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Geometric Software: Is the worst over? - Views on News from Equitymaster
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Geometric Software: Is the worst over?
Apr 22, 2006

Performance Summary
Geometric Software Solutions (GSS), announced its consolidated results for the fourth quarter and full-year ended March 2006 late yesterday. The company recorded a decent growth in its topline during FY06 driven by the strong performances of both its business segments viz. products and projects. However, due mainly to the lower margins, as also higher depreciation charges and increased share of minority interest, the bottomline has reduced on a year-on-year basis.

Financial performance (Consolidated): A snapshot…
(Rs m) 3QFY06 4QFY06 Change FY05 FY06 Change
Net sales 599 639 6.7% 1,682 2,234 32.8%
Expenditure 448 478 6.6% 1,216 1,741 43.2%
Operating profit (EBDIT) 151 161 6.9% 466 493 5.8%
Operating profit margin (%) 25.2% 25.3%   27.7% 22.1%  
Other income (40) 39   51 68 33.6%
Interest 0 - - 0 0 1233.3%
Depreciation 46 49 7.3% 128 172 34.4%
Profit before tax 65 152 133.3% 389 390 0.0%
Tax 12 27 119.3% 71 68 -4.3%
Minority interest 13 18 34.5% 44 64 46.0%
Profit after tax/(loss) 39 107 171.2% 275 258 -6.2%
Net profit margin (%) 6.6% 16.7%   16.3% 11.5%  
No. of shares (m) 56.5 56.7   55.8 56.7  
Diluted earnings per share (Rs)       4.8 4.6  
P/E ratio (x)         27.9  

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 has grown its revenues and profits at a CAGR of 37% and 26% respectively.

What has driven performance in FY06?
Products and projects drive topline: In FY06, GSS grew both its products as well as services businesses at good rates, thus leading to the 33% YoY growth in its topline. The products business grew at a scorching pace of nearly 97% YoY. This could be attributed to the fact that in FY06, TekSoft’s revenue for the full year was consolidated, whereas in FY05, it was consolidated only for the fourth quarter.

Project revenues, on the other hand, also grew at a decent pace of over 25% YoY. The company’s strategy of working more with industrial partners than OEMs, where visibility is lower but margins are higher, appears to be paying off. Revenues from industrial partners as a percentage of sales increased to as much as 43% in 4QFY06 (38% in 4QFY05), higher than the contribution from software OEMs like UGS and Dassault Systemes (42%). The company added 5 customers during the quarter, including 4 in engineering services.

The quarter under consideration saw GSS sign a ‘Term Sheet’, enabling the company to proceed with the acquisition of an engineering services company. Owing to the fact that due diligence is yet to be done and a few other issues needing to be resolved, the company has not named the target company. In the past, GSS has stated on numerous occasions that it is looking to acquire a company in the engineering services space that would have revenues in the region of around US$ 10 m. Thus, this move is in line with the company’s strategy. For this purpose, the company will take on debt of between US$ 10 m and US$ 15 m, and also make a preferential issue to ICICI Ventures at Rs 117.66 per share. The company will be selling one of its properties in order to partly pay off the debt component. As per the company, the deal would be completed by mid-July 2006.

Segment wise performance…
(Rs m) FY05 Contribution FY06 Contribution Change
Products
Revenues 176 10.4% 345 15.5% 96.6%
PBIT 80 10.6% 170 19.5% 112.6%
PBIT margins 45.6%   49.3%   3.7%
Projects
Revenues 1,506 89.6% 1,889 84.5% 25.4%
PBIT 675 89.4% 704 80.5% 4.3%
PBIT margins 44.8%   37.3%   -7.5%
           
Net PBT* 389   390   0.0%
Net PBT margins 25.9%   20.6%   -5.2%

During the quarter, with a view to ensure future growth of the business, GSS has created 5 business units with bottomline responsibility – Product Development Services, PLM Solutions unit, Engineering Services, Desktop Products and Technologies, and Enterprise Products. Going forward, GSS plans to spin off the Engineering Services and Enterprise Products business units into subsidiary companies, so that they can better address market needs through their focus.

The employee hiring was a net of 67 this quarter. Utilisation rates improved from 84% in 3QFY06 to 88% in 4QFY06 (including trainees). Attrition rates increased to 19.4% in the last quarter (annualised). This is undoubtedly a cause for concern and, going forward, the company will need to take effective steps to curb this attrition rate to more sustainable levels. Resource fulfillment continues to be an issue that GSS needs to address effectively over the longer term, given the problems it has faced this year. At the end of FY06, GSS had 1,441 software developers on its rolls. 3D PLM had 450 people on its rolls, an addition of 25 people from 3QFY06. GSS has said that the growth of 3D PLM is in line with its expectations.

Higher costs result in margin pressure: Due to costs increasing at a much faster rate than revenues, the operating margins of GSS fell by as many as 560 basis points. Employee costs, the main cost item for software companies like GSS, increased to 56.0% of sales (54.9% in FY05). Other expenses rose to 16.6% of sales this year (12.7% in FY05). Thus, the considerably larger increase in expenses has resulted in operating profits growing by a mere 6% YoY. The company, going forward, will need to incur higher sales and marketing expenses in order to win more business in new initiatives like engineering services. The acquisition would reduce pressure to some extent.

Lower margins, higher depreciation hammers profits: Despite higher other income earned this year, lower margins, as well as higher depreciation charges and higher minority interest (on account of higher profits earned by 3D PLM), net profits for FY06 fell by over 6% YoY. It should be noted that in FY06, GSS changed its accounting policy regarding forex gains/losses. In FY05, gains or losses on account of forex fluctuations were amortised over the period of such contracts. This year the company has resorted to using the mark-to-market valuation of gains or losses, where these are accounted for in the quarter itself.

Performance in the recent past…
  1QFY06 2QFY06 3QFY06 4QFY06
Sales (QoQ growth, %) (2.6) 5.0 17.4 6.7
Operating margins (%) 17.2 19.1 25.2 25.3
Profits (QoQ growth, %) (3.7) (56.6) 16.2 171.2
Employee costs (% of sales) 61.3 58.6 52.4 53.2
Employee base (nos.) 1,275 1,316 1,374 1,441

What to expect?
At the current price of Rs 127, the stock is trading at a price to earnings multiple of 10.7 times our estimated FY08 earnings. The board has recommended a final dividend of Rs 0.80 per share (dividend yield of 0.6%). FY06 has undoubtedly been a difficult year for the company, wherein it faced delays in the execution of some projects, as well as resource fulfillment issues, leading to the company having to leave some revenues on the table. Given the fact that GSS is a niche company with a small size, these problems adversely impacted it.

However, we believe that the worst is over for the company. A few steps taken by the management this year, such as creation of 5 new business divisions with bottomline responsibility, a shift to industrial customers’ revenues, good traction in the product business, and, probably most importantly, the announcement of a target company for acquisition in the engineering services space, leads us to believe that going forward, the company could see renewed growth in its business. Nonetheless, we continue to remain concerned about the fact that GSS is facing attrition issues and lack of scalability, which, given the fact that it is small, can adversely impact it in future as well. To that extent, the risk is possibly greater for GSS.

The management has guided for a growth of 35% YoY in topline for FY07 in dollar terms (organic growth). Barring unforeseen forex movements, the bottomline for the year is also estimated to grow at a similar rate in dollar terms. While traditionally, GSS has not given quarterly guidance, in 1QFY07, the company believes that it can grow revenues in high single or low double digits sequentially. The company’s margins will be impacted due to a salary revision carried out in April. Going forward, how GSS manages its costs in line with its revenue growth will be a key factor to watch out for. While the revenue guidance seems robust, we believe that it is the costs that one must watch out for.

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