Hughes Software Systems: Hold/Buy on declines

Recommendation: Hold/Buy on declines

Krishnan Thiagarajan

HUGHES Software Systems is one of the few product-cum-service focussed software companies in the country today.

Focussed primarily as a `convergence play'-- based on the growing integration of voice, data and video and its simultaneous transmission over communication networks -- Hughes has positioned itself as a key player in the high growth segment of telecommunication technologies.

The driving force behind the communications revolution has been the increasing role of `software' in communication facilities and equipment. As a company which has graduated from software services to products, Hughes has carved a niche for itself as a software solutions provider to equipment vendors, service providers and systems integrators in the communications industry.

Since its initial public offering of equity in October 1999 of 8.75 lakh equity shares at Rs 630, Hughes Software has grown from strength to strength, expanding its product portfolio and service offerings, increasing its market reach and reporting a sound financial performance. Even before its IPO, the company's financial record was extremely good.

Between 1992-93 and 1998-99, the company recorded a compounded annual growth rate of 51 per cent and 65 per cent in revenues and post-tax earnings respectively. At the current market price of Rs 1,095.75 (after giving effect to a two-for-one stock split), the stock trades at a price-earnings multiple of 81 times its annualised 2000-01 earnings. The stock was first listed at the BSE at Rs 1,600 on November 11, 1999.

Competitive strengths

The strong points of Hughes Software are:

The `Hughes' affiliation: As a company promoted by Hughes Electronics Corporation (a wholly-owned subsidiary of General Motors Corporation, US) through its subsidiaries, Hughes will continue to derive the strength of the parent's brand name, domain expertise in communication technologies and outsourcing contracts to Indian offshore development centres.

Starting off as a software development service provider for Hughes Network Systems (HNS), US -- a division of Hughes Electronics Corporation -- Hughes has consciously reduced its dependence on its overseas parent. At the time of the IPO, in October 1999, HNS accounted for around 74 per cent of Hughes revenues, down from 100 per cent in 1995.

Hughes has been largely successful in its commitment to broadbase its revenue profile. For the first six months ended September 30, 2000, HNS accounted for 39 per cent of Hughes' revenues of Rs 80.20 crore, down sharply from 67 per cent in the corresponding previous period. During this period, the contribution of non-HNS clients rose to 34 per cent from 23 per cent in the previous year.

Enhanced product offerings: With the high level of expertise gained in communication technologies by providing software development services for HNS from 1992, Hughes consciously gravitated towards product development in late 1997. At the time of the IPO, Hughes had developed four products sold under the names -- ProtoQuick, IntelliQuick, MultiQuick and SwiftBill.

In the combined domain of telecommunications and information technology, the four key high growth areas are Internet, Voice-over-IP, wireless access and broadband. Of these, the Hughes product portfolio is fully focussed on offering solutions in the first three areas.

In Voice-over-IP, Hughes has launched a slew of standards-based protocol stacks and components under the MultiQuick series, to become a `one-stop-shop' for VoIP products. Similarly, in the wireless network arena, it has developed the protocol stack developed under the ProtoQuick series, and intelligent networking and service nodes under the IntelliQuick series. In the Internet/e-commerce arena, Hughes has developed two products, SwiftBill -- an electronic bill presentation and payment solution -- and RightServe -- which provides targeted Web banner advertising services using the Application Service Provider model.

From a services player, Hughes is consciously shifting to products. According to the Hughes strategy, product development is expected to make them a long-term and sustaining player, achieving high profitability and high per employee revenues, thereby maximising the shareholder value. In response to a question on revenue mix, the president and managing director, Mr Arun Kumar, in a recent interview to Business Line , said: ``Fundamentally, we are seeing the revenue mix shifting two years from now to 50 per cent from products and 50 per cent from services.''

This shift is also evident from the revenue break-up in the first six months of 2000-01. Products contributed 27 per cent of Hughes revenues, up from 10 per cent in the corresponding previous period.

Outsourcing strength: By virtue of setting up its offshore software development centres in India, Hughes is well-positioned to capitalise on the software outsourcing opportunities emerging in the rest of the world. As equipment vendors, systems integrators and service providers in the communications industry are increasingly relying on third party software services, the opportunities for growth for Hughes are immense. As skilled manpower is available in India at affordable costs, Hughes has the advantage of offering `competitively'-priced offshore solutions to Fortune 1000 companies.

Hughes is also well-positioned to exploit the synergies of the product-cum-services model. For instance, the product expertise gained by Hughes was largely through domain expertise acquired in software development. By undertaking fixed-price projects rather than time and material contracts, Hughes used the experience gained in full life-cycle projects starting from problem definition, system design, implementation, testing, delivery and finally to post sales support in product development. Similarly, it is reducing the development time and cost for software projects by reusing development tools and modules developed when creating new products.

Business risks

The key risk areas for Hughes are:

Client concentration: All efforts by Hughes to broadbase its client profile still does not detract from the fact that its dependence on a single client -- HNS -- is still high. The contribution to this one client at 54 per cent for the year-ended March 31, 2000, was significantly higher than 10 per cent for Wipro and 7.2 per cent for Infosys Technologies.

Given that growth stocks have low tolerance for revenue and earnings disappointment (as Mastek discovered recently when AT&T, one of its key clients, cut down its outsourcing work to the company), any slowdown in software development projects from HNS can work to the detriment of Hughes. Though HNS' contribution is down to 39 per cent in the first six months ended September 30, 2000, it is still considerably higher than its pure frontline software service peers such as Infosys and Wipro.

Product model: The product model (which is being combined with the services model) is a high-risk-high-growth strategy and investors ought to be conscious of the risks involved. Although in a product model, the payoffs (particularly in the high-growth communications industry) can be fairly large, it also requires a constant monitoring of the demand for the communications products developed by Hughes.

However, Hughes has evolved a risk-mitigation strategy. According to the IPO offer document, product development at Hughes begins only after a product idea has been carefully evaluated on a 12-point scale, equally weighted between business attractiveness and organisational capabilities. For this purpose, Hughes has created three councils -- technology, product and marketing -- to evaluate, allocate resources and de-risk product ideas.

The product development is based on a three-stage process of building components, sub-systems and complete systems. Through the phased development, Hughes has the prospect of recovering its investments through any of these stages. Similarly, it is also mitigating its risks by working on its products across different emerging standards, thereby broadbasing its overall market opportunity. Though working on a single standard may offer higher payoffs if it succeeds, working on different standards may lower pay-offs, but also reduce risks, as varying standards will expand the market opportunity through inter-operability with different equipment and software developed by different vendors.

Investment recommendation

At the current price earnings multiple (PEM) of 81 times, Hughes valuation is in line with that of pure frontline software service companies. As a product-cum-service company, the stock is expected to be re-rated to a higher PEM. Given the immense opportunities opening up in the communications industry, the Hughes tag and the depth of the product range, investment can be considered in this stock at the current price levels.

It appears that the sharp rise in travelling and conveyance and other expenditure (probably marketing expenses) trimmed the operating profit margins by around 3.15 percentage points in the first half of 2000-01 to 32.2 per cent over the corresponding previous period. Though this may be a cause for concern in the near term, as the contribution of products in the total revenues goes up and its market reach spans Europe and Asia (in addition to the US), the margins may improve again. Investors can use price weaknesses, triggered by an overall market decline, to take exposure in the stock.