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Flextronics Software: Where to from here? - Views on News from Equitymaster
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  • Apr 6, 2005

    Flextronics Software: Where to from here?

    Flextronics Software Systems (formerly Hughes Software Systems), a 70% subsidiary of leading electronic manufacturing solutions provider, Flextronics Corporation - Singapore, is a niche player in the Indian software industry. It is a provider of software services, products and BPO services to the global communications and networking industry. It specialises in convergent network solutions, such as wireless, wireline, Next Generation Fixed and IP networks.

    Lately, due to the revival in the global telecom industry, Flextronics has started to improve its financial performance. We analyse the performance of the company over the past few years and do a bit of 'future-gazing'.

    Financial performance
    Flextronics has shown a slight inconsistency in performance over the years. The key reason for this is its significant dependence on one vertical - telecom, for growth. This exposes it to a high risk, as the telecom industry is highly volatile in nature. As a result, the CAGR of sales and profits over the given period has not been as impressive as industry bellwether Infosys.

    In FY02, even though sales increased by a decent 18%, employee expenses were considerably higher on an absolute basis by almost 50%. This, in spite of the fact that employee headcount increased by only 9%. This clearly reflects the company being affected due to rising wage cost, with average cost per employee going up by 36%. The ultimate result was that the net profit was down by as much as 17%, despite the 18% rise in sales.

    In FY03, there was a global economic slowdown, and the telecom industry went into a downturn, as mentioned above. This badly affected Flextronics, with sales falling by 6%, resulting in a fall in operating profits, operating margins and a fall in net profits by over 25%. Expenses also fell, but lesser than sales. The company, in order to diversify its risk, has started providing its services to telecom service providers, apart from telecom OEMs, which it used to do earlier.

    This diversification and the global upturn in the telecom industry helped its sales improve considerably in FY04, albeit this was on a lower base. Sales grew by as much as 63%, and even though expenses increased by 56%, profit after tax rose by over 100% in the year. Employee costs increased by over 90%, but because of the much-improved topline performance and a lower base effect of the previous year, profits soared.

    However, due to the adverse performance in FY03, the CAGR for the topline for the period FY01 to FY04 was limited to 22%, despite an impressive FY04. This is considerably lower than industry bellwether Infosys, which has managed a CAGR of 34%. The bottomline CAGR is even lower, at a mere 7%. In our view, this reflects the risks associated with a company like Flextronics, which is a niche player, and focuses on the highly volatile telecom industry.

    Flextronics: Volatility is the name of the game!
    (Rs m) FY01 FY02 FY03 FY04 9mFY05 CAGR (01-04)
    Sales 1,985 2,349 2,204 3,583 3,509 21.8%
    Expenditure 1,262 1,682 1,650 2,588 2,497 27.0%
    Operating profit (EBDIT) 723 667 554 995 1,012 11.2%
    Operating profit margin 36.4% 28.4% 25.1% 27.8% 28.8%  
    Other income 109 132 87 79 64  
    Depreciation 149 211 181 209 196  
    Profit before tax/(loss) 682 587 458 862 844 8.1%
    Tax 51 64 80 89 66  
    Profit after tax/(loss) 629 522 379 774 778 7.1%
    Net profit margin (%) 31.7% 22.2% 17.2% 21.6% 22.2%  
    No. of shares (m) 33.4 33.4 33.6 33.9 34.5  
    Diluted earnings per share (Rs)* 18.2 15.1 11.0 22.4 30.1 7.1%
    P/E ratio (x)         17.2  
    * annualised            

    Segmental analysis
    Flextronics was bought out by Flextronics Corporation - Singapore, in early FY05. The former parent was Hughes Network Systems, a company owned by media baron Rupert Murdoch. This company used to provide a fair amount of business to Flextronics, as much as 36% in FY01. Over the years, the non-HNS part of revenues has been growing at a much faster pace. The acquisition of new clients and diversification into the telecom service provider domain has been the main driver of this trend. Going forward, this trend is expected to continue.

    However, after the sell-out by HNS, we believe that there is a risk of loss of business. In FY04, HNS contributed almost 22% of revenues to the company. This is still a fairly significant amount, and if HNS decides to stop buying services from Flextronics, it could affect the company adversely in the medium term.

    Segmental break-up: Reducing dependence on HNS
    FY01 FY02 FY03 FY04
    Segments (Rs m) % of total (Rs m) % of total (Rs m) % of total (Rs m) % of total
    HNS Services 714 36.0% 989 42.1% 633 28.7% 770 21.5%
    Other services 705 35.5% 818 34.8% 1,045 47.4% 2,057 57.4%
    Products 566 28.5% 542 23.1% 505 22.9% 591 16.5%
    BPO - -   22 1.0% 165 4.6%
      1,985   2,349   2,204   3,583  

    What to expect?
    The performance of Flextronics this year has been impressive, with 9mFY05 sales almost equaling sales for the entire FY04. Profits have already overtaken FY04 figures. The last quarter is expected to be good for Flextronics, and the management has guided for an over 30% sales growth and a similar level of profit growth for FY05 over the previous year. Further diversification into new products and services as well as geographical diversification would be the key factors that would enable the company to de-risk its business model. It already earns a majority of revenues from Europe, unlike other software companies that are largely dependent on the US.

    However, despite the impressive performance of the company in the last 2 financial years, given the fact that it depends upon only one industry for its revenues, there is a risk. An economic slowdown could also adversely affect the company. Another factor that could be of concern to investors is the risk of possible loss of business from HNS, its former parent. Also, since Flextronics is now the majority shareholder, this could trigger a de-listing sometime in the future. We have seen in the past, MNCs take over majority shareholding in their Indian subsidiaries and subsequently de-list from the bourses. Therefore, one needs to take this into account as well, as this may not necessarily be in the interest of the investors.

    At the current price of Rs 518, the stock is trading at a price-to-earnings multiple of 17.2 times annualised 9mFY05 earnings. This is at the higher end of the valuation spectrum for the stock. The upcoming quarterly and annual results to be announced by the management will provide a clearer picture, going forward. We would advise investors to practice caution at current levels owing to the aforesaid concerns. There is nothing wrong in pursuing a niche business plan, but risks associated are higher. For the conservative investor, sticking to the top guns in the sector would be the prudent thing to do.

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