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Hughes Software: What to do?

Jun 9, 2004

Hughes Software Systems Limited (HSS), a subsidiary of the US based Hughes Network Systems (HNS), announced yesterday that Flextronics, a Singapore-based electronic manufacturing services provider, will acquire HNS' entire 55% stake in the company. As consideration, Flextronics will pay Rs 547 per share, amounting to a total of US$ 226 m (to be paid fully in cash). The acquisition will be completed by October this year. However, before that, in June 2004, pursuant to Securities and Exchange Board of India (SEBI) regulations, Flextronics will be making an open offer to purchase an additional 20% of the outstanding shares in HSS, at a price no less than Rs 547 per share. On the basis of price-to-sales, Flextronics consideration for HSS' 55% stake stands at 2.8x FY04 earnings. Now, before going any further, here is a brief outline about the two companies.

Hughes Software Systems (HSS)

HSS is primarily focused on networking and telecommunications related systems software. The company has traditionally provided services to equipment manufacturers like Cisco and Lucent. To counter the severe down turn in the global telecom industry, HSS has broadened its service portfolio and the company now caters to telecom service providers, has added new offerings like business process outsourcing, and is looking at penetrating the financial services industry. Over the period between FY00 and FY04, the company's sales and profits have grown at CAGR of 35% and 20% respectively.

However, this growth has been rather choppy, mainly due to the uncertainties surrounding the recovery of the global telecom industry. The effect can then be seen in HSS' underperformance in the stock markets where it has underperformed the benchmarks.

Flextronics

Flextronics is a Singapore-based electronics manufacturing services provider and delivers operational services to technology companies. The company's FY04 revenues were US$ 14.5 bn, the major contributors being handheld devices (35% of revenues), computers and office automation (22%), communications infrastructure (17%) and others (26%). Its revenues have grown at a CAGR of 20% over the last five years. What this revenue break-up highlights is the strong presence of Flextronics in the telecom hardware space (50% of revenues). The clientele of the company includes telecom and telecom-related majors like Cisco, Sony-Ericsson, Lucent, Nortel, IBM, Siemens and Philips. So, this acquisition of HSS is a strategic fit into the overall scheme of things for Flextronics.

So, is the valuation fair and what should HSS shareholders do?

At present, HSS is trading at a price-to-sales ratio of 5x FY04 sales and 3x our estimated FY06 sales (P/E of 14.3x FY06E earnings). As such, the price offered by Flextronics at 2.8x seems to be reasonable by the look of it. Just to put things in perspective, when Infosys acquired Expert Information Systems of Australia in December 2003, the deal was done at 1.3x sales (Expert derived 74% of its revenues from the telecom space).

So, what are the options in front of an HSS shareholder? One, considering the synergies in the acquisition, a shareholder could stay put believing that revenue growth could be faster in the future. As of now, there has not been any committed business from Flextronics on this front whereas when HP acquired Digital, the former had provided guidance of the magnitude of business that could flow in the future to the latter. So, there is uncertainty on this front.

Besides, like we have seen in the past, Flextronics might go in for delisting of HSS' shares from the Indian markets, thus denying Indian invertors from participating in the company's future growth. In this case, the shareholders may be forced to participate in the offer. Considering the history of MNCs de-listing their subsidiaries from the Indian markets and thus denying Indian investors share in growth of these subsidiaries, investors need to practice caution. Investors could use this opportunity as an exit option, if they feel that risk-return trade-off is skewed towards risk.

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