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Patni Computers: Will growth sustain?

Mar 2, 2005

Introduction to results
Patni Computer Systems (PCS) recently reported strong results for the full year ending December 2004. While topline has grown YoY by 27%, a marginal expansion in operating margins and higher other income has aided a much faster growth in the bottomline.

Financial Performance (Consolidated): A snapshot
(Rs m) CY03 CY04 Change
Sales 11,648 14,765 26.8%
Expenditure 9079 11,415 25.7%
Operating profit (EBDITA) 2,569 3,350 30.4%
Operating profit margin (%) 22.1% 22.7%  
Other income 142 208 46.5%
Depreciation 430 516 20.1%
Interest 2 2 -0.4%
Profit before tax 2,279 3,042 33.4%
Extraordinary items   46  
Tax 437 417 -4.6%
Profit after tax/(loss) 1,843 2,577 39.9%
Net profit margin (%) 15.8% 17.5%  
No. of shares (m) 111.6 124.1  
Diluted earnings per share* (Rs) 14.8 20.8  
P/E ratio (x)   18.1  
(* annualised)      

What is the company’s business?
PCS is a mid-sized company 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 over 31% to consolidated revenues in CY04. Among verticals, PCS has a substantial presence in the financial services, insurance and manufacturing verticals. The share of revenues from these verticals in CY04 was over 75%.

What has driven performance in CY04?
Increase in revenues from other service lines powers growth:  Patni’s service lines other than application development and maintenance (ADM) grew by 53.7% YoY during the year, thus aiding the overall growth in the topline. The company offers enterprise application systems, R&D services, embedded technology services, enterprise systems management and business process outsourcing services, apart from ADM services, where margins are typically higher, and thus, the healthy growth in revenues in these services aided margins to a great extent.

During the last quarter, the company acquired Cymbal Corporation for US$ 68 m. Cymbal is a US-based telecom industry focused IT services provider. This acquisition has given Patni a presence in the telecom vertical, adding to its existing presence in verticals like insurance, manufacturing and financial services, from which it derives over 75% of its revenues.

Increase in offshore revenues boosts margins:  Patni increased the share of offshore services to 63.4% of total revenues during CY04, as compared to 59.9% in CY03. This resulted in a slight improvement in the company’s margins, with operating margins rising 60 basis points from 22.1% to 22.7%, and net profit margins increasing 170 basis points from 15.8% to 17.5%. Also aiding the margin expansion was the leverage on the selling, general and administration (SG&A) expenses front. SG&A expenses as a proportion of revenues declined from 18.9% in CY03 to 17.9% in CY04.

Net profits:  Apart from the expansion in operating margins, a higher other income component and lower taxes resulted in a growth of almost 40% YoY in net profits.

What to expect?
At the current market price of Rs 375, the stock is trading at a price to earnings multiple of 18.1 times CY04 earnings. This is considerably lower than those of its peers like Infosys and TCS, which enjoy much higher valuations in the range of around 25 to 30 times earnings. One of the main reasons for this has been the under performance of PCS vis-ŕ-vis its peers. Moreover, PCS also earns as much as 87.7% of its revenues from the US, and although this is slightly lower than last year’s figure of 88.8%, it is still very high, and as such the company faces considerable risk to its business and profitability if any adverse development affects the US markets. This higher risk has also been factored into the stock, and thus, companies with a greater degree of diversification in terms of tapping a greater number of markets for business have enjoyed a higher valuation. It must also be noted that the company’s operating margins and net profit margins are considerably lower than those of its peers. The attrition rates for the company at 19.4% are also higher than the industry average of around 17%. We believe that the company, in order to be able to enjoy similar valuations as its peers, will need to get its act together, and move into the higher realms of the value chain. This, we believe, could be the next major push factor that could enable PCS to get on a higher growth trajectory, and in the process, enjoy higher valuations. However, at the current juncture, and taking a long-term perspective, we believe that there are better stocks to choose from the Indian IT bandwagon.

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