Reaching Out

Pound Wise: Hughes Software Systems

Hughes Software's recent initiatives to de-risk its business could adversely impact its performance over the next few quarters

Hughes Software Systems (HSS) has been in a restructuring mode for some time now. The reason being the unprecedented slowdown in the telecom industry globally.

Given the sharp drop in spending by telecom equipment manufacturers (which contributed to over 80 per cent of Hughes' topline last fiscal), Hughes was left with no option but to diversify its revenue stream.

For Hughes, the most obvious choice was to shift its focus to telecom service providers (TSP). And rightly so, as the $11 billion TSP segment has a high growth potential -- estimated to grow at a CAGR of 20 per cent over the next couple of years.

Moreover, this move will expand the breadth of services offered by the company, while maintaining the core positioning within the design and consulting of network elements. Consequently, the company decided to foray into areas of product support, maintenance and testing of communication networks in the last fiscal.

This was closely followed by the announcement to tap the opportunity in the IT-enabled services or business process outsourcing(BPO) business. In BPO, the company aims to leverage its domain expertise by providing technical support to clients. It has already made some headway, acquiring an order from its parent Hughes Network Systems' (HNS) Direcway product line.

These initiatives, though reactive rather than proactive in nature, are seen as positive steps aimed at arresting the continued declining trend in the company's core business.

However, the latest announcement to diversify into an industry other than telecom domain has come as an unpleasant surprise. Predictably so, as the company intends to foray into the already crowded banking, financial services and insurance (BFSI) industry space.

Long way to go: In spite of the argument that the company had little choice but to diversify into other industry domains due to the continued squeeze on spending in the telecom space, analysts don't seem to be very comfortable with the management's decision.

There is a general feeling that the diversification into BFSI will dilute the company's niche positioning. Besides, it may also require some radical reorganisation.

Although the spending in the BFSI vertical is arguably the highest and the fastest growing among IT domains, competition is also very intense, especially among Indian companies. In addition to frontline companies like TCS, Infosys, Satyam and Wipro, many second-rung companies like Polaris and i-flex have well-established relationships in this space.

"It is a difficult situation for Hughes as the BFSI vertical is highly competitive. Especially since the existing players have a proven track records, giving them an edge over any new entrant," points out Hrishi Modi, senior investment analyst, Ask-Raymond James Securities.

So the only way Hughes can gain a toehold in the BFSI business is to make a sizeable acquisition. This, however, will not be easy with just around $20 million (Rs 94 crore) in cash that the company has on its balance sheet. Besides, the target company will probably drive a hard bargain from someone like Hughes (a telecom software company) in the current business environment.

Apart from this, the initiatives to de-risk its business by diversification effectively puts the company on an investment mode. While the new ventures will take some time before they start adding to the bottom line, but it will clearly put pressure on the margins in the intermediate term.

Financials: After the disappointing first-quarter results, the company recorded growth in all business segments: HNS (2.8 per cent), non-HNS (17.4 per cent) and products (5.5 per cent), leading to a 9.9 per cent sequentil growth in topline to Rs 52.1 crore.

The topline growth was aided by the expansion of business with large non-HNS clients like Nokia and NEC, and repeat business from Johnson Controls, SS8 and Leapstone.

But the highlight of the second quarter results was the 10.7 per cent expansion in the company's operating margins to 19.4 per cent. The jump in the margins was largely due to the 400 basis points improvement in employee utilisation to 84 per cent.

This was achieved by the reduction of employee strength by 46 professional as part of its rationalisation programme. This apart, the provisioning for bad and doubtful debts was much lower at Rs 1 crore as compared to Rs 4.6 crore in the previous quarter.

Consequently, net profits vaulted by 86 per cent to Rs 8.3 crore. But it should be noted that the jump in net profits has been primarily due to change in the accounting policy for research and product development expenses.

The company wrote-off only Rs 0.7 crore as compared to R 4.2 crore capitalised in the current quarter. Without the change in accounting policy, the operational expenses would have been higher by Rs 3.5 crore.

Apart from this, debtor days remain high at 130 days, with 6 per cent of debtors above 180 days and 26 per cent of the receivables coming from tier-2 customers.

Moreover, there haven't been a significant addition to the order book, despite the impressive client acquisition in the last quarter. It added 13 new clients, 11 in services and 2 in products business. But the order backlog increased marginally to $12.5 million as compared to $11.8 million reported in the previous quarter.

Outlook: Going forward, the management has indicated a sequential growth of 10 per cent for the current quarter. This is again expected to be achieved on the back of a growth in the non-HNS business, while HNS business will more or less remain flat.

Not surprisingly, since the company has added 11 new non-HNS clients in the services segment in the last quarter. Products revenues will continue to remain volatile.

However, despite the early signs of revival, the company is not expected to meet its guidance of 15 per cent growth in revenues and net margins of 25 per cent in FY03 (It was actually not re-iterated by the company in the recent conference call).

More so, as the new initiatives are not expected to add to the growth in bottom line in the near future. "These new initiatives will take 6-8 quarters to break-even but the associated costs will be reflected in the books during the gestation period also. Thus, it is going to be tough next few quarters," feels Sohini Andani, research analyst at LKP Shares and Securities.

But the product business can provide some surprises. In fact, the recent surge in the Hughes scrip was triggered by the possibility of it bagging orders in the products segment. At the current price of Rs 197 the scrip trades at 16.8 times its FY03 estimated earnings.