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Geometric Software: Scalability issues!

Jul 20, 2005

Introduction to results
Geometric Software Solutions (GSS) has announced its consolidated results for the first quarter ending June 2005. The company has shown a decline in revenues for the first time after 10 consecutive quarters of QoQ revenue growth. However, the management had already indicated earlier that it expected revenues for 1QFY06 to be lower on a QoQ basis, due mainly to a delay in completion of a fixed price project. Margins also took a big hit during the quarter, mainly due to the planned salary revisions carried out in April.

Financial performance (Consolidated): A snapshot…
(Rs m) 4QFY05 1QFY06 Change
Net sales 499 486 -2.6%
Expenditure 369 403 9.2%
Operating profit (EBDIT) 131 83 -36.1%
Operating profit margin (%) 26.2% 17.2%  
Other income 26 71 171.5%
Interest - 0  
Depreciation 37 37 -0.3%
Profit before tax 120 118 -2.0%
Tax 25 20 -19.4%
Minority interest 14 19 40.4%
Profit after tax/(loss) 81 78 -3.7%
Net profit margin (%) 16.2% 16.0%  
No. of shares 11.2 11.2  
Diluted earnings per share (Rs)* 28.9 27.8  
P/E ratio (x)   20.1  
(* annualised)      

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 FY05, GSS has grown its revenues and profits at a CAGR of 39% and 36% respectively.

What has driven performance in 1QFY06?
Products and projects disappoint:  GSS’ 1QFY06 revenues declined by 3% on a QoQ basis. This was the first time after 10 consecutive quarters of sequential growth that the company has reported a sequential decline in revenues. The major reasons for this decline were delays in the completion of a major fixed price project, thereby making it ineligible for revenue recognition, delay in commencement of some new projects and ramp-down of business from one of GSS’ key customers, Powerway.

Segment-wise performance
(Rs m) 4QFY05 Contribution 1QFY06 Contribution Change
Revenues 76 15.2% 69 14.3% -8.4%
PBIT 34 15.2% 26 14.5% -24.2%
PBIT margins 45.1%   37.3%    
Revenues 423 84.8% 416 85.7% -1.6%
PBIT 190 84.8% 152 85.5% -20.0%
PBIT margins 45.0%   36.6%    

The company’s products as well as projects businesses showed a sequential decline in revenues. The product business’ revenues declined by 8% QoQ. The company’s PDM-X and CAD-PDM products registered almost nil revenues, while TekSoft and Geometry components and technologies showed an increase. In the CAD-PDM segment, the company has indicated that building up a product and launching a distribution network is proving to be a challenge and it is making efforts to tie up agreements for such activities and acquiring customers.

As regards projects, there was a 2% QoQ decline witnessed in revenues, for reasons as stated above, relating to delays in completion of a major project and delays in commencement of several new projects, apart from a ramp-down in business from a major client. Employee utilisation, as a consequence, was adversely affected and was down at 80% from 85% in 4QFY05, the lowest in several quarters. At the end of 1QFY06, GSS had 1,275 software developers, an increase of 119 people over 4QFY05. 3D PLM had 385 people on its rolls and while GSS has not given any number, its performance was in line with company expectations. Offshore revenues declined to 59% in 1QFY06 from 60% in 4QFY05, while onsite revenues increased to 27% from 25% last quarter. Products contributed 14% of revenues, down from 15% in 4QFY05. The company added 4 new clients during the quarter. Revenues from industrial customers contributed to over 35% of revenues (35% in 4QFY05).

Salary revisions, unforeseen expenses hammer margins:  A significant increase in employee costs, mainly due to the salary revisions in April and a 217% rise in training costs due to the commencement of the PLM institute had an adverse impact on margins. Unforeseen expenses, such as extensive usage of diesel for the company’s facility in Pune, led to total expenses as a percentage of sales rising from 73.8% in 4QFY05 to 82.8% in 1QFY06. Consequently, margins crashed by as much as 900 basis points. The margins would have taken an even bigger hit, had it not been for the rationalisation of manpower carried out in TekSoft and the growth in the engineering services division (ESD) with lower average salary costs.

Higher other income and lower taxes cushion the fall in profits:  GSS reported a massive 172% QoQ growth in its other income component. This has almost single-handedly cushioned the impact of the lower margins on profits and as a result, the company’s 4% QoQ fall in profits is not as pronounced as the fall at the operating level (down 36% QoQ). However, it should be noted that the reason as to why this has happened is that GSS has changed its accounting policy relating to booking of outstanding forward contracts. From this quarter, the company has shifted to a mark-to-market valuation of forward contracts and as a result, changes in the mark-to-market valuation of outstanding forward contracts will be reflected and booked every quarter. A lower tax outgo also helped profits. The impact of the fringe benefits tax (FBT) was Rs 1.1 m.

Performance in the recent past…
  2QFY05 3QFY05 4QFY05 1QFY06
Sales (QoQ growth, %) 14.1 9.1 14.7 (2.6)
Operating margins (%) 27.8 33.0 26.2 17.2
Profits (QoQ growth, %) 23.9 25.8 1.7 (3.7)
Employee costs (% of sales) 55.4 52.3 53.8 61.3
Onsite revenues (% of sales) 24.0 26.0 24.7 27.0
Employee base (nos.) 872 1,035 1,156 1,275

What to expect?
At the current price of Rs 560, the stock is trading at a price to earnings multiple of 20.1 times its annualised 1QFY06 earnings and 15.3 times our estimated FY06 earnings estimates. This quarter has shown the risks inherent in a company like GSS, when even one delay in any major project can impact revenues and profits negatively. Thus, the company needs to take initiatives on the scalability front and build up resources for the future. Quite clearly, GSS also needs to work on its product strategy, given challenges faced by it during this quarter.

While we believe that the initiatives that GSS is taking to reach the target of US$ 100 m revenues by FY07 are in the right direction, we continue to be cautious on the actual achievability of that target. The engineering services division and the products businesses are expected to play critical roles going forward. Inorganic growth is also an area that the company has on its radar for future growth. The fact that GSS is derisking its business from the OEM customers (65% of revenues) towards industrial customers (35%) is also a move in the right direction.

Given that the projects delayed during 1QFY06 are expected to commence this quarter, we expect the company to start showing traction in volumes, going forward. We had recently recommended a ‘Buy’ on the stock with a target price of Rs 750 in the long-term. From the current levels, this implies an upside of 33.9% point-to-point, or CAGR of around 15.7% by FY07. We maintain our recommendation on the company.

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