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Patni Computers: Mixed results

Aug 9, 2005

Introduction to results
Patni Computer Systems (PCS) announced its results for the second quarter of CY05 (the company's financial year ends in December). During 2QCY05, while topline has grown at a healthy rate, mainly led by volume growth, the salary increases carried out during the quarter resulted in a considerable fall in margins. Higher other income and a considerably lower effective tax rate led to the fall in net profit being cushioned to some extent.

Consolidated Financial Performance (US GAAP): A snapshot
(Rs m) 1QCY05 2QCY05 Change
Sales 4,337 4,730 9.1%
Expenditure 3,361 3,900 16.0%
Operating profit (EBDITA) 976 830 -15.0%
Operating profit margin (%) 22.5% 17.5%  
Other income 40 54 34.2%
Depreciation 145 160 10.9%
Profit before tax 872 724 -17.0%
Extraordinary items - -  
Tax 189 102 -46.1%
Profit after tax/(loss) 682 621 -8.9%
Net profit margin (%) 15.7% 13.1%  
No. of shares (m) 134.0 125.0  
Diluted earnings per share* (Rs) 20.4 19.9  
P/E ratio (x)   18.8  
(* annualised)      

What is the company's business?
PCS is India's sixth-largest software services exporter, engaged in providing software solutions and services, domestically and internationally. The company's sphere of offerings includes application development and integration, application maintenance, enterprise application systems, R&D services and business process outsourcing services. PCS has the GE Group as its largest client, with a revenue contribution of 23% to consolidated revenues in 2QCY05. Among verticals, PCS has a substantial presence in the financial services, insurance and manufacturing verticals. The share of revenues from these verticals in 2QCY05 was over 66%.

What has driven performance in 2QCY05?
Volume growth drives revenues:  During 2QCY05, PCS grew revenues at a strong 9% QoQ. This growth was led by an increase in volumes billed. The management has indicated that the pricing environment has remained largely stable during 2QCY05. The telecom vertical has witnessed a strong sequential growth of nearly 20%. The contribution of this vertical has now risen to nearly 15% of revenues. Cymbal, a US-based telecom software service provider, that was acquired by Patni, seems to be showing good traction. Manufacturing and the product engineering practice have also witnessed good traction, growing sequentially by 12% and 22% respectively. During 2QCFY05, revenue contribution from GE declined as a percentage of total revenues from 24.9% in 1QCY05 and 33.4% in 2QCY04 to 23.0% during the current quarter. Clearly, the trend is similar across companies, like TCS, where the contribution of a single key client (in this case, GE) has reduced, revenues have remained largely stable and the contribution of other clients has risen.

Higher employee costs impact margins:  During 2QCY05, Patni, like numerous other software companies, carried out an upward revision in salaries of its employees. The offshore salaries increased by an average of 17%, while for onsite salaries, it was 4%. This has impacted margins adversely. Margins fell by 500 basis points during the quarter. Cost of revenues as a percentage of sales rose to 63.6% in 2QCY05 from 58.0% during the previous quarter. However, leverage on the SG&A front (including salaries), which reduced as a percentage of sales from 19.5% in 1QCY05 to 19.0% this quarter, has helped pare the margin decline to an extent.

Other income cushions fall in bottomline:  PCS' other income component rose by 34%, which has helped reduce the impact of the lower margins on the net profit. In fact, the company managed to increase other income despite a loss on the foreign exchange front, due to the impact of rupee appreciation against the Euro and Pound. A considerably lower effective tax rate, down to 14.1% from 21.7% in 1QCY05, has also helped mitigate the impact of the lower margins and net profit, as a result, was down by 9% QoQ.

Performance in the recent pastů
  3QCY04 4QCY04 1QCY05 2QCY05
Sales growth (%, QoQ) 2.7% 6.5% 8.1% 9.1%
EBIDTA margins (%) 24.7% 23.0% 22.5% 17.5%
Profit growth (%, QoQ) 12.2% 4.4% -5.8% -8.9%

What to expect?
At the current market price of Rs 373, the stock is trading at a price to earnings multiple of 18.8 times annualised 2QCY05 earnings. This is at the higher end of the valuation spectrum, given the valuations at which its peers like Satyam and HCL Technologies are trading. This is considerably lower than the valuations at which its top-rung peers Infosys, TCS and Wipro trade.

PCS continues to earn a large proportion of its revenues from the US. This was around 85.3% during 2QCY05, which is considerably higher than the extent to which peers like Infosys and Satyam depend on the US markets. As such, the company faces considerable risk to its business and profitability if any adverse development affects the US markets. This higher risk also seems to have been factored into the stock and thus, companies with a greater degree of diversification in terms of tapping a greater number of markets for business have enjoyed a higher valuation. It must also be noted that the company's operating margins and net profit margins are considerably lower than those of its peers.

Overall, given various operating metrics in comparison with its peers, we believe that there are better stocks to choose from in the software sector.

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