High client concentration
The company’s over-dependence on few clients is a worrying factor

Patni Computer Systems (Patni), India’s sixth largest software exporter, is entering the capital markets with its Initial Public Offering (IPO). It has opted for the 100% book-building method. Patni is offering 1.87-crore equity shares comprising a fresh issue of 1.34 crore equity shares and an offer for sale of 53 lakh equity shares of Rs 2 each. Offerors are promoters (37 lakh shares) and GE Capital Mauritius Equity Investment (16 lakh shares). The proceeds from the issue will be used for strategic initiatives, increasing sales, marketing and promotional activities and general corporate purposes.

Patni derives about 60% of its revenues from just two clients, The GE group and State Farm Insurance. While in FY 2001, FY 2002 and the nine months ended September 2003, the GE group accounted for 56.8%, 50.7% and 42.5% of the total sales, State Farm Insurance accounted for 11.5%, 16.0% and 17.4% during the same period. This is in stark contrast with the client profiles of other major Indian software companies. For instance, top client for Satyam Computer accounted for 12.9% of its revenues in the December 2003 quarter and the same stood 5.5% for Infosys.

High dependence on a single client exposes Patni to a significant risk of revenues and pricing pressure. History suggests that a few of the large companies have had bitter experiences with the GE Group on the pricing front. Till now the company had kept employee costs under check and this should have helped it to earn decent margins in spite of lower rates. Being a closely-held company also must have facilitated this. We will have to see how the company manages the pressure from employees for higher salaries and from investors for consistent quarter-on-quarter (q-on-q) growth in earnings in the face of pressure from large clients to keep the rates at lower levels. The company has neither revealed its average rates in prospectus nor it wants to reveal that separately, even though IT companies generally share this information routinely.

Patni has been one of the worst paymasters in the industry. This has resulted in higher attrition rate (also probably the highest in the industry). To contain the attrition rate, the company has already given a handsome (again probably the highest in the industry) rise in salary to the employees after April 2003. Even then, the wage levels stand below industry peers.

The impact of the hike in salary is already telling on its operating profit margin (OPM). Patni’s OPM crashed from 24% to 17.7% for the nine months ended September 2003, compared to the same period last year. This is against an OPM of 26.8% for Satyam and 32.9% for Infosys.

Patni also faces higher risk in the form of business contracts. Its fixed price contracts accounted for as high as 48.7% of its total business in the nine month ended September 2003. In fixed-price service level agreements (SLA) revenues are conditional upon predetermined performance levels. If the same is unsatisfactory, it could result in lower-than-anticipated revenue and profit.

Patni also faces a geographical risk. For the nine-months period ended September 2003, it derived as much as 88.9% of its revenues from the US alone. This is against 72.2% for Infosys, and 73.5% for Satyam and 41.1% for Polaris, 80% for Mphasis and 54% for Wipro.

Nevertheless, Patni’s proven capacity to manage large clients, delivery excellence, domain expertise (in insurance, financial services and manufacturing industries) and referrals will serve it in good stead in the emerging era of large outsourcing deals. The company has also over the past few years invested heavily in selling and distribution, which should help it expand its client and geographical profiles.

The price range of Rs 200-Rs 230 discounts the nine-month annualised EPS (of Rs 14.1) 14.2 and 16.3 times. This compares favourably with P/E (on nine-month annualised EPS) of 30 for Infosys, 21 for Satyam and 42 for Wipro. It is also lower than the P/Es of many other reputed medium-sized companies. However, while other companies are showing year-on-year earnings growth of above 20%, Patni’s nine-month net profit is down 2%.

The Indian software export industry has surely bottomed out and is poised for consistent growth. While volume growth had never been a problem, rates have also stabilised and Indian offshore outsourcing story is now well-accepted. Patni has the capacity to capitalise on this opportunity in the long run. However, in the short run, its capacity to post decent earnings growth will be constrained by its over dependence on few clients and salary pressures.