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Patni Computers: Challenges galore!

May 9, 2006

Introduction to results
Patni Computer Systems (PCS) recently announced its results for 1QCY06 (the company's financial year ends in December). During the quarter, the company saw a relatively muted sequential growth in its topline, partly due to a lower realised rupee-dollar rate. Margins took a hit, due to considerably higher salary costs, because of transition of onsite resources to a gross compensation structure. The lower margins and also a higher effective tax rate have led to a sequential dip in the bottomline during the quarter.

Financial Performance (US GAAP): A snapshot
(Rs m) 4QCY05 1QCY06 Change
Sales 5,569 5,776 3.7%
Expenditure 4,464 4,753 6.5%
Operating profit (EBDITA) 1,106 1,022 -7.6%
Operating profit margin (%) 19.9% 17.7%
Other income (78) 11
Depreciation 189 193 2.3%
Profit before tax 840 840 0.0%
Tax 179 197 10.5%
Profit after tax/(loss) 661 642 -2.8%
Net profit margin (%) 11.9% 11.1%
No. of shares (m) 127.5 139.4
Diluted earnings per share (Rs)* 18.9
P/E ratio (x)* 20.2
* 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 16.5% to consolidated revenues in 1QCY06. Among verticals, PCS has a substantial presence in the financial services, insurance, telecom and manufacturing verticals. The share of revenues from these verticals in 1QCY06 was over 79%.

What has driven performance in 1QCY06?
Volumes drive the topline: During the quarter, the company recorded a near-4% QoQ growth in its topline. This was mainly a result of volume growth, as also an increase in average billing rates. The company was able to negotiate higher rates with existing clients, and get better rates from new business. This is an industry-wide trend, and has also been alluded to by some of the top-tier peers of Patni. However, it must be mentioned here that revenues in dollar terms grew by nearly 5% QoQ. This is a reflection of the fact that Patni's realised rupee rate was lower than in the last quarter, at Rs 44.48 to a dollar (Rs 44.95 in 4QCY05).

Client metrics improved in 1QCY06 as compared to 4QCY05. The company added a net of 7 new clients during the quarter. The total number of US$ 1 m clients remained constant at 61. As regards GE, its largest customer, revenues constituted 16.5% of the total in 1QCY06 as compared to 17.7% in 1QCY05. In absolute terms, GE revenues actually feel on a sequential basis by 3.3%. Non-GE clients grew at a sequential rate of over 5%. However, one factor to consider is that Patni's revenue performance this quarter has been relatively muted in rupee terms when compared to its peers, such as TCS and Wipro.

Higher costs result in margins crashing: During 1QCY06, Patni saw its margins fall by 216 basis points. In fact, the operating profits, even in absolute terms, were down by nearly 8% QoQ. The major drivers for this poor performance were higher onsite compensation costs, resulting from the transition of its US onsite resources to a gross (of payroll taxes) compensation structure. The impact of this was US$ 1.8 m (approx. Rs 80 m).The utilisation rates this quarter were also lower at 67.8% (68.6% in 4QCY05), leading to higher salary costs to the extent of US$ 1.4 m (approx. Rs 62.3 m). SG&A expenses also increased from 18.5% of revenues in 4QCY05 to 20.0% this quarter.

Lower margins, higher taxes dent bottomline: Due to the lower margins and also due to a higher effective tax rate, the company saw a near-3% QoQ fall in its net profit. This was despite a considerable improvement in other income, which stood at Rs 11 m, as compared to Rs 78 m loss in 4QCY05.

Performance in the recent pastů
2QCY05 3QCY05 4QCY05 1QCY06
Sales growth (%, QoQ) 9.1 9.9 7.2 3.7
EBIDTA margins (%) 17.5 18.0 19.9 17.7
Profits growth (%, QoQ) 8.9 14.8 (7.4) (2.8)

What to expect?
At the current market price of Rs 382, the stock is trading at a price to earnings multiple of 20.2 times its trailing 12-month earnings. The company continues to under-perform the top-tier companies in the sector. The management has re-iterated its topline guidance for the full-year. However, due to additional costs incurred in transitioning their onsite staff to a gross compensation structure, as also the compensation hikes planned this year being higher than previously expected, the management has said that it expects the company's full-year (CY06) earnings to be lower than originally expected.

For 2QCY06, the management has guided for a 6% QoQ growth in revenues, at an exchange rate of Rs 44.60 to a dollar. However, due to the increase in salary and visa costs, profit after tax is expected to be US$ 11 m (Rs 490.6 m), which is a near-24% QoQ fall in profits. This is undoubtedly a cause for concern, and while the management has said that the second quarter is traditionally lower for Patni in terms of earnings, the company will need to show considerably higher growth momentum in the second half of CY06 in order to achieve decent profit growth this fiscal. In fact, if Patni does record profits in line with the management's expectations in 2QCY06, merely in order to achieve the same level of profits as in CY05, the company will need to grow at a QoQ pace of over 55% each in 3Q and 4QCY06.

Thus, it is clear that Patni has faced some challenges in growing its bottomline consistently. The guidance given for 2QCY06 implies the third successive quarter of sequential profit decline. The attrition rate of the company has also crossed 20%. 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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