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Hughes Software: Bad start

Jul 18, 2002

Hughes Software (HSS) has made a terrible start to FY03. The company has posted an 18% sequential (QoQ) drop in revenues in 1QFY03. The drop in net profits is even steeper at 65%. Things look equally bad compared to 1QFY02. Revenues are down by 25% YoY and the bottom line has declined by a significant 76%.

(Rs m) 4QFY02 1QFY03 Change
Sales 580 474 -18.3%
Other Income 32 25 -21.9%
Expenditure 414 433 4.6%
Operating Profit (EBDIT) 166 41 -75.3%
Operating Profit Margin (%) 28.6% 8.6%
Interest - -
Depreciation 55 52 -5.5%
Capitalization of product
development expenses
(37)
Profit before Tax 143 51 -64.3%
Tax 16 7 -56.3%
Profit after Tax/(Loss) 127 44 -65.4%
Net profit margin (%) 21.9% 9.3%
No. of Shares (eoy) (m) 33.3 33.3
Diluted Earnings per share* 15.3 5.3
P/E (x) 34.8
*(annualised)

The dismal performance is due to revenues from its parent HNS falling steeply, 36% sequentially. The product sales were also weak and were lower by 27% compared to 4QFY02.

On the brighter side, revenues from non-HNS clients grew by 12%. The company saw an expansion of its relationship with NEC & Nokia and bagged its first direct orders from the satellite segment (Thrane & Thrane and Inmarsat). According to the company, the contribution to revenues from Fortune 100 customers and Ďother well established companies increasedí. One of the imperatives for the company is to reduce its dependence on HNS. At least on this front the company performance has not disappointed. To diversify further, HSS has jumped onto the BPO bandwagon, and expects cash to flow in from next fiscal.

While the management blames the advisory put out by various countries against traveling to India responsible for the poor performance, the poor health of the telecom sector is equally responsible. HSS derives almost all of its revenues providing software and services to telecom equipment manufacturers and service providers.

Revenue mix
(Rs m) 4QFY02 1QFY03 Change
HNS Services 232 40.0% 147 31.0% -36.7%
Non-HNS Services 186 32.0% 209 44.0% 12.4%
Products 162 28.0% 119 25.0% -27.0%
Total 580 100.0% 474 100.0%

The company has made a change in its accounting policy. It has started capitalizing product development expenses. What this means is that the expenses for product development will not be written off as expense in the quarter in which they are incurred, but will be written off gradually over a period of time. This effectively results into lower expenses and therefore, higher net profits. Companies do this because they feel that benefits of expenses incurred in product development, will accrue over a period of time and thus, write off the expense gradually. Had the company not capitalized product development expenses this quarter, the sequential fall in net profits would have been steeper at 94%, instead of 65% that has been reported.

At the current market price of Rs 184, the stock is trading at a P/E multiple of 35x its 1QFY03 annualized earnings. The stock price is likely to witness further decline on the back of the dismal performance. While the performance has some bright spots, what has eclipsed them is the way management has communicated. Missing earnings guidance so consistently only hurts the managementís credibility.

To conclude, the company has performed in the area where it should have i.e. improving business from non-HNS clients. Also the downturn in the telecom segment is beyond the managementís area of influence. The fact remains that the telecommunication technology is changing rapidly and there is likely to be a demand for service providers like HSS. However, the biggest concern is the managementís changing tack on accounting policy. If at a later date, HSS decides to revert to its old policy of writing of product development expenses at one shot, then the numbers will look really ugly.


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