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Geometric Software: Calculations gone awry! - Views on News from Equitymaster
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Geometric Software: Calculations gone awry!
Oct 22, 2005

Introduction to results
Geometric Software Solutions (GSS) announced its consolidated results for the second quarter and half-year ending September 2005 late yesterday. The company has shown a slow growth in revenues for the quarter, due to issues such as delayed ramp up of projects. This is the second successive quarter that GSS has faced this problem. Due to lower expenses because of lower hiring carried out this quarter, margins saw an expansion of 190 basis points. However, considerably lower other income due to a mark-to-market loss on outstanding forward contracts has badly hit the net profit. This performance is in the context of the management giving a second profit warning earlier this month. The performance in the half-year has been decent on the revenue front, but bottomline has been uninspiring.

Financial performance (Consolidated): A snapshot…
(Rs m) 1QFY06 2QFY06 Change 1HFY05 1HFY06 Change
Net sales 486 510 5.0% 748 996 33.2%
Expenditure 403 413 2.5% 556 815 46.7%
Operating profit (EBDIT) 83 98 17.1% 192 181 -5.8%
Operating profit margin (%) 17.2% 19.1%   25.7% 18.2%  
Other income 71 (2) -102.5% 30 69 128.1%
Interest 0 0 -6.3% 0 0 933.3%
Depreciation 37 41 11.7% 59 77 30.7%
Profit before tax 118 55 -53.4% 163 172 5.6%
Tax 20 8 -61.8% 29 28 -2.6%
Minority interest 19 13 -31.5% 20 32 62.3%
Profit after tax/(loss) 78 34 -56.6% 114 112 -2.2%
Net profit margin (%) 16.0% 6.6%   15.3% 11.2%  
No. of shares 56.3 56.3   55.3 56.3  
Diluted earnings per share (Rs)* 5.5 2.4   4.1 4.0  
P/E ratio (x)         21.9  
(* 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 2QFY06?
A sense of déjà vu: In 2QFY06, GSS’ revenues grew at a slow rate of 5.0% sequentially. Once again, the pressure faced by the company has been similar as compared to the previous quarter, with projects that were scheduled to start earlier having been delayed. GSS also did not anticipate certain changes in the business environment, such as a slowdown in the auto sector in some countries, holidays in Europe and changes in a few customers’ organizational structure. Due to these factors, the starting date for numerous projects has got postponed, leading to an adverse impact on revenues. It should be noted that the automotive sector is a key vertical on which GSS is highly dependent and as a result of the above-mentioned factors, revenue growth was a lot slower than originally anticipated.

Segment-wise performance
(Rs m) 1QFY06 Contribution 2QFY06 Contribution Change
Products
Revenues 69 14.3% 75 14.7% 8.0%
PBIT 26 14.5% 33 17.7% 28.8%
PBIT margins 37.3%   44.5%    
Projects
Revenues 416 85.7% 435 85.3% 4.5%
PBIT 152 85.5% 155 82.3% 1.7%
PBIT margins 36.6%   35.6%    

The company’s products business grew at 8.0% sequentially. TekSoft revenues declined slightly, as the effects of Hurricane Katrina/Rita eroded business confidence to some extent in the key US market. Thus, GSS’ other product lines, such as eDrawings and component technologies have managed to see some growth in 2QFY06. GSS continues to face problems in getting a distribution set-up in place for its CAD-PDM product, which was a problem faced by the company is the previous quarter as well. GSS has stated in its analyst note that it is working to get alignment between partners over the next sixty days.

Project revenues grew by 4.5% sequentially and this, as stated above, was due to reasons such as delayed ramp ups, slowdown in the auto sector in some countries and holidays in Europe. The employee hiring was just a net of 41 this quarter, the slowest in recent times, reflecting the poor performance of the company due to reasons as mentioned above. Utilisation rates were down at 76% compared to 80% in 1QFY06, the lowest in several quarters. At the end of 2QFY06, GSS had 1,316 software developers. 3D PLM had 400 people on its rolls, an addition of 15 people from 1QFY06. GSS has said that the growth of 3D PLM is in line with its expectations. Offshore revenues grew from 59% in 1QFY06 to 60% in 2QFY06, while onsite revenues decreased to 26% from 27% last quarter. Products contributed 15% of revenues, up from 14% in 1QFY06. The company added 5 new clients during the quarter. Revenues from industrial customers continue to contribute over 35% of revenues (35% in 1QFY06).

Lower costs help margin expansion: Due to considerably lower hiring carried out during the quarter, salary costs reduced as a percentage of revenues from 61.3% in 1QFY06 to 58.6% this quarter. This was the major reason for the margin expansion of 190 basis points. This has arrested a slide in margins during the last 2 quarters, from 33.0% in 3QFY05 to 17.2% last quarter. The salary revisions in 1QFY06 have also been factored in. It should be noted that although margin expansion was witnessed, the kind of hiring carried out during the quarter does not enthuse much confidence. Clearly, the delays in ramp ups have adversely affected GSS and as a result, it is not expected to make up the lost revenues during the latter half of the year, despite not having lost any orders as such.

Lower other income pounds profits: GSS’ other income was negative this quarter, due mainly to mark-to-market losses on its outstanding forward contracts. It can be recalled that the company had, in 1QFY06, changed its accounting policy relating to booking of outstanding forward contracts and changes in the mark-to-market valuation of outstanding forward contracts will be reflected and booked every quarter. This quarter, GSS recorded a loss of Rs 13.8 m on this count, compared to a profit of Rs 60.3 m last quarter. This was the major reason as to why the company was badly hit on the profit front, which fell by as much as 56.6% QoQ. The effective tax rate fell from 17.4% in 1QFY06 to 14.3% this quarter. This was because of an increase in profits from some of its units that continue to enjoy a tax holiday. GSS expects the average tax rate to revert back to the 1QFY06 levels. The effect of the fringe benefits tax (FBT) was Rs 2.1 m.

Performance in the recent past…
  3QFY05 4QFY05 1QFY06 2QFY06
Sales (QoQ growth, %) 9.1 14.7 (2.6) 5.0
Operating margins (%) 33.0 26.2 17.2 19.1
Profits (QoQ growth, %) 25.8 1.7 (3.7) (56.6)
Employee costs (% of sales) 52.3 53.8 61.3 58.6
Onsite revenues (% of sales) 26.0 24.7 27.0 26.0
Employee base (nos.) 1,035 1,156 1,275 1,316

What to expect?
At the current price of Rs 86, the stock is trading at a price to earnings multiple of 7.2 times our estimated FY08 earnings. This has been the second successive quarter in which GSS’ management has given a profit warning and the company’s performance has been severely impacted. This clearly reflects 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.

The events of the past few months have prompted us to revise downwards our revenue and profit estimates. Investors considering an entry into the stock will have to contend with additional volatility risk, something that we have mentioned regularly in past analysis of the company as well.

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 find it very difficult to believe that the company will actually achieve 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.

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