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Patni Computers: Subdued performance…

May 9, 2005

Introduction to results
Patni Computer Systems (PCS) announced its results for the first quarter of CY05 (the company's financial year ends in December). During 1QCY05, while topline has grown by 8% QoQ, proportionately higher SG&A expenses caused expenses to rise at a faster pace, resulting in a drop of 50 basis points in margins. This in turn, as well as lower other income and considerably higher taxes paid resulted in net profit for 1QFY05 falling by 6% QoQ.

Consolidated Financial Performance (US GAAP): A snapshot
(Rs m) 4QCY04 1QCY05 Change
Sales 4,012 4,337 8.1%
Expenditure 3,089 3,361 8.8%
Operating profit (EBDITA) 923 976 5.7%
Operating profit margin (%) 23.0% 22.5%  
Other income 52 40 -23.2%
Depreciation 142 145 1.7%
Profit before tax 834 872 4.6%
Tax 109 189 73.6%
Profit after tax/(loss) 724 682 -5.8%
Net profit margin (%) 18.1% 15.7%  
No. of shares (m) 136.7 134.0  
Diluted earnings per share* (Rs) 21.6 20.4  
P/E ratio (x)   16.7  
(* annualised)      

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 nearly 25% to consolidated revenues in 1QCY05. Among verticals, PCS has a substantial presence in the financial services, insurance and manufacturing verticals. The share of revenues from these verticals in 1QCY05 was nearly 68%.

What has driven performance in 1QCY05?
Volume growth drives revenues:  During 1QCY05, PCS' revenues grew by 8% QoQ. Volume growth was the main driver of this increase. PCS' management has indicated that the pricing environment has been largely stable during the quarter. The telecom vertical contributed to as much as 14% of the total revenues for the quarter, aided by the consolidation of the revenues of Cymbal Corporation during 4QCFY04. 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. During 1QCFY05, revenue contribution from GE declined as a percentage of total revenues from 27% in 4QCY04 to 25% during the current quarter.

Higher SG&A and employee costs impact:  Patni incurred considerably higher SG&A costs during 1QCY05 as compared to the previous quarter. SG&A expenses as a percentage of revenues rose from 17.9% during 4QCY04 to 19.5% during 1QCY05. This caused a higher than proportionate rise in expenditure compared to revenues, resulting in a 50 basis point fall in margins QoQ.

This rise in SG&A expenses was caused by a combination of factors, namely a rise in expenses for the acquired telecom business of Cymbal, higher sales and marketing (S&M) costs and higher employee costs. PCS has indicated that, of the total costs, around US$ 1 m (1% of sales in 1QCY05) are non-recurring in nature and as a result, are not expected to be incurred during the next few quarters. In fact, if we take away the effect of these non-recurring expenses, total expenditure has risen at a relatively lower rate than revenues and the company would have witnessed an increase in margins by 50 basis points. Higher employee costs also contributed to the decline in margins. PCS increased its employee headcount by 765 during 1QCY05. Coupled with a low utilisation rate of around 65% during the quarter, lower offshore contribution to revenues (63% during 1QCY05 compared to 64% during 4QCY04) and higher SG&A expenses, the end result was an adverse impact on margins.

Net profits:  Apart from the contraction in operating margins, lower other income, lower forex gains and considerably higher taxes paid during the quarter resulted in a negative impact on net profit, which fell by 6% QoQ. The increased tax provisioning during the quarter was the result of an amount of about US$ 1 m relating to an adjustment for an earlier year's income tax assessment. If we take away the impact of this adjustment, net profit would have actually risen by 0.2% QoQ.

What to expect?
At the current market price of Rs 340, the stock is trading at a price to earnings multiple of 16.7 times annualised 1QCY05 earnings. This is at the higher end of the valuation spectrum, given the valuations at which its peers like Satyam and HCL Technologies are trading. This is considerably lower than the valuations at which its top-rung peers Infosys, TCS and Wipro trade.

One of the main reasons for this has been the under performance of PCS vis-à-vis its peers. Moreover, PCS also earns a large proportion of its revenues from the US.This was around 87.7% during CY04, which is considerably higher than the extent to which Infosys depends on the US markets. As such, the company faces considerable risk to its business and profitability if any adverse development affects the US markets. This higher risk also seems to have 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 19.6% (1QCY05) are also higher than the industry average of around 17% and considerably higher than what Infosys and TCS witness.

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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