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Hughes Software: Down but not out

Jul 20, 2002

Hughes Software (HSS) has done it again. We mean that the company has once again missed its earnings guidance. The company for 1QFY03 posted numbers that were way below its own expectations. Had it not been for a change in accounting policy the sequential decline in net profits would have been 94%. And no, Hughes Software is not into software education. The software company that has been focused on the providing software solutions for convergent networks (networks that can interoperate between telephones, Internet and new technologies like 3G) blames the advisory put out against India by western governments for the disastrous performance. The company posted an 18% sequential drop in net profits and the drop in bottom line was a steep 65%.

It has started capitalizing product development expenses. What this means is that the expenses for product development will not be written off 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%.

Not for the weak hearted
Growth (QoQ) FY01 1QFY02 2QFY02 3QFY02 4QFY02 FY02 1QFY03
HNS Services 23.3% 8.3% 8.0% 12.0% -15.8% 38.1% -36.7%
Non-HNS Services 156.1% 5.1% -6.3% -15.0% 0.0% 15.1% 12.4%
Products 159.0% -8.0% -59.3% 98.0% 17.9% -2.8% -27.0%
Total revenues 85.0% 2.3% -15.5% 12.0% -3.2% 18.3% -18.3%

The shortfall in revenues was due to lesser amount of business coming in from its parent HNS (Hughes Network Systems). The revenues declined by 36% sequentially. Infact, in 4QFY02 also revenues from the parent company had seen a sequential fall of 16%. The product sales were also weak, lower by 27% compared to 4QFY02. Thus, more than travel advisories, the weakness in the telecom sector is to blame for the performance.

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). The contract awarded by Thrane and Thrane, a manufacturer of mobile satellite communications equipment, is to engineer a solution that will be a bridge between proprietary satellite network technology (legacy systems) and 3G services (emerging technology).

HNS concentration: Diluting?
% Contribution of revenues FY01 1QFY02 2QFY02 3QFY02 4QFY02 FY02 1QFY03
HNS Services 36.0% 36.0% 46.0% 46.0% 40.0% 42.0% 31.0%
Non-HNS Services 36.0% 37.0% 41.0% 31.0% 32.0% 35.0% 44.0%
Products 28.0% 27.0% 13.0% 23.0% 28.0% 23.0% 25.0%
Operating Profit Margin 36.3% 34.4% 17.4% 31.4% 28.6% 28.3% 8.4%

During the first quarter of the fiscal, the company launched a solution known as Service Creation Environment. The product allows the creation of convergent services across different kind of networks PSTN (telephones), wireline (Internet) and wireless networks (like 3G). The demand for such solution is likely to grow exponentially as emerging technologies become more and more popular.

According to the company, the contribution to revenues from Fortune 100 customers and ‘other well established companies increased’. 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. But this is just for one quarter. Revenues from non-HNS clients have been equally volatile in the past.

On a more macro, level the problems lies in the fact that Hughes Software’s clients traditionally have been OEM (original equipment manufacturers) for the telecommunications industry like Cisco, Motorola and Nortel. These companies are facing tough times as they had significantly ramped up capacity during the tech boom. With collapse of the IT spending bubble, these companies have excess capacity. Therefore, these companies have cut down on costs to maintain margins. This has impacted suppliers like Hughes Software.

Hughes is now looking beyond the OEM space and is trying to offer its services to application service providers. The service providers are those who offer fixed or mobile telephone services, like MTNL and BSNL in India. Hughes plans to provide services in both technical and commercial areas. While technical services would include management of network infrastructure and applications, the offerings in the commercial area are likely to include business support services. The company is currently focusing on billing and commercial applications apart from systems integration services. The other areas where Hughes plans to offer services include operational support systems like technical helpdesk and back end services.

Thus, Hughes has slightly shifted its focus from purely technology related software to accommodate the integration of networking and communications software with business application software. This makes a lot of sense. A telecom service provider is just like any other company and therefore needs software to look into day-to-day commercial and sales operations. However, details like service usage is available from the networking systems. Thus, a seamless integration between the business and the networking systems would not only help these companies improve operational efficiency but would also help in developing business intelligence. In future, the application service providers would look forward to understanding usage pattern much more in detail. They could easily get answers like what age group is making long distance calls? Thus, companies like Hughes could extend their services in the future to implement business intelligence solutions.

While Hughes’ performance for 1QFY03 had some bright spots, what eclipsed them is the way management has communicated. Missing earnings guidance so consistently only hurts the management’s 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 management’s 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 Hughes Software. However, the biggest concern is the management’s changing tack on accounting policy. If at a later date, the company decides to revert to its old policy of writing off product development expenses at one shot, then the numbers will look really ugly.

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