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Hughes Software: Nothing spectacular

Jan 20, 2005

Introduction to results
Hughes Software Solutions (HSS), on a standalone basis, has reported decent growth for the quarter and nine-month period ending December 2004. For 3QFY05, while sequential growth in the topline seems sedate, the company has witnessed a contraction in operating margins owing to higher staff costs.

Financial performance (Standalone): A snapshot
(Rs m) 2QFY05 3QFY05 Change 9mFY04 9mFY05 Change
Sales 1,166 1,217 4.4% 2,580 3,466 34.3%
Expenditure 833 880 5.6% 1,837 2,497 35.9%
Operating profit (EBDIT) 333 337 1.2% 743 969 30.4%
Operating profit margin (%) 28.6% 27.7%   28.8% 28.0%  
Other income 15 18 20.0% 52 64 23.1%
Depreciation 62 67 8.1% 163 186 14.1%
Profit before tax 286 288 0.7% 632 847 34.0%
Tax 28 12 -57.1% 71 66 -7.0%
Profit after tax/(loss) 258 276 7.0% 561 781 39.2%
Net profit margin (%) 22.1% 22.7%   21.7% 22.5%  
No. of shares 34.0 34.0   33.7 34.0  
Diluted earnings per share* (Rs) 30.4 32.5   22.0 30.6  
P/E ratio (x)         16.3  
* annualised            

Leading telecom solutions provider
HSS, a subsidiary of the Singapore-based electronic manufacturing services provider, Flextronics, is a focused player in networking and communications related systems software. As the downturn engulfing the telecom industry worldwide forced the company to broaden its service portfolio, it is now eyeing larger share of revenues from the telecom service providers, business process outsourcing and the financial services industry for future growth. The largest contributor to HSS' revenues is the services segment (79%), followed by products (17%) and BPO (4%).

What has driven performance in 3QFY05?
Product business drives topline growth:  The relatively strong growth of the services segment was stalled in this quarter, as revenues from the same grew sequentially by a mere 2%. The product business, however, was the driver of topline in 3QFY05, with a sequential growth of over 18%. While the management has not indicated how much has HNS (the erstwhile parent) contributed to the services business, we believe that a major part of this 2% sequential growth in revenues was contributed by the non-HNS category, where the company has witnessed increased traction over the past few quarters. The last time we had a conference call with the management of the company, it had indicated that it is expecting strong demand from the Voice over Internet Protocol (VoIP) technology space and this is the area where the company is likely to have most of its product and service offerings. The strong growth in the product business seems to be a fallout of the same. BPO business (4% of revenues) grew sequentially by 4% in 3QFY05. HSS added 9 new clients in the quarter (14 in 2QFY05).

Higher staff costs impair margins:  Apart from a sedate sequential growth in the topline during the quarter, higher staff costs (as % of sales) led to the margins declining by around 90 basis points. This rise in staff costs was despite a slow rate of hiring (gross addition of 233 employees) and seems an effect of the higher than average payouts that the company is making to retain its domain experts and consultants. Utilisation also dropped to 91% (92% in 2QFY05), thus affecting the margins. Going forward, we believe that any improvement or stabilisation in HSS margins is likely to be led by growth in its product business, revenues from which are margin accretive.

Cost details…
(Rs m) 2QFY05 % of sales 3QFY05 % of sales Change
Staff cost 550 47.2% 596 49.0% 8.4%
Traveling cost 89 7.6% 75 6.2% -15.7%
Other expenses 183 15.7% 196 16.1% 7.1%
Total cost 822 70.5% 867 71.2% 5.5%

Lower taxes aid net profits:  The net profit growth has outpaced growth in topline and this seems a result of a 50% decline in tax liabilities for HSS in 3QFY05, on account of a prior period tax adjustment of Rs 13 m. This has also led to a 60 basis points expansion of net profit margins.

Performance in recent times
  4QFY04 1QFY05 2QFY05 3QFY05
Sales growth (%, QoQ) 3.9 8.0 7.7 4.4
OPM (%) 26.2 27.5 28.6 27.7
Profits (%, QoQ) (11.3) 27.8 4.5 7.0
Services (QoQ growth, %) 2.6 10.7 9.0 1.8
Products (QoQ growth, %) 10.4 (4.7) 0.5 18.3
BPO (QoQ growth, %) 3.9 8.0 7.7 4.4

What to expect?
At the current price of Rs 500, the stock is trading at a price to earnings multiple of 16.3 times (standalone) and 16.4 times (consolidated) annualised 9mFY05 earnings, which are on the higher side of the valuation spectrum. For the consolidated entity (including Tenet), the management has projected sales to grow sequentially by 4%-5% in 4QFY05. This seems almost in line with the management's earlier estimates of 30%-35% and 33%-37% YoY growth in sales and profits respectively for FY05. While the growth in product business in this quarter raises confidence, sustainability remains an issue considering the volatile past of this segment's performance. Over that, the benefits of ownership by the new parent, Flextronics, are still to be spelled out by the company. Concerns also remain on account of the fact that Flextronics might de-list HSS from the Indian bourses, as has been seen in past cases of other MNCs doing the same with their listed Indian subsidiaries. Investors should, thus, practice caution.

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