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Geometric Software: Scaling up for the future!

Oct 17, 2006

Performance summary
Geometric Software Solutions (GSS), announced its consolidated results for the second quarter and half-year ended September 2006 late yesterday evening. The company has recorded a strong growth in its topline during the quarter, which was a result of good traction in its major business lines. However, due to considerably higher costs and lower utilisation rates, margins saw a contraction, and operating profits were lower in absolute terms on a sequential basis. However, despite the lower margins, higher other income and a lower effective tax rate led to a strong sequential growth in net profit for the quarter. For the half-year, the performance has been good.

Financial performance (Consolidated): A snapshot…
(Rs m) 1QFY07 2QFY07 Change 1HFY06 1HFY07 Change
Net sales 721 800 10.9% 996 1,521 52.6%
Expenditure 558 649 16.4% 815 1,207 48.0%
Operating profit (EBDIT) 163 151 -7.7% 181 314 73.4%
Operating profit margin (%) 22.6% 18.8%   18.2% 20.6%  
Other income (29) 29   69 (0)  
Interest - -   0 - -100.0%
Depreciation 49 50 1.2% 77 99 27.8%
Profit before tax 85 130 53.0% 172 214 24.4%
Tax 10 14 38.0% 28 24 -16.0%
Minority interest 11 15 32.9% 32 26 -18.7%
Profit after tax/(loss) 63 101 59.0% 112 164 47.0%
Net profit margin (%) 8.8% 12.6%   11.2% 10.8%  
No. of shares (m) 60.7 61.0   56.3 61.0  
Diluted earnings per share (Rs)*         5.1  
P/E ratio (x)*         22.7  
*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 2QFY07?
Topline traction continues: During 2QFY07, GSS recorded a strong 10.9% QoQ growth in its topline. This was driven by continued strong growth in most of its business segments. While the projects business grew at a strong 12.1% QoQ, the products business saw a more sedate 3.8% QoQ growth.

In the projects business, GSS’ PLM Solutions business unit continued to record a good performance, as industrial customers ramped up business, while revenues from partners/software OEMs also witnessed an up-tick. The company won 2 major new customers during the quarter, and will start executing these projects from the early part of 3QFY07. The Product Development Services unit also saw good traction, as did Enterprise Products, which won a Formula 1 major in Europe as a customer, apart from a Japanese auto major and a major PLM vendor.

The Engineering Services business also grew at a steady pace of 22.6% QoQ in dollar terms and 24.0% QoQ in rupee terms, adding several new customers, including a large auto OEM and an automotive tier-1 supplier. GSS’ strategy of working more with industrial partners than OEMs continues to bear fruit. Revenues from industrial partners as a percentage of sales increased to 47% in 2QFY07 (45% in 1QFY07 and 35% in 2QFY06). The contribution from software OEMs like UGS and Dassault Systemes was 40%.

GSS this quarter acquired the engineering services unit of Modern Engineering for a consideration of US$ 32 m, including US$ 7 m in working capital loans. Modern Engineering is a US-based company with US$ 40 m in revenues, and the objective is to create a global engineering solutions provider with an expansive services portfolio. GSS now is one of the few companies globally to have strong capabilities in both PLM solutions as well as integrated engineering solutions, and the company’s objective of becoming an end-to-end PLM solutions provider has now been considerably enhanced. GSS is focussing on the ES space as a method of de-risking its revenues away from PLM services. While the growth potential in ES is undoubtedly 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. Nonetheless, given its strong focus on this domain, we believe that it will be a strong differentiator for the company in future.

Segment wise performance…
(Rs m) 1QFY07 Contribution 2QFY07 Contribution Change
Revenues 102 14.1% 106 13.2% 3.8%
PBIT 53 18.1% 54 17.6% 2.9%
PBIT margins 51.7%   51.3%   -0.4%
Revenues 619 85.9% 694 86.8% 12.1%
PBIT 238 81.9% 253 82.4% 6.3%
PBIT margins 38.5%   36.5%   -2.0%

As regards employees, the net hiring was 237 this quarter, which is the highest in quite a few quarters. The utilisation rate as a result decreased from 91% in 1QFY07 to 87% this quarter (including trainees). The company has once again this quarter faced resource constraints and has clearly mentioned that it has had to leave some revenues on the table due to lack of adequate manpower to staff those projects. The attrition rate (annualised) stands at 22.9% for the quarter, clearly a concern. Given the fact that GSS requires specialised talent, since it operates in a niche domain, higher attrition rates will clearly hamper the company’s ability to execute effectively, which is a risk that has always been associated with the company in the past. Nonetheless, GSS has stated that it expects the utilisation rates to dip further in the near-term, as it makes efforts to build a strong bench in order to adequately staff itself to win more business. At the end of 2QFY07, GSS had 1,761 software developers on its rolls. 3D PLM (JV with Dassault) had 500 people on its rolls, an addition of 25 people from 1QFY07.

Higher costs pressurise margins: Due to considerably higher costs, particularly software development costs, travel and communication costs incurred this quarter, GSS saw a significant 381 basis points fall in its operating margins. In fact, even in absolute terms, operating profits fell by 7.7% QoQ. The management has indicated that it intends to focus on SG&A costs and software development costs as 2 areas where it believes it can control costs better going forward.

Higher other income, lower taxes power profits: Despite the lower margins this quarter, higher other income to the tune of Rs 28.9 m (loss of Rs 29.3 m last quarter) and a lower effective tax rate led to a strong 59.0% QoQ growth in net profits. The higher other income was mainly due to a gain on forex fluctuations to the tune of Rs 9.3 m, as compared to a loss of Rs 45.2 m in 1QFY07.

Performance in the recent past…
  3QFY06 4QFY06 1QFY07 2QFY07
Sales (QoQ growth, %) 17.4 6.7 12.8 10.9
Operating margins (%) 25.2 25.3 22.6 18.8
Profits (QoQ growth, %) 16.2 171.2 (40.5) 59.0
Employee costs (% of sales) 52.4 53.2 56.5 57.9
Employee base (nos.) 1,374 1,441 1,524 1,761

What to expect?
At the current price of Rs 115, the stock is trading at a price-to-earnings multiple of 13.5 times our estimated FY08 EPS. This quarter, the company, as we mentioned above, has acquired the engineering services unit of Modern Engineering of the US. This company is based in Detroit, and has customers such as General Motors, Ford, DaimlerChrysler, Honda, Nissan and Caterpillar. This move will enable GSS to achieve its vision of becoming an end-to-end PLM solutions provider, and will give it strong domain knowledge, a presence in a greater number of geographies, access to a blue-chip client base and greater scale.

The company has appointed Dr. Ravi Gopinath as the Managing Director and CEO of the company for a period of 3 years effective October 4, 2006, while Mr. Manu Parpia has been re-designated as Vice-Chairman and Executive Director. Dr. Gopinath was previously heading the Engineering and Industrial Services division of TCS.

However, resource fulfillment issues continue to impact GSS, as mentioned above. The company has clearly said that this is a matter of concern, and given the niche nature of GSS’ business, it will more likely be more difficult for the company to find talented and adequately qualified people with the necessary domain knowledge in this business as compared to companies like Infosys or TCS.

Going forward, given the niche nature of GSS’ business and initiatives like creating 5 business units with bottomline responsibility, and the renewed focus on the ES space with the acquisition, 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. We will shortly re-visit our number for GSS following the company’s acquisition of Modern.

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