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Research meeting extracts: Hughes Software - Views on News from Equitymaster
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Research meeting extracts: Hughes Software
Sep 28, 2004

We recently had a research meeting with Hughes Software Services (HSS), the leading player in the networking and communication related systems software space. The focus of the meeting was to understand the company’s future growth prospects. Following are the excerpts of the meeting.

Background
HSS, a subsidiary of the Singapore-based electronic manufacturing services provider, Flextronics, is a focused player in networking and communications related systems software. While the downturn engulfing the telecom industry worldwide forced HSS to broaden its service portfolio, the company is now eyeing larger share of revenues from the telecom service providers, business process outsourcing and the financial services industry for future growth. The largest contributor to HSS’ revenues is the services segment (81% contribution), followed by products (15%) and BPO (4%).

Key impressions from the research meeting
Addressable market: As per TIA’s (Telecommunications Industry Association) Telecommunications Market Review and Forecast (2002) report, the CTI (computer telephony integration) system software and hardware market is expected to grow at a 21% CAGR through the 2001-2005, to reach nearly U$ 1.4 bn in 2005. This presents HSS a huge opportunity to grow going forward.

On Flextronics: The management has indicated that since Flextronics acquired HSS only a few months back, things are still being worked out. However, HSS is looking at various options. There are a number of areas where there are synergies. While HSS could go to Flextronics’ clients with its offerings, the latter itself could be a very large client for the company.

Sales: The management expects FY04 revenues to grow YoY by around 30%-35%. This forecast seems to be based on strong growth momentum from the non-HNS (Hughes Network Systems – the erstwhile parent) and product segments. HSS is especially expecting strong demand from the Voice over Internet Protocol (VoIP) technology space and this is the area where the company is likely to have most of its product and service offerings. As a matter of fact, the management has indicated that capex towards telecom infrastructure has improved from what has been seen in the last three years. This will provide Hughes the potential to grow its business going forward. HSS is currently seeing volume growth both from existing and new clients. However, the overall outlook looks cautious. We have maintained our CAGR for sales at 31% for the period FY04-07. Apart from BPO (83% CAGR), the fastest growing segment is likely to be the non-HNS services segment (33% CAGR). CAGR for products is expected to be 20% over this period.

Margins: While the management has not been specific with regard to the company’s margins going forward, we believe that continued investment towards R&D, and sales/marketing infrastructure is likely to affect margins. From FY04 levels of 27.8%, we expect margins to decline to 26.5% in FY05 and 23.8% by FY07. However, any further upside in revenues from the products segment is likely to help Hughes in paring this decline in margins. The management expects profits to grow by 33%-37% YoY in FY05.

Conclusion
Based on our inferences from the research meeting, we have maintained HSS’ expected FY05 and FY06 EPS at Rs 29.5 and Rs 36.0 respectively. At the current price of Rs 584, the stock is trading at a P/E multiple of 16.2x FY06 expected EPS, which is at the higher end of the valuation spectrum.

Considering that there could be synergies between HSS and Flextronics, a shareholder could stay put in the stock believing that revenue growth could be faster in the future. However, since there has not been any committed business from Flextronics, there is uncertainty on this front. Also, as we have seen in the past that MNCs have delisted their subsidiaries from the Indian stock exchanges, Flextronics’ might do the same with Hughes.

On the performance front, HSS’ growth has been very volatile in the past and, as such, it becomes all the more difficult to believe the management’s projections for growth in FY05. Also, the global telecom spending is yet to attain some sustainability and, to that extent, investors need to exercise caution. From the current levels, we expect HSS' stock to return 33% by FY07, a CAGR of 10%.

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