussion, an investor would notice that after selling off the TUI InfoTec JV, Sonata Software Ltd remained with only two business divisions, the Software/International IT Services division, and Domestic Products and Services division.
An investor would also remember that out of these two divisions, the Software/International IT Services division is more profitable than the Domestic Products and Services division. While reading more about the business of the company, an investor notices that the difference in the profitability of these two divisions is very large.
The Domestic Product and Services business has very low margins of 2-3%.
January 27, 2020 conference call of Sonata Software Ltd, page 11:
Rishit Shah: Right, in the domestic segment only, so what is basically the margin profile over there in the domestic segment?
Srikar Reddy: Margin profile there would have been about 2-3%.
The management of Sonata Software Ltd acknowledges that the margins in the Domestic Products and Services business are low. However, it has stated that in this business, they do not focus on the profit margins but on the return on capital employed in the business.
FY2019 annual report, page 20:
Domestic products and services has showed growth of 30% in PAT. The focus in this business has always been to manage Return on Capital Employed (ROCE), which is 27% for the year under review.
An investor may appreciate that the Domestic Product and Services business has the ability to generate a good return on capital when she notices that even though this business contributes about two-third of revenue for Sonata Software Ltd in any year, it requires only 3.5% of its total employees in this business.
May 2020 conference call transcript, Sonata Software Ltd (source)
Jagannathan Chakravarthi Narasimhan: International head count is at 4,066 as on March 31, 2020.
- The domestic business headcount is 145 people as on March 31, 2020.
Nevertheless, an investor should appreciate that the Domestic Products and Services business involves reselling the software products of key brands like Microsoft etc. In this business, there is very high competition as many vendors compete with each other to resell the same software to the users. In such a scenario, an investor would appreciate that the players tend to compete with each other mainly on price. As a result, the business gets a lower profit margin.
The credit rating agency, CRISIL, has highlighted this aspect of price-based competition in the Domestic Products and Services business in its report for Sonata Software Ltd in July 2017. CRISIL also highlighted that due to intense competition, it is difficult for the company to take price hikes.
a large portion of its revenues are derived from the software distribution business which is essentially a segment where price competition is very high. CRISIL believes that SSL’s profitability would remain constrained over the medium term as competition limits increases in realisation
In the current times where the coronavirus has led to stress in the economy, the price-based competition in the Indian market has increased further as the customers have become more price-conscious. As a result, Sonata Software Ltd has to give discounts to the customers and in turn, take a hit on its profit margins.
August 2020 conference call transcript, Sonata Software Ltd (source)
Palem Srikar Reddy: I think — I mean, the market have now, I think, driven people to ask for more discounts and price pressures and so on and so forth on the customer side because I think the Indian economy is still not in a great shape. And so that means that the principles have to discount it and then they discount it, we have to also pass on something — this comes to the client. So it’s been a huge market pressure reacting to the situation in the market. So that’s why the margins in the Indian business are lower than normal.
Therefore, an investor would appreciate that the Domestic Products & Services business has an intense competition where many software resellers compete with each other mainly on the price to gain business. As a result, this business has a lower profit margin of 2-3%.
On the contrary, the International IT/Software Services business has a comparatively high-profit margin of 23-24% and the company seems confident that it can maintain these profit margins in the International IT Services business despite challenges.
August 2020 conference call transcript, Sonata Software Ltd (source)
Mohit Jain: And sir, second thing, on the margin side, if you could give some outlook, like how sustainable is like IT Services margins?
Palem Srikar Reddy: I think they’re very sustainable.
Mohit Jain: So we will continue to run at 23%, 24% despite revenue drop for that?
Palem Srikar Reddy: Yes. Because I think we have seen a little shift from on cycle option, it’s just (inaudible) reasonable shift on the costs. I think we are very confident that, as I said, unless something else happens, we’re quite confident that we’ll maintain these margins.
Therefore, an investor would appreciate that after selling the TUI InfoTec JV in September 2012, Sonata Software Ltd is left with two business divisions. Out of these, the International IT Services division has high-profit margins and the Domestic Products and Services business has low-profit margins.
Every year, the revenue contribution from these two business divisions keeps on changing. As a result, whenever the contribution from International IT Services division increases, the company reports an increase in profit margin. On the contrary, whenever the contribution from Domestic Products and Services business increases, then the company reports a decline in profit margins.
The below table showing the contribution in the revenue of Sonata Software Ltd from its two business division over FY2013-2020 clearly indicates that in the years like FY2014, FY2015, FY2018 etc. when the revenue contribution from the International IT Services increased, then Sonata Software Ltd reported a higher OPM from the previous year. Whereas in the years like FY2017 and FY2020 when the revenue contribution from the Domestic Products and Services business increased, then Sonata Software Ltd reported a lower OPM from the previous year.
The credit rating agency, CRISIL, also highlighted the key reason for the significant improvement in the OPM of Sonata Software Ltd from FY2013 to FY2016 was the increase in revenue contribution from the International IT Services business. During this period, the OPM of the company had increased from about 4% in FY2013 to 10% in FY2016.
July 2016 credit rating report of Sonata Software Ltd by CRISIL:
Its revenue from the international business increased from Rs 3.35 billion in fiscal 2013 to Rs 7.06 billion in fiscal 2016, and the revenue share of this business in total group revenue rose from 25% to 36%. Accordingly, the group’s operating margin improved from 4% to 10.7% during this period, as the international business has higher operating margin than the domestic software distribution business.
Therefore, going ahead, an investor should keep a close watch on the revenue contribution of Sonata Software Ltd from the two business divisions and the profit margins in the International IT Services division. This is because the profit margins in the Domestic Products and Services business are expected to stay low due to intense price-based competition from the vendors. As a result, any impact on the profit margins of the International IT Services division would have a significant influence on the profitability of the company.
While looking at the tax payout ratio of Sonata Software Ltd., an investor notices that for most of the years, the tax payout ratio of the company has been below the standard corporate tax rate prevalent in India.
While reading the annual reports, an investor notices that the key reasons for a low tax payout ratio are related to the tax incentives provided by the govt. for the export of services as well as lower taxes on the non-operating income/other income of the company.
FY2018 annual report, page 126:
The Group has units in Bengaluru registered as Special Economic Zone (SEZ) units, which are entitled to a tax holiday under Section 10AA of the Income Tax Act, 1961. The Group also has Software Technology Parks of India (STPI) units in Bengaluru and Hyderabad which were earlier entitled to a tax holiday under Section 10A of the Income Tax Act, 1961.
Dividend income from certain category of investments is exempt from tax
Further advised reading: How to do Financial Analysis of a Company
Operating Efficiency Analysis of Sonata Software Ltd:
a) Net fixed asset turnover (NFAT) of Sonata Software Ltd:
When an investor analyses the net fixed asset turnover (NFAT) of Sonata Software Ltd in the past years (FY2011-20), then she notices that the NFAT of the company has been consistently in the high ranges of 15 and above.
An investor would notice that the business of Sonata Software Ltd is primarily based on providing services to the clients in its International IT Services division and trading activities for its Domestic Products and Services division. In both these divisions, the key business drivers are its employees. Therefore, the tangible fixed assets like buildings etc. are not a direct determinant of the business productivity of Sonata Software Ltd.
As a result, NFAT may not be the best parameter to judge the asset utilization efficiency for Sonata Software Ltd.
b) Inventory turnover ratio of Sonata Software Ltd:
While analysing the financial performance and the annual reports of Sonata Software Ltd, an investor notices that the company does not keep any physical inventory at least FY2017. Even in the prior period when it reported inventory holding, then the amount of inventory was very low as compared to its revenue. This is because as mentioned above, the key business activity of the company is providing services, which do not require any processing of physical products.
Therefore, the parameter of the inventory turnover ratio loses its relevance for Sonata Software Ltd.
c) Analysis of receivables days of Sonata Software Ltd:
While analysing the receivables position of the company, an investor notices that the receivables days of Sonata Software Ltd have consistently increased over the years. The company used to have receivables days of 47 in FY2012, which has steadily increased to 74 days in FY2019 and FY2020.
Looking at the increasing receivables days, an investor may appreciate that the customers of Sonata Software Ltd have a higher negotiating power and as a result, are able to get better payment terms from the company.
While analysing the customer profile of Sonata Software Ltd, an investor notices that the company has a high customer concentration. The contribution from the top 10 customers for the company is very high at about 70% in recent times. Moreover, the contribution from the top 10 customers for Sonata Software Ltd has been high consistently for the last 10 years.
In FY2011, the company got 78% of the business of International IT Services from the top 10 customers.
FY2011 annual report, page 10:
Top 10 clients contribute 78% of revenues of our IT services business.
In FY2018 and FY2019, the contribution from the top 10 customers was 70% and 68% respectively. The credit rating agency, CRISIL has also highlighted customer concentration as one of the key risks for Sonata Software Ltd in its April 2020 report for the company.
For fiscal 2019, the top 10 customers accounted for 69% of SSL’s revenue (70% in fiscal 2018). Given its modest scale of operations (compared to larger peers), SSL’s business risk profile will remain vulnerable to client concentration risk.
An investor would appreciate that due to concentration of revenue from a few customers, Sonata Software Ltd is in a situation where it cannot afford to let go of any of its large customers without a significant impact on its business. As a result, the company seems to accept extended payment terms from its customers.
The company had to face the impact of client concentration risk in Q4-FY2020 when the business of one of its largest clients that contributed about 15-20% of the revenue of the company was severely impacted due to coronavirus.
May 2020 conference call of Sonata Software Ltd:
Palem Srikar Reddy: ..we had this 1 single large client in the travel sector, who was contributing between 15% to 20% of the revenues of the company, and they had to more or less suspend the majority of their operations.
As a result, it does not come as a surprise to the investor that the large customers seem to be able to get increasingly lenient payment terms from Sonata Software Ltd leading to an increase in receivables days over the years.
Nevertheless, when an investor reads more about the receivables position of Sonata Software Ltd, then she notices that the company has taken an insurance cover for its receivables so that in an eventuality, it does not suffer a huge loss.
May 2020 conference call of Sonata Software Ltd:
Anubhav Mukherjee: And in the domestic business, in the past 1.5 months of lockdown, have we seen any spike of like bad — like percentage of receivables that are going bad or something like that?
Palem Srikar Reddy: Right. As I just mentioned, we have insurance on our receivables.
Therefore, despite the above-stated challenges, the company seems to have controlled its working capital position well. As a result, it has been able to convert its profits (PAT) as cash flow from operations (CFO).
When an investor compares the cumulative net profit after tax (cPAT) and cumulative cash flow from operations (cCFO) of Sonata Software Ltd for FY2011-20, then she notices that it has collected almost entire profits as cash flow from operating activities.
Over FY2011-20, Sonata Software Ltd reported a total cumulative net profit after tax (cPAT) of ₹1,300 cr. During the same period, it reported cumulative cash flow from operations (cCFO) of ₹1,397 cr.
It is advised that investors should read the article on CFO calculation, which would help them understand the situations in which companies tend to have the CFO lower than their PAT. In addition, the investors would also understand the situations when the companies would have their CFO higher than the PAT.
Further advised reading: Understanding Cash Flow from Operations (CFO)
The Margin of Safety in the Business of Sonata Software Ltd:
a) Self-Sustainable Growth Rate (SSGR):
Upon reading the SSGR article, an investor would appreciate that if a company is growing at a rate equal to or less than the SSGR and it is able to convert its profits into cash flow from operations, then it would be able to fund its growth from its internal resources without the need of external sources of funds.
Conversely, if any company attempts to grow its sales at a rate higher than its SSGR, then its internal resources would not be sufficient to fund its growth aspirations. As a result, the company would have to rely on additional sources of funds like debt or equity dilution to meet the cash requirements to generate its target growth.
While analysing the SSGR of Sonata Software Ltd, an investor would notice that the company has consistently had a very high SSGR of 50% to 150% over the years. One of the key reasons for very high SSGR for the company has been its very high asset turnover. As discussed above, Sonata Software Ltd has consistently had a high NFAT of 15 and above.
While studying the formula for calculation of SSGR, an investor would understand that the SSGR directly depends on the net fixed asset turnover (NFAT) of a company.
SSGR = NFAT * NPM * (1-DPR) – Dep
- SSGR = Self Sustainable Growth Rate in %
- Dep = Depreciation rate as a % of net fixed assets
- NFAT = Net fixed asset turnover (Sales/average net fixed assets over the year)
- NPM = Net profit margin as % of sales
- DPR = Dividend paid as % of net profit after tax
(For systematic algebraic calculation of SSGR formula: Click Here)
Therefore, an investor would notice that Sonata Software Ltd has continuously had a high SSGR (50%-150%) over the last 10 years (FY2011-FY2020). This is primarily because; the business of the company is not dependent on heavy investments in physical infrastructure like plant & machinery.
The company can increase its business significantly by hiring more employees and making them work primarily in the field without having to create any manufacturing plants.
Therefore, the parameters of NFAT, as well as the ratio of SSGR, are both high for Sonata Software Ltd.
b) Free Cash Flow (FCF) Analysis of Sonata Software Ltd:
While looking at the cash flow performance of Sonata Software Ltd, an investor notices that during FY2011-2020, it generated cash flow from operations of ₹1,397 cr. However, during the same period, it did a capital expenditure of about ₹437 cr. Please note that while calculating the capital expenditure (Capex), we have ignored the negative capex for FY2013 when it sold its stake in the TUI InfoTec JV.
Therefore, during this period (FY2011-2020), Sonata Software Ltd had a free cash flow (FCF) of ₹960 cr (=1,397 – 437).
In addition, during this period, the company had a non-operating income of ₹236 cr and an interest expense of ₹70 cr. As a result, the company total free surplus cash of ₹1,126 cr (=960 + 236 – 70). Please note that the capitalized interest is already factored in as a part of capex deducted earlier.
An investor notices that the company has used the surplus cash of ₹1,126 cr along with the incremental debt of ₹55 cr over FY2011-2020, in the following manner:
- Paid dividends excluding dividend distribution tax of about ₹800 cr during FY2011-2020. On this, the company would have paid about 20% (about ₹160 cr as the dividend distribution tax).
- The remaining amount seems to be present with the company as an increase in cash & investments of about ₹242 cr over FY2011-2020. The cash & investments balance of Sonata Software Ltd increased from ₹168 cr in FY2011 to ₹410 cr in FY2020.
Further advised reading: Free Cash Flow: A Complete Guide to Understanding FCF
Further advised reading: 3 Simple Ways to Assess “Margin of Safety”: The Cornerstone of Stock Investing
Additional aspects of Sonata Software Ltd:
On analysing Sonata Software Ltd and after reading its publicly available past annual reports and other public documents, an investor comes across certain other aspects of the company, which are important for any investor to know while making an investment decision.
1) Management Succession of Sonata Software Ltd:
The company was established in 1986 and currently, Mr Srikar Reddy, aged 62 years, is leading the company as its MD & CEO since February 2012.
Mr. Reddy joined the company in 1986 when it was founded and since then, he has worked in different roles. He was working as the Deputy-Managing Director and Chief Operating Officer of the company before getting the role of MD&CEO in 2012.
FY2012 annual report, page 12:
Mr. P. Srikar Reddy, existing Deputy Managing Director & COO appointed as Managing Director and CEO with effect from 14 th February, 2012.
In FY2012, there were some successive significant changes in the senior management of Sonata Software Ltd. First, the existing Vice Chairman and Managing Director of the company, Mr. B. Ramaswamy, resigned in August 2011.
FY2012 annual report, page 12:
Mr. B. Ramaswamy ceased to be Vice Chairman and Managing Director w.e.f 16 th August, 2011
Thereafter, the company hired Mr. Sanjay Viswanathan as MD & CEO. However, he resigned from the job within 6 months of joining it.
FY2012 annual report, page 12:
Mr. Sanjay Viswanathan was appointed as Managing Director & CEO w.e.f 17 th August, 2011 and he resigned as Managing Director & CEO w.e.f 14 th February, 2012
Mr. Sanjay Viswanathan was an external-hire for Sonata Software Ltd and he was working as a consultant based in London before joining the company (source).
Sanjay Viswanathan is the new CEO of leading IT consulting and software services provider, Sonata Software.
An alumnus of Harvard Business School and Strathclyde University, he brings about two decades of business leadership experience across technology, media, healthcare and manufacturing businesses. Prior to his appointment at Sonata, Sanjay was based in London and has advised FTSE 100, Fortune 500, bluechip consulting firms, PE firms, and privately held companies
An investor would remember from the above discussion on the business divisions of Sonata Software Ltd that during FY2012-FY2013, the company was going through a tough time. First, in FY2012, the company reported losses as its German JV, TUI InfoTec was not performing well. Thereafter, the company had to sell the JV at a significant loss.
An investor may assume that the poor performance of the company and the failure of the JV might be one of the reasons for such frequent leadership changes. While analysing the turn of events, an investor gets to know that the company’s parting of ways by VC & CEO, Mr. B. Ramaswamy was not harmonious and subsequently, Mr. Ramaswamy filed a legal suit against Sonata Software Ltd for recovery of ₹23.19 cr as remuneration and allotment of 11,20,000 equity shares of the company (source).
Karnataka High Court: B Ramaswamy vs M/S Sonata Software Limited on 30 August, 2017
The said suit has been filed by the petitioner seeking recovery of a sum of Rs.23.19 crores along with interest at the rate of 18% p.a. with monthly rests from the date of the suit till the date of payment. Another prayer sought by the plaintiff is to direct the defendants to issue to the plaintiff 11,20,000 equity Shares of the first defendant Company i.e., M/s Sonata Software Limited.
In light of the above, an investor would appreciate that in FY2012-2013, Sonata Software Ltd faced many leadership challenges.
It might be a case where the existing VC & CEO, Mr. Ramaswamy was fired by the company probably holding him responsible for the failure and the losses of the German JV. Mr. Ramaswamy, then filed legal suit to recover money from Sonata Software Ltd. Investors may contact the company directly for more details and clarifications in this matter.
Thereafter, the company hired an external candidate as MD & CEO; however, he left the company within 6 months. Either he did not like the company or the company was not happy with his approach.
In any case, finally, the leadership situation at Sonata Software Ltd stabilized in February 2012 when the internal candidate, Mr. P. Srikar Reddy, who had been with the company since inception took over the charge as MD & CEO. Thereafter, Mr. Reddy is leading the company until date.
From the above discussion, an investor would appreciate that despite the challenges, Sonata Software Ltd has continued with its practice of getting professional instead of promoters for providing the executive leadership to the company.
Because of relying on professionals, instead of promoters, for key leadership positions, Sonata Software Ltd has been able to get qualified personnel for its leadership roles.
Regarding the role of promoters in the company management and the succession planning in the promoter family, an investor may contact the company directly.
Further advised reading: Steps to Assess Management Quality before Buying Stocks
2) Acquisitions and initiatives by Sonata Software Ltd
While analysing the annual reports and other public documents about the company, an investor notices that Sonata Software Ltd has consistently done acquisitions, joint ventures, buying minor equity stakes, entering new geographies etc. in order to grow its business.
In 2006, the company did a joint venture with TUI group: TUI InfoTec.
In 2011, Sonata Software Ltd entered into a JV in Qatar (FY2012 annual report, page 7):
In June 2011, we announced a Joint Venture in Qatar under the name of Sonata Software (Qatar) LLC, with Mohammad Nasser Abdullah Al MISNAD.
In FY2015, the company acquired Rezopia Inc, USA and the business of Xyka Software Pvt. Ltd, India (FY2015 annual report, page 16).
In FY2016, the company acquired Halosys Inc., USA providing mobility enablement technology and IBIS Inc. to improve its skills of Microsoft Dynamics implementation for Retail and Distribution industries (FY2016 annual report, page 12-13).
In FY2018, Sonata Software Ltd acquired 15% stake in Izara, a Danish company and acquired the copyright of TRANSIT and RETINA softwares in India (FY2018 annual report, page 6).
In FY2019, the company acquired Scalable Data Systems, Australia, and Sopris Systems, USA for improving its Microsoft Dynamics skills. It also acquired some stake in Retail10X, working in retail artificial intelligence software-as-a-service (SaaS) segment (FY2019 annual report, page 10).
In FY2020, Sonata Software Ltd acquired GAPbuster Limited, an Australia based company working in customer experience (CX) segment. The company also acquired a minor stake in SemiCab, USA working in fleet management services (FY2020 annual report, page 6).
An investor would notice that almost every year, the company has acquired one company or another. While discussing the general characteristics of the business of companies operating in the IT services industry, we noted that such acquisitions are frequent in this industry.
In the August 2020 conference call, the MD & CEO of the company in talked about the strategy behind these acquisitions.
Mr. P. Srikar Reddy: the strategies have been — if you take the travel was — because we have the travel vertical, we’ve got IP in that vertical.
And then I think when digital transformation was really picking up and mobility was a key aspect, we bought an enterprise mobility platform, which could be used to deliver mobile apps. So that it’s strategic to our digital transformation offering.
And then, of course, we started focusing on the Microsoft Dynamics ecosystem about 5, 6 years ago. And I think we have made 3 acquisitions there to strengthen both the horizontals, verticals, local talent, 2 in the U.S., 1 in Australia. So that was really very strategic to become a big player in the Dynamic ecosystem globally.
And then the last one, in the customer experience, again, driving digital transformation or our old Platformation.
Therefore, an investor would notice that the company made acquisitions in the focus areas where it needed to strengthen its skill-sets as the business environment evolved.
However, an investor may note that not every acquisition, JV, or new geography may be a profitable decision for the company.
For example, the decision to enter Qatar in 2011 does not seem to have worked for the company, as the Qatar JV has never made any profits since its inception.
Many times, the decision of an acquisition or a JV is hailed as a landmark event when it is taken. However, later on, the decision may not turn out to be profitable.
Sonata Software Ltd faced such a situation in its German JV with TUI group, TUI InfoTec wherein 2006, when the JV was entered into, then it was termed to be a major achievement for the company.
The MD of the company at that time, Mr. B. Ramaswamy, told media that it is a great deal for the company as it allows an entry in the infrastructure management segment (source).
The company also aims to enter the infrastructure management space with this acquisition, which normally would take years to build and develop, Mr Ramaswamy said. “This is an enormous leapfrog for us in the infrastructure management space,” he added.
Mr. Ramaswamy also stressed that the deal is great for Sonata Software Ltd as it puts the company in the $250+ million revenue category and the company could now bid for larger projects (source).
“The acquisition has put us in the $250 million-plus revenue category which considerably increases our ability to bid for larger deals,” he said.
“Now we can easily go for $30-40 million deal sizes,” he added.
The deal also included a guarantee of a certain amount of revenue from the TUI group to the JV. In fact, the TUI group compensated the JV for the periods when it could not give the promised amount of business to it.
In FY2011, Sonata Software Ltd received about ₹7.8 cr from TUI group as compensation/refund of the purchase price paid by it for its investment in the JV. The company reduced the goodwill in the balance sheet by an equal amount (FY2011 annual report, page 40).
FY2011 annual report, page 51:
The adjustment to the Goodwill relates to a refund of part of the purchase price of investment made in TUI InfoTec on account of non achievement of assured revenues.
This development highlights that the business of the JV was not progressing as expected at the time of its establishment in 2006.
In addition, when an investor analyses the performance of TUI InfoTec JV over the years, then she notices that the profit after tax of the JV was continuously declining since FY2008.
FY2011 annual report, page 3:
PAT of TUI InfoTec GmbH: Consolidated
- FY07 (5 months): ₹21 cr
- FY08: ₹46 cr
- FY09: ₹28 cr
- FY10: ₹28 cr
- FY11: ₹20 cr
The revenue guarantee from the TUI group to the JV ended in December 2011 and the JV was facing many challenges.
FY2012 annual report, page 4:
The revenue guarantee to the Joint Venture by TUI AG expired in December, 2011. Your Company is working alongside the Management of the Joint Venture to address the issues at the Joint Venture and is confident of reaching a solution.
It seems that the JV did not have any sound independent business model. As a result, the moment, the revenue guarantee from the TUI group ended in FY2012, the JV reported huge losses, which in turn, led to overall losses for Sonata Software Ltd in FY2012.
As the JV did not have an independent business model, therefore, immediately after the expiry of the revenue guarantee, Sonata Software Ltd sold off the JV stake back to TUI group at a significant loss of ₹71 cr. (FY2012: ₹13 cr and FY2013: ₹58 cr).
FY2013 annual report, page 54:
The loss on disposal of TUI of ₹ 580,557,355 (net off the loss of ₹ 130,502,537 recognized in the period 1 st October, 2011 to 31 st March, 2012) is included under Exceptional items in the Statement of Profit and loss.
It may be that the existing CEO, Mr. Ramaswamy was fired due to the failure and the resultant losses of this JV. Due to the lack of any independent business model, the JV was to prove to be a significant drain on the resources of Sonata Software Ltd. Investors may contact the company directly for more details and clarifications in this matter.
In the light of the above discussion as well as many other corporate instances of mixed responses of acquisitions, joint ventures etc., an investor should always be cautious of positive statements by the management of companies at the time of acquisitions. She should always monitor the developments regarding the business performance of the companies after the acquisition and make an independent judgment.
In the case of acquisitions by Sonata Software Ltd, an investor notices that Rezopia Inc. and Halosys Technologies Inc. are reporting increasing losses year after year.
In FY2020, Sonata Software Ltd merged both Rezopia Inc. and Halosys Technologies Inc. with Sonata Software North America. Therefore, unfortunately, now, there will not be any separate disclosure about the financial performance of these two acquisitions.
FY2020 annual report, page 26:
Rezopia Inc. and Halosys Technologies Inc. merged with Sonata Software North America (SSNA) w.e.f June 14, 2019.
In light of the above developments, we advise investors to always do an independent assessment of the performance of the acquired companies. This is because many times, the acquisitions are done with a lot of positive sentiments and statements in the media and it is very easy for the investors to be influenced and reduce the stringent due diligence required for acquisitions and their subsequent performance.
3) Insourcing professional fees of Sonata Software Ltd:
While analysing the annual reports of the company, an investor notices that the company spends a significant amount on “Insourcing Professional Fees”. The company has not defined this item/term in its significant accounting policies section of the annual reports. However, from the name, it seems like the consulting charges paid for the services of those professionals who are not employed by the company on its rolls i.e. permanent basis but whose services are availed by the company on a temporary or project basis.
An investor may note that Insourcing Professional Fees are different from Legal Fees and Professional & Technical fees, as Sonata Software Ltd has disclosed them separately in its annual reports (FY2020 annual report, page 139).
During FY2012-2020, the insourcing professional fees have increased at a significant pace. It has increased from ₹3 cr in FY2012 to ₹93 cr in FY2020. When seen as a percentage of employee costs of the company, it has increased from 1% of employee costs in FY2012 to about 15-16% now.
As it is a significant expense item and is increasing at a fast pace, therefore, investors may seek more details about this expense and make their opinion about it.
4) Large income tax disputed liabilities of Sonata Software Ltd:
While reading the annual reports of the company, an investor notices that every year, the company has disclosed disputes with income tax authorities, which are for significantly large amounts of money.
In FY2020 annual report, page 141, the company disclosed the amount of disputed income tax liabilities at ₹513 cr, which was ₹547 cr in FY2019.
These liabilities are nearly double than the net profit after tax of ₹277 cr reported by the company for FY2020 and are more than the entire cash & investment balance of ₹410 cr disclosed by the company at March 31, 2020.
When an investor analyses the nature of these income tax disputes, then she notices that these are primarily related to two aspects.
First, the disputes are related to the incentives under the Software Technology Park Scheme of India (STPI) scheme (Section 10A of the Income-tax Act, 1961). The company has calculated its taxes by availing incentives under its multiple entities whereas the income tax dept. is saying that all these multiple entities are effectively one entity, and therefore, the company has availed excess incentives. Therefore, it needs to pay a higher amount of tax.
FY2020 annual report, page 141:
The Income-tax department in its assessments has been denying or limiting the benefits of Section 10A of the Act to the multiple undertakings of the Company on the ground that they were in fact one single unit and thus the benefits claimed were in excess of permissible limits
In addition, income tax dept. has disputed the incentives availed by the company under Section 10A of the Income-tax Act, 1961 for the services provided to its subsidiaries.
Before the existence of the above-mentioned Section 10A of the Income-tax Act, 1961, the company took benefits under Section 80 O of the Act. Income tax dept. has disputed these benefits as well.
Second, the other key aspect of the disputes between the company and the income tax dept.is related to the classification of payments done by Sonata Software Ltd to companies like Microsoft for buying the licenses of their software. The company treats it as a normal expense whereas the income tax dept. treats these payments are “royalty” that requires withholding of a certain amount as tax similar to TDS. The income tax dept. contends that Sonata Software Ltd should have withheld the tax on these payments and deposited it to the govt. This forms one part of this dispute.
Another part is that, as per income tax, as Sonata Software Ltd has not withheld and has not deposited the tax on these payments, therefore, these payments to buy the licenses would not be treated as an expense. Because of the disallowance of these expenses, the income tax dept. has arrived at a higher profit before tax and is demanding a higher amount of tax than what the company has paid to the govt.
These disputes are continuing for multiple years and appeals have been filed at multiple levels.
While assessing these disputes, an investor should keep in mind that in the case at any stage any tribunal or court determined that Sonata Software Ltd had to pay these amounts of money, then it would be a big setback to the company.
Investors would remember the case of “adjusted gross revenue (AGR) dues” case of telecom companies, which had hit the telecom companies hard and had pushed many companies to the verge of bankruptcy. (Source: Supreme Court Rules Against Telecom Operators In Rs 92,000-Crore AGR Dispute: BloombergQuint).
Therefore, in the instances of legal disputes involving large amounts of money that may have a significant impact on the financial position of the companies, an investor should always be cautious. The investor should not take these disputes lightly and closely track the developments related to these appeals.
An investor may contact the company directly to know more details and clarification about these disputes.
5) Errors in the annual reports of Sonata Software Ltd:
While reading the annual reports of the company, an investor notices that in two instances, the company has done a few errors while presenting the data in its annual reports.
First, in FY2013 annual report, on page 54, in the segmental results section, the company reported the following data for the year (₹):
- Products: 9,412,566,127
- Services: 3,686,006,046
- Unallocable: 12,357,499
- Total: 28,725,714,729
An investor would notice that the total of Product, Services and Unallocable revenue in FY2013 should be 13,110,929,672 i.e. a total revenue of ₹1,311 cr. However, by mistake, the company has mentioned the total revenue for FY2013 as ₹2,872 cr on page 54 of the FY2013 annual report.
In another instance in the FY2016 annual report, at page 38, while disclosing the changes in the shareholding of SRIKAR PALEM REDDY, the MD & CEO of the company, Sonata Software Ltd made an error in disclosing the stake in the company held by him after a sale transaction of 149,776 shares, i.e. 0.14% stake of the company.
At the start of the year, Mr. Reddy held 1,515,004 shares of the company i.e. 1.44% stake. Thereafter, he sold 149,776 shares i.e. 0.14% stake in the company. After this transaction, an investor would appreciate that Mr. Reddy was left with 1,365,228 shares i.e. 1.30% stake in the company. However, the annual reports erroneously state that the remaining number of shares (1,365,228 shares) constitute a 0.14% stake of the company instead of a 1.30% stake of the company.
Therefore, we advise investors to always crosscheck the data presented by any company by doing their own back of the envelope calculations. This is because it is not uncommon to find errors in the data presented by the companies in their annual reports.
The Margin of Safety in the market price of Sonata Software Ltd:
Currently (Oct. 4, 2020), Sonata Software Ltd is available at a price to earnings (PE) ratio of about 12.6 based on consolidated earnings for twelve months ending June 2020 (i.e. from July 2019-June 2020). The PE ratio of 12.6 offers a very little margin of safety in the purchase price as described by Benjamin Graham in his book The Intelligent Investor.
However, we recommend that an investor may read the following articles to assess the PE ratio to be paid for any stock, takes into account the strength of the business model of the company as well. The strength in the business model of any company is measured by way of its self-sustainable growth rate and the free cash flow generating the ability of the company.
In the absence of any strength in the business model of the company, even a low PE ratio of the company’s stock may be signs of a value trap where instead of being a bargain; the low valuation of the stock price may represent the poor business dynamics of the company.
- 3 Principles to Decide the Ideal P/E Ratio of a Stock for Value Investors
- How to Earn High Returns at Low Risk – Invest in Low P/E Stocks
- Hidden Risk of Investing in High P/E Stocks
Overall, Sonata Software Ltd seems a company that has been growing its sales at about 10-12% year on year over the last 10 years (FY2011-2020). Over recent years, FY2013 onwards, the company has witnessed consistent growth in its sales. However, the operating profit margin (OPM) of the company has been fluctuating between 8-11%.
The company primarily operates in two business segments, International IT Services, and Domestic Products and Services division. The International IT Services business is a high margin business, which employs more than 95% of people in the company. The Domestic Products and Services business is a low margin business, which has intense price-based competition from many players. The contribution of these two business divisions in the overall revenue of the company keeps on changing year on year. As a result, the overall profit margins of the company keep on changing year on year.
To grow its business, Sonata Software Ltd has done many acquisitions, the formation of joint ventures etc. over the years. However, not all of them have been successful. Previously, one of the much-hyped deal of forming a joint venture with a large travel company, TUI Group, was hailed as a landmark deal for the company. However, over time, the JV led to large losses for the company. As a result, Sonata Software Ltd reported a sharp decline in revenue in FY2013 and reported net losses in FY2012 and FY2013.
Apparently, the company changed its senior leadership to revive its business after the setback. The outgoing CEO, Mr. B Ramaswamy, sued the company to recover money and equity share allotments from Sonata Software Ltd. After many leadership changes in quick succession in FY2013, the senior leadership of the company seems to be stable until now.
Nevertheless, even afterwards, when an investor assesses the fate of joint venture and acquisitions like Qatar, Rezopia and Halosys, then she witnesses that either they are not making profits or their losses are increasing year on year. As a result, it is advised that an investor should keep a close watch on the business results of the acquisitions.
Sonata Software Ltd suffers from customer concentration and as a result, its business suffered when one of its largest clients contributing 15-20% of the revenue had to shut down its activities in the coronavirus pandemic. In addition, the customers contributing a large portion of its revenues exercise higher negotiating power and in turn, gain increasing lenient payment terms from the company. Therefore, an investor notices that the receivables days of the company has increased consistently over the last 10 years. Nevertheless, as per the company, it has taken insurance for its receivables to protect it from customer defaults.
The company has availed tax holidays and incentives under schemes like SEZ and STPI. As a result, the company has been able to save on tax payments. However, over the years, the company has faced many disputes with income tax dept. about the tax liabilities of the company. As a result, it is needed that an investor should keep a close watch on the developments related to the resolution of these tax disputes, which involve an amount of money that is significantly large to materially affect the financial position of the company.
Going ahead, an investor should monitor the profit margins of the company, its receivables position, integration and performance of acquired companies, any new acquisitions or joint ventures, and outcome of disputed tax liabilities.
Further advised reading: How to Monitor Stocks in your Portfolio
In case of any additional information and clarifications, an investor may contact the company directly.
These are our views on Sonata Software Ltd. However, investors should do their own analysis before making any investment-related decisions about the company.
You may use the following steps to analyse the company: “Selecting Top Stocks to Buy – A Step by Step Process of Finding Multibagger Stocks”
I hope it helps!
Dr Vijay Malik
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Registration status with SEBI:
I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013.
Details of financial interest in the Subject Company:
Currently, I do not own stocks of the companies mentioned above in my portfolio.