Patni offer's worth it

IPO WATCH

Patni Computer Systems' is the largest IPO to hit the markets in 2004 - so far. Based on the price band of Rs 200-230, the issue size will be between Rs 375 and Rs 430 crore.

According to Nasscom, it's the sixth largest player in the software services industry. Besides, the company's growth rate in the last three years has been impressive - revenues grew at an average rate of 36 per cent, and net profit grew at 27 per cent.

But even at the upper end of the price band, the issue is priced at 16.7 times annualised earnings for the nine-month period ended September 30, 2003. This is lower than the FY04 price-earnings ratio for all other IT majors.

In fact, even Satyam Computers, which is valued at a considerable discount to peers, gets a P/E of over 19 times estimated FY04 earnings. It does seem as if the company has left enough money 'on the table' for investors to benefit from listing gains.

But come to think of it, the company's business model is different from that of its peers and this could be one of the reasons for the relatively lower valuations. Patni gets around 42.5 per cent of its revenues from one client - GE - which is known to be a tough customer.

Besides, fixed price contracts account for almost 50 per cent of revenues. Analysts see these two factors as a risk to both revenues and profitability.

The GE factor: GE is known to be a hard bargainer. Both Infosys and Wipro had got out of GE projects because of various reasons including pricing. GE is currently Satyam Computers' largest client, accounting for around 15 per cent of its revenues.

This has, at times, caused some volatility in Satyam's quarterly performance. In Patni's case, the over 40 per cent exposure to GE could cause even more volatility, and this hardly helps, given the markets' obsession with quarterly performances.

For instance, on a sequential comparison, GE revenues had fallen 5.5 per cent in the September quarter and 3.5 per cent in the June quarter for Patni.

Another concern relating to the high exposure to GE is whether the company will have to constantly take price cuts.

According to the company, price cuts taken in the past few years were negligible. Patni has managed this because it has passed on a part of the savings made on fixed price contracts to GE. As GE's cost has been coming down, there has apparently been no need for a lowering of prices.

It's interesting to note that revenues from GE grew just 4 per cent in the nine months till September 30, 2003. But what worked in the company's favour is that other accounts grew revenues 48.9 per cent, leading to an overall growth of 25.8 per cent.

The upshot: dependence on GE has come down. At the end of the March quarter (Q1), GE accounted for 49 per cent of revenues and by the September quarter, the exposure had come down to 37 per cent.

With other clients ramping up (besides possible new clients), this proportion is expected to come down further.

As of now, a huge chunk of GE revenues come from annuity businesses which is expected to continue as in many cases Patni is the either primary or sole supplier for GE. This provides some amount of visibility and stability to Patni's revenue flow.

Fixed price fixation: Revenues from fixed-price contracts (including fixed- price SLAs) accounted for 48.7 per cent of revenues in the nine months till September 30, 2003.

Now, these type of contracts are conditional upon predetermined performance levels, which, if unsatisfactory, could result in less revenues.

Besides, even if there are cost overruns, it would have to be borne by the service provider simply because the price has already been fixed. This could obviously lead to a hit on margins.

But Patni has had few problems with delivery, and it generally gets into a fixed-price agreement only after getting familiar with the work involved and only if the process is at a mature stage.

In such cases, the risk of cost overruns is much lower. Nevertheless, revenue in the case of fixed-price contracts is recognised on a percentage of completion basis, and this could result in volatility in quarterly results.

Margins: Although the company is quick to explain away the rationale for having a high proportion of fixed-price contracts and the low risk with GE, the fact remains that its margins are lower than most of its peers.

In the quarter ended September 30, 2003, Patni's operating margin stood at 19 per cent, compared to 33 per cent for Infosys, 26 per cent for Satyam, and 21 per cent for Wipro.

Interestingly, however, its gross margins are more or less comparable with peers and the reason for the company's lower margins is a high SG&A (selling, general and administration) component.

Patni's SG&A expenses stood at 22.4 per cent of sales in the September quarter, compared to just 14.9 per cent for Infosys and 14.4 per cent for Wipro.

Reason: Patni operates on a subsidiary model for its overseas operations, compared to the branch model adopted by most of its peers.

This involves a higher level of presence in the overseas offices, which obviously shoots up administrative costs. In fact, G&A expenses account for around 14.5 per cent of sales for Patni, compared to a range of 8-10 per cent for peers.

The positive factor is that G&A expenses, unlike selling or direct expenses, do not move in line with sales, and, hence, there is scope for this expense head to come down as a percentage of sales.

But these savings may be offset by higher salary costs, especially since retaining employees have become a challenge lately -- Patni's attrition rate (annualised) was as high as 27 per cent in the September quarter.

And in any case, if some savings remain, the company plans to invest it in additional sales and marketing efforts, which means that net margins can (at best) be expected to remain around current levels.

Earnings growth, therefore, will largely be a function of revenue growth, the outlook for which is good given the increased acceptance of offshore outsourcing.

Valuations: Based on annualised earnings for the nine-month period ended September 30, 2003, the IPO price band values the company between 14.4 to 16.6 times, which is a much lower valuation compared to peers in the sector.

Although the company is confident about its business model despite the high client concentration and the high proportion of fixed- price SLAs, the pricing of the IPO does point to an acknowledgement of the fact that the markets would still be circumspect about these factors. Yet, another way to look at it is that it has left enough money 'on the table'.

If, as expected, the dependence on GE goes down further, and if margins are stable, valuations could be much higher after listing. In any case, unless there is a drastic fall in the markets, the Patni IPO leaves enough room for listing gains.