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Geometric Software: ‘Engineering’ growth! - Views on News from Equitymaster

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Geometric Software: ‘Engineering’ growth!
Jan 15, 2007

Performance summary
Geometric Software Solutions recently announced mixed results for the third quarter of FY07. While consolidated topline has grown by 34% QoQ, the bottomline growth has been muted at 5% QoQ, largely due to higher employee costs and the consequent compression in operating margins. The consolidated numbers (in the first table below) include the performance of Modern Engineering, which GSS had acquired in early October 2006. In fact, a large part of the topline growth has come on account of this acquisition as, excluding this, the consolidated topline has grown by a mere 3% QoQ (see second table below).

GSS’ performance for the nine-month period has been strong, both including and excluding Modern. This is because Modern’s acquisition was with effect from November 1, 2006. For the two months ended December 2006, Modern’s revenues were US$ 5.6 m and it operated at net margins of 1.6%. This is seen in the depression in net margins of the consolidated entity.

Consolidated financial performance (Including Modern)
(Rs m) 2QFY07 3QFY07 Change 9mFY06 9mFY07 Change
Net sales 800 1,067 33.5% 1,595 2,588 62.2%
Expenditure 649 897 38.3% 1,263 2,104 66.6%
Operating profit (EBDIT) 151 170 13.0% 332 484 45.8%
Operating profit margin (%) 18.8% 15.9%   20.8% 18.7%  
Other income 29 49 69.8% 29 49 67.7%
Interest - 16   0 16  
Depreciation 50 57 14.0% 123 156 26.6%
Profit before tax 130 146 12.7% 238 361 51.8%
Tax 14 22 58.7% 41 46 12.1%
Minority interest 15 19 25.5% 46 45 -1.2%
Profit after tax/(loss) 101 105 4.5% 151 270 78.5%
Net profit margin (%) 12.6% 9.9%   9.5% 10.4%  
No. of shares (m)       56.4 61.3  
Diluted earnings per share (Rs)*         6.1  
P/E ratio (x)*         22.3  
* On a trailing 12-month basis            

Leading PLM solutions provider
GSS operates in the highly niche area of providing product lifecycle management (PLM) technologies and solutions to the global mechanical design, manufacturing, hi-tech and industrial markets. The company’s presence in the domain of geometry provides it with a competitive advantage in the form of high entry barriers on account of high-levels of technical skill-set requirements. From FY01 to FY06, GSS grew its revenues and profits at compounded rates of 37% and 26% respectively.

Performance summary
What has driven performance in 3QFY07? Here is the consolidated financial snapshot of GSS, excluding Modern. The rest of the analysis follows the same pattern, as the company has not provided more details on Modern during this quarter.

Consolidated financial performance (Excluding Modern)
(Rs m) 2QFY07 3QFY07 Change 9mFY06 9mFY07 Change
Net sales 800 822 2.8% 1,595 2,343 46.9%
Expenditure 645 661 2.6% 1,269 1,861 46.6%
Operating profit (EBDIT) 155 161 3.9% 326 482 47.8%
Operating profit margin (%) 19.4% 19.6%   20.4% 20.6%  
Other income 24 40 69.4% 15 30 99.9%
Interest - 9   - 9  
Depreciation 49 51 3.8% 103 146 41.4%
Profit before tax 130 141 8.8% 238 356 49.9%
Tax 14 21 51.0% 41 45 11.2%
Minority interest 15 19 25.1% 46 45 -1.3%
Profit after tax/(loss) 101 101 0.5% 151 266 75.8%
Net profit margin (%) 12.6% 12.3%   9.5% 11.3%  
No. of shares (m)       56.4 61.3  
Diluted earnings per share (Rs)*         6.1  
P/E ratio (x)*         22.5  
* On a trailing 12-month basis            

Engineering services steal the show: The 3% QoQ topline growth for GSS was mainly due to stellar performance from the company’s Engineering services business, which reported sales growth of 14% QoQ (in rupee terms). This business formed almost 11% of GSS consolidated topline during 3QFY07 (9% in 2QFY07). The company’s major business of PLM services (77% of revenues) was lacklustre, reporting a marginal growth of 2% QoQ. The product business (12% of revenues) witnessed a revenue decline of 2% QoQ during the quarter.

Segment-wise revenue performance
(Rs m) 2QFY07 Contribution 3QFY07 Contribution Change
PLM Solutions 240 30.0% 222 27.1% -7.3%
Product Development Services & 3D PLM 379 47.4% 408 49.6% 7.7%
Engineering Services 75 9.4% 86 10.5% 14.1%
Desktop Technologies & Solutions 77 9.6% 83 10.1% 8.6%
Enterprise Products 20 2.5% 21 2.5% 3.1%
Miscellaneous Products 9 1.1% 2 0.2% -79.7%
Total 800 100.0% 822 100.0% 2.8%

As seen from the table above, within the PLM services segment, while PLM solutions reported sales decline of 7% QoQ, the Product Development Services & 3D PLM division grew by 8% QoQ. Investors should, however note that, due to acquisition of Matrix-One by Dassault Systems, revenues from the former, which were earlier part of PLM Solutions segment are now classified under Product Development Services and 3D PLM.

The management has indicated of increased traction in the company’s direct work with industrial customers. Added to this, following the acquisition of Modern, the engineering services offshoring from the latter is expected to steadily increase going forward, which we believe will be a big positive for GSS.

GSS (excluding Modern) added a net of 169 people during 3QFY07. However, while the strength of the offshore base increased by 177, there was a marginal reduction in the number of employees working on onsite projects. At the end of 3QFY07, GSS had 1,931 software developers on its rolls. 3D PLM (JV with Dassault) had 515 employees. The attrition rate (annualised) stood at 20.4% during 3QFY07 (23% in 2QFY07). While attrition is a major concern for all technology companies, this is more serious for GSS, given the fact that the company requires specialised talent, since it operates in a niche domain.

Re-take on Modern Engineering: In October 2006, GSS acquired the engineering services unit of Modern Engineering for a consideration of US$ 32 m, including US$ 7 m in working capital loans. Modern Engineering is a US-based company with US$ 40 m in revenues, and the objective is to create a global engineering solutions provider with an expansive services portfolio. Post this acquisition, GSS has become one of the few companies globally to have strong capabilities in both PLM solutions as well as integrated engineering solutions, and the company’s objective of becoming an end-to-end PLM solutions provider has now been considerably enhanced. GSS is focusing on the Engineering Services space as a method of de-risking its revenues away from PLM services. While the growth potential in Engineering Services is undoubtedly significant, the fact that this business is more people-intensive and linear in terms of growth (requires more people to generate additional revenues), and that there is significant competition, with TCS, Infosys, Wipro, Satyam and HCL Tech, all in contention, as well as some mid-sized software companies like Infotech Enterprises, the company will more likely take a hit on its margins going forward. Nonetheless, given its strong focus on this domain, we believe that it will be a strong differentiator for the company in future.

Lower employee costs aid margins: Savings in software development expenses and sales & marketing expenses (as percentage of sales) helped GSS (excluding Modern) expand its margins by 20 basis points (0.2%) sequentially during 3QFY07. Within software development expenses, it was the decline in employee costs (from 53.5% of sales in 2QFY07 to 52.8% in 3QFY07), which aided the margin expansion. The management has once again indicated that it intends to focus on SG&A costs and software development costs as the key areas where it believes it can control costs better going forward.

If one were to look at the profitability picture including the acquisition of Modern, operating margins declined by 290 basis points (2.9%) sequentially during 3QFY07. This was mainly owing to higher expenses of senior management travel for business development, and to support the integration of Modern. The company also increased its delivery capacity in Bangalore to handle increased engineering work.

Higher taxes dent bottomline: Despite the improvement in operating margins, and due to higher effective tax rate, GSS’ consolidated (excluding Modern) net profits could manage a growth of only 0.5% QoQ. While other income grew by 69% QoQ, effective tax rate jumped from nearly 11% in 2QFY07 to 15% in 3QFY07, thus impacting the bottomline picture. The higher other income was mainly due to Rs 26.9 m (Rs 9.3 m in 2QFY07) gain on forex fluctuations.

What to expect?
At the current price of Rs 137, the stock is trading at 10.3 times our estimated FY09 consolidated (including Modern) earnings. This makes the stock attractive for long-term holding. For FY07, the management has maintained its revenue guidance of 35% YoY growth (excluding Modern).

GSS is in the process of strengthening its sales team in terms of numbers and competencies, and increasingly focusing on direct selling to customers, which we believe will turn out to be a big positive in the future. The company also plans to enhance the joint efforts with Modern in the US, European and Japanese markets to drive cross selling in the automotive and industrial segments.

The company also plans to begin upgradation of its delivery facilities as it scales up faster in the future. Also, there will be additional costs incurred towards a successful integration of Modern, which is expected to be one of the key drivers for the company’s growth in the future. We believe that while these efforts might impact the company’s profitability in the short-term, the long-term synergies and advantages are expected to outweigh the same. However, our concern pertains to the scalability issues that might hamper growth in the future.

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