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Patni Computers: Mixed performance

Feb 22, 2006

Introduction to results
Patni Computer Systems (PCS) recently announced its results for CY05 (the company's financial year ends in December). During the calendar year, topline has shown an impressive growth, helped partly by the acquisition of Cymbal, as also volume growth. However, due to higher-than-proportionate expenses, margins witnessed a significant contraction. Despite higher other income, the bottomline grew at a much slower pace than the topline, due to a combination of the lower margins, as well as higher depreciation charges and taxes paid.

Consolidated Financial Performance (US GAAP): A snapshot
(Rs m) 3QCY05 4QCY05 Change CY04 CY05 Change
Sales 5,197 5,569 7.2% 14,131 20,242 43.2%
Expenditure 4,262 4,464 4.7% 10,918 16,317 49.4%
Operating profit (EBDITA) 935 1,106 18.2% 3,213 3,926 22.2%
Operating profit margin (%) 18.0% 19.9%   22.7% 19.4%  
Other income 92 (78) -183.8% 21 114 456.1%
Depreciation 176 189 7.1% 490 684 39.4%
Profit before tax 851 840 -1.4% 2,743 3,356 22.3%
Extraordinary items - -   -44 0  
Tax 138 179 29.5% 333 620 86.3%
Profit after tax/(loss) 714 661 -7.4% 2,366 2,736 15.6%
Net profit margin (%) 13.7% 11.9%   16.7% 13.5%  
No. of shares (m) 126.7 127.5   124.1 127.5  
Diluted earnings per share (Rs)       19.1 21.5  
P/E ratio (x)*         21.9  
* P/E ratio calculated on a trailing 12-month basis.

What is the company's business?
PCS is India's sixth-largest software services exporter, engaged in providing software solutions and services, domestically and internationally. The company's sphere of offerings includes application development and integration, application maintenance, enterprise application systems, R&D services and business process outsourcing services. PCS has the GE Group as its largest client, with a revenue contribution of 22.1% to consolidated revenues in CY05. Among verticals, PCS has a substantial presence in the financial services, insurance, telecom and manufacturing verticals. The share of revenues from these verticals in CY05 was nearly 81%.

What has driven performance in CY05?
Volume-driven topline: In CY05, the main drivers for the impressive 43.2% YoY topline growth witnessed by Patni were volumes. The management has indicated that volumes and marginally higher billing rates proved to be the main reasons for the strong traction seen in revenues. In dollar terms, the topline grew by 37.9% YoY, thus, reflecting the fact that Patni benefited at the operating level from a higher realised rupee-dollar rate.

The highlight of the year for Patni was undoubtedly winning part of the US$ 2.2 bn ABN Amro outsourcing deal, along with Infosys, TCS, IBM and Accenture. There was an increased offshore content this year (64.6%, compared to 63.4% in CY04). This is undoubtedly a positive for margins, as they are higher for offshore services. In fact, lack of movement of work offshore would invalidate the very concept of the offshore delivery model, which implies that whatever work can be moved offshore, should be moved. This also leads to margin enhancement.

Client metrics improved for PCS in CY05 as compared to CY04. The company added 29 new clients (net) during the year, with the total number of US$ 1 m clients increasing from 46 in CY04 to 61 at the end of CY05. As regards GE, its largest customer, revenues constituted 22.1% of total revenues in CY05 as compared to 31.7% in CY04. Thus, this is a significant improvement this year for Patni, as too much dependence on one client for revenues can prove to be risky. In percentage terms, GE revenues were flat in CY05, actually falling by 0.1% YoY. Thus, this year witnessed an impressive performance from PCS in terms of new client acquisition, growing non-GE clients and greater de-risking of revenues. To put it in numbers, non-GE clients grew at an impressive rate of 63.4% YoY.

Higher costs result in margin contraction: During CY05, Patni incurred significantly higher expenses, both on the sales and marketing (S&M) side as well as on the cost of revenues front. This was mainly due to expansion initiatives. PCS expanded its sales team and also recruited several domain-focussed sales personnel, resulting in higher salary costs. Cost of sales as a percentage of revenues rose from 59.1% in CY04 to 61.7% this year. The end result was that operating margins fell by 334 basis points, resulting in the operating profit growing at a slower rate than revenues.

Higher depreciation and taxes subdue bottomline growth: Despite PCS recording a growth in other income to the tune of 456.1% YoY, higher depreciation charges, coupled with a considerably higher effective tax rate, resulted in net profits growing at 15.6% YoY, much lower than the topline growth. It should also be noted here that PCS had reassessed provisions for payroll. The net impact of this on the bottomline was US$ 1.4 m (Rs 62.9 m).

Performance in the recent pastů
  1QCY05 2QCY05 3QCY05 4QCY05
Sales growth (%, QoQ) 8.1 9.1 9.9 7.2
EBIDTA margins (%) 22.5 17.5 18.0 19.9
Profits growth (%, QoQ) 5.8 8.9 14.8 (7.4)

What to expect?
At the current market price of Rs 470, the stock is trading at a price to earnings multiple of 21.9 times CY05 earnings. This year has witnessed a decent performance from PCS, aided also by the completed acquisition of Cymbal. At these valuations, the stock still trades at a fair discount to its top rung peers like Satyam and HCL Technologies and a big discount to the big three software companies - Infosys, TCS and Wipro.

PCS' revenue from the US forms a considerable chunk of the total, being as high as 84.8% in CY05, which, albeit lower than the 87.8% in CY04, is still considerably higher than the extent to which peers like Infosys and Satyam depend on the US markets. As such, the company faces considerable risk to its business and profitability if any adverse development affects the US markets. In terms of operating metrics, be it sales growth, operating margins, profit growth, revenue de-risking and revenues per employee, PCS trails its peers considerably. On a longer-term basis, we continue to prefer the top-tier plays in the software sector, due to their significantly higher scalability, strong track record, more de-risked revenue profile and breadth of offerings.

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