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Flextronics Software: All-round growth!

Dec 13, 2005

Performance summary
Flextronics Software Solutions (FSS) had announced its consolidated results for the second quarter ended September 2005. During the quarter, FSS reported a strong sequential topline growth, as all the major segments grew at a decent pace. Margin expansion was witnessed due to savings in staff costs. Margin expansion, along with a lower-than-proportionate rise in depreciation charges and a lower effective tax rate, led to an impressive sequential profit growth.

Financial performance (Consolidated): A snapshot
(Rs m) 1QFY06 2QFY06 Change
Sales 1,254 1,464 16.7%
Expenditure 950 1,071 12.7%
Operating profit (EBDIT) 304 393 29.3%
Operating profit margin (%) 24.2% 26.8%
Other income 44 46 4.5%
Depreciation 68 73 7.4%
Profit before tax 280 366 30.7%
Tax 35 40 14.3%
Prior period items - 2
Profit after tax/(loss) 245 324 32.2%
Net profit margin (%) 19.5% 22.1%
No. of shares 34.3 34.8
Diluted earnings per share* (Rs) 28.2 37.2
P/E ratio (x) 18.8
* annualised

Leading telecom solutions provider
FSS, a subsidiary of the Singapore-based electronic manufacturing services provider, Flextronics, is a focused player in the networking and communications related systems software space. As the downturn engulfing the telecom industry worldwide forced the company to broaden its service portfolio, it is now eyeing larger share of revenues from telecom service providers and business process outsourcing (BPO) for future growth. The largest contributor to FSS’ revenues is the services segment (81%), followed by products (15%) and BPO (4%). During the period FY01 to FY05, FSS has grown its revenues and profits at compounded annual growth rates (CAGR) of 25% and 14% respectively, clearly under-performing the industry.

What has driven performance in 2QFY06?
All-round growth: During 2QFY06, all the three major business segments of FSS, namely services, products and BPO, witnessed impressive growth. The services business grew at 12.6% QoQ, the products business saw a scorching 45.9% QoQ jump, while the BPO business witnessed a 16.7% QoQ increase. This all-round growth has come for the first time since 3QFY05 and even in that quarter, overall revenue growth was relatively slow. It should be noted that this follows a lacklustre performance the previous quarter. In fact, prior to this performance, the products business had witnessed two successive quarters of de-growth. Therefore, this growth is, undoubtedly, on a lower base.

Lower staff costs cause margin expansion: Due mainly to lower staff costs as a percentage of total revenues, FSS’ operating margins expanded by as much as 260 basis points. It can be recalled that in the previous quarter, FSS had carried out an upward revision in salaries. This resulted in a 480 basis points margin contraction in 1QFY06. Due to the rise in staff costs having been factored in, margin expansion was helped. As a percentage of revenues, these decreased to 46.4%, compared to 49.8% in 1QFY06. Going forward, any further improvement in FSS’ margins is likely to be led by growth in its product business, revenues from which are margin-accretive. Given the performance in this quarter, if FSS is able to sustain this, margins could witness a further upside.

Cost details…
(Rs m) 1QFY06 % of sales 2QFY06 % of sales Change
Staff cost 625 49.8% 680 46.4% 8.8%
Traveling cost 87 6.9% 72 4.9% -17.2%
Other expenses 221 17.6% 301 20.6% 36.2%
Total cost 933 74.4% 1,053 71.9% 12.9%

Margin expansion sends bottomline soaring: Due to the strong margin expansion witnessed this quarter, the bottomline grew by as much as 32.2% sequentially. This was also aided to an extent by lower depreciation costs as a percentage of revenues. The effective tax rate also reduced to 10.9% (12.5% in 1QFY06), aiding the growth in sequential net profit even further.

Performance in recent times…
3QFY05 4QFY05 1QFY06 2QFY06
Sales growth (%, QoQ) 4.4 6.9 (3.6) 15.5
OPM (%) 27.7 29.0 24.2 26.9
Profits growth (%, QoQ) 7.0 8.7 (18.3) 31.0
Services (QoQ growth, %) 1.8 10.5 (2.5) 12.6
Products (QoQ growth, %) 18.3 (19.6) (11.0) 45.9
BPO (QoQ growth, %) 4.4 5.2 (3.6) 16.7

What to expect?
At the current price of Rs 701, the stock is trading at a price to earnings multiple of 18.8 times annualised 2QFY06 earnings. The improved performance of the company’s products business, where margins are generally higher, is a heartening feature of this quarter’s performance. The services business also saw good traction. The BPO business finally saw good growth in the quarter. This business has been largely lacklustre in recent times. Flextronics has fixed the offer price at Rs 725 per share for the buyback.

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