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Geometric Software: Volatility continues!

Jul 18, 2006

Performance summary
Geometric Software Solutions (GSS) announced its consolidated results for the first quarter ended June 2006 late yesterday. The company has recorded a strong growth in its topline during the quarter, which was a result of good traction in its major business segments, viz. products and projects. However, due mainly to higher employee costs because of the salary revisions, margins saw a contraction. Due to lower margins, as also a negative other income due to forex fluctuations, net profits have declined on a sequential basis.

Financial performance (Consolidated): A snapshot…
(Rs m) 4QFY06 1QFY07 Change
Net sales 639 721 12.8%
Expenditure 478 558 16.7%
Operating profit (EBDIT) 161 163 1.1%
Operating profit margin (%) 25.3% 22.6%  
Other income 39 (29)  
Interest - - -
Depreciation 49 49 0.8%
Profit before tax 152 85 -44.2%
Tax 27 10 -63.4%
Minority interest 18 11 -37.1%
Profit after tax/(loss) 107 63 -40.5%
Net profit margin (%) 16.7% 8.8%  
No. of shares (m) 56.7 60.7  
Diluted earnings per share (Rs)*   4.0  
P/E ratio (x)*   21.2  
* On a trailing 12-month basis.

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 compounded rates of 37% and 26% respectively.

What has driven performance in 1QFY07?
Robust topline: In 1QFY07, GSS saw a strong 12.8% QoQ growth in its topline. This was driven by strong business traction in both its segments. While the projects business saw an impressive 13.7% QoQ growth, the products business grew at a relatively more sedate pace of 7.4% QoQ.

In the projects business, GSS continues with its strategy of working more with industrial partners than OEMs, where visibility is lower but margins are higher. Revenues from industrial partners as a percentage of sales increased to as much as 45% in 1QFY07 (43% in 4QFY06 and 35% in 1QFY06). The contribution from software OEMs like UGS and Dassault Systemes was 41%.

As regards the engineering services (ES) acquisition, GSS has said that it is slightly delayed, but on track. The company plans to close out the acquisition during 2QFY07. GSS is focussing more on the ES space as a method of de-risking its revenues away from PLM services. It has raised funds in order to fund any future acquisitions that it may make in this segment. While the growth potential is significant, the fact that this business is more people-intensive and linear in terms of growth (requires more people to generate additional revenues), and that there is significant competition, with TCS, Infosys, Wipro, Satyam and HCL Tech, all in contention, as well as some mid-sized software companies like Infotech Enterprises, the company will more likely take a hit on its margins going forward.

Segment wise performance…
(Rs m) 4QFY06 Contribution 1QFY07 Contribution Change
Revenues 95 14.8% 102 14.1% 7.4%
PBIT 48 18.6% 53 18.1% 8.9%
PBIT margins 51.0%   51.7%   0.7%
Revenues 544 85.2% 619 85.9% 13.7%
PBIT 211 81.4% 238 81.9% 13.1%
PBIT margins 38.7%   38.5%   -0.2%

As regards employees, the net hiring was 83 this quarter. Utilisation rates improved from 88% in 4QFY06 to 91% this quarter (including trainees). The company has clearly mentioned that it continues to face resource constraints, and it actually had to leave some revenues on the table due to the fact that it did not have the requisite employees on board to execute these projects. Attrition rates were at nearly 24% (annualised for the quarter). This is clearly a concern, and GSS has stated that there is a scarcity of developers with 2 to 4 years of experience. Thus, issues with attrition rates and resource constraints continue to adversely impact the company, which is a risk that any investor will have to take if he or she is considering an investment in the stock. At the end of 1QFY07, GSS had 1,524 software developers on its rolls. 3D PLM (JV with Dassault) had 475 people on its rolls, an addition of 15 people from 4QFY06.

Employee costs pressurise margins: The annual salary increases during the quarter led to a 262 basis points (2.6%) decline in operating margins in 1QFY07. Employee costs increased as a percentage of sales from 53.2% to 56.5%. GSS has said that it increased salaries in April 2006 in line with market trends. Going forward, given the fact that resource constraints are adversely impacting the company, it expects to scale up recruitment.

Lower margins, forex losses hammer profits: Due in part to the lower margins, as well as mark-to-market losses on forward contracts (loss of Rs 45.2 m in 1QFY07, as compared to a profit of Rs 24.5 m in 4QFY06), the company’s net profits were hammered, down by as much as 40.5% QoQ. The fact that fluctuations in the other income component have such a significant impact on GSS’ bottomline is indeed a matter of great concern for investors. The company plans to review its current approach to hedging and its accounting treatment.

Performance in the recent past…
  2QFY06 3QFY06 4QFY06 1QFY07
Sales (QoQ growth, %) 5.0 17.4 6.7 12.8
Operating margins (%) 19.1 25.2 25.3 22.6
Profits (QoQ growth, %) (56.6) 16.2 171.2 (40.5)
Employee costs (% of sales) 58.6 52.4 53.2 56.5
Employee base (nos.) 1,316 1,374 1,441 1,524

What to expect?
At the current price of Rs 85, the stock is trading at a price to earnings multiple of 9.9 times our estimated FY08 EPS. Resource fulfillment issues continue to impact GSS, as mentioned above. The company has clearly said that there is a shortage of programmers in the 2 to 4 years work experience category. Given the importance of finding quality manpower for a niche company like GSS, this is a matter of concern.

Another major factor is the impact that forex fluctuations have on the company’s profits. Given that the base is so low, even small currency movements can make a significant difference to the overall profitability. While GSS is witnessing decent business traction, the above-mentioned factors do increase the risk profile of the stock.

Consequently, with the niche nature of GSS’ business and initiatives like creating 5 business units with bottomline responsibility, and the renewed focus on the ES space, we believe that growth at the topline level may not be such an issue. However, as mentioned above, resource fulfillment issues have led to the company leaving some revenues on the table. Thus, GSS continues to face rising 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 greater for GSS.

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