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Satyam: All’s well, but…
Jan 19, 2007

Performance summary
India’s fourth largest software services firm, Satyam, has announced mixed results for the third quarter and nine-months ended December 2006. For 3QFY07, while revenues have grown by 4% QoQ, net profits are up 5% QoQ. The bottomline has benefited from the 210 basis points (2.1%) expansion in operating margins during the quarter, which has been a consequence of lower employee costs (as a percentage of sales). The bottomline performance for 9mFY07 has been impacted by a considerably lower other income.

Financial performance (Consolidated): A snapshot…
(Rs m) 2QFY07 3QFY07 Change 9mFY06 9mFY07 Change
Sales 16,019 16,611 3.7% 34,790 47,059 35.3%
Expenditure 12,394 12,511 0.9% 26,473 35,784 35.2%
Operating profit (EBDIT) 3,625 4,100 13.1% 8,317 11,275 35.6%
Operating profit margin (%) 22.6% 24.7%   23.9% 24.0%  
Other income 282 102 -64.0% 3,044 1,129 -62.9%
Interest 27 32 18.8% 39 85 117.9%
Depreciation 375 394 5.0% 1,001 1,131 12.9%
Miscellaneous expenditure written off - -   1 - -100.0%
Profit before tax 3,505 3,776 7.7% 10,320 11,188 8.4%
Tax 307 403 31.5% 1,678 1,078 -35.7%
Minority interest - -   (7) (1)  
Share of loss in associate company - -   (79) -  
Profit after tax/(loss) 3,198 3,372 5.4% 8,571 10,112 18.0%
Net profit margin (%) 20.0% 20.3%   24.6% 21.5%  
No. of shares (m)       668.9 675.0  
Diluted earnings per share (Rs)* 8.8% 10.7%     19.2  
P/E ratio (x)*         25.5  
* On a trailing 12-months basis            

Fourth largest software services exporter
Satyam is one of the leading players in the Indian software services space and its offerings include application development and maintenance services (47% of 3QFY07 standalone revenues), consulting and enterprise business solutions (42%), extended engineering solutions and infrastructure management services. Satyam also provides BPO services through its subsidiary, Nipuna. Over the past couple of years, the company has managed to move up the software value chain, as is visible from the rapid growth in the high-end service of package implementation. The contribution of this service has been consistently increasing over the past few years and now constitute a major portion of revenues. During the period FY01 to FY06, Satyam has grown its revenues and profits at compounded rates of 28% and 30% respectively.

What has driven performance in 3QFY07?
Rupee pressure on topline: After the strong quarterly performance in the previous quarter, Satyam’s performance in 3QFY07 was laidback, as revenues grew by less than 4% QoQ. This growth was largely led by strong growth in volumes (8% QoQ) and marginal rise in billing rates (0.4% QoQ for onsite rates and 0.1% QoQ for offshore rates). However, the effect of these factors was almost negated by the appreciation of the rupee against the US dollar, which impacted the revenue growth by a negative 4%. Overall, the core volume growth continues to impress, led by a strong demand environment in the technology offshoring market. A greater part of discretionary spending (spending on new projects to effect increases in capacities/sales) is now being directed towards the global delivery model and this factor is clearly a key one for top-tier software companies like Satyam.

As regards delivery-based revenues, Satyam continued its shift towards expanding the contribution of the offshore component in total revenues. In 3QFY07, offshore revenues formed 48.9% of the company’s standalone revenues (47.6% in 2QFY07). As seen from this, the company’s, like its peers’, conscious efforts to move work offshore appears to be paying off, which is a clear positive.

An analysis of the performance based on service lines shows that the Consulting and Enterprise Business Solutions (CEBS, package implementation) business continues to be the key growth driver for the company. This segment recorded sales growth of 8% QoQ during 3QFY07, thereby increasing its contribution to total revenues to 42% (40% in 2QFY07). The application development and maintenance services (47% of revenues) grew at a marginal rate of 2% QoQ, much in line with what has been seen in the case of Infosys and TCS. Nipuna, Satyam’s BPO subsidiary, recorded revenues of US$ 9.0 m in 3QFY07, sequential growth of 8.2%. The company, however, continues to be in the red, as seen from the US$ 1.2 m loss recorded in the quarter.

Satyam added a total of 34 new clients during the quarter (35 in 2QFY07). The company’s active client base now stands at 523 (541 including subsidiaries). On the manpower front, the company added a net of 3,280 employees (inclusive of subsidiaries) during 3QFY07. While the attrition rate decline marginally to 17.6% on a trailing 12-month basis, it still remains the highest among its peers. Going forward, the key factor to watch out for will be the sustainability of this fall, as competition for talent seems to be intensifying by the day.

Offshore move aids margins: As indicated above, the share of offshore component in Satyam’s total revenues increased to nearly 49% in 3QFY07. This aided the company’s consolidated operating margins, which expanded by 210 basis points sequentially during the quarter. The impact of offshore move was seen in lower employee costs, which, as percentage of sales, declined from 61.3% in 2QFY07 to 58.2% in 3QFY07. However, the rupee appreciation against the US dollar and lower utilisation rates limited the pace of margin expansion.

Lower other income impacts bottomline:The benefit of strong operating margin expansion failed to flow to the bottomline, as the company recorded a substantial fall in other income (down 64% QoQ). Increase in the effective tax rates, from 8.8% in 2QFY07 to 10.7% in 3QFY07, also negatively impacted the net profit margins during the quarter. The lower other income was primarily a factor of forex losses to the tune of Rs 355 m (Rs 13 m in 2QFY07). Excluding the impact of these losses, the net profits would have been up by 16% QoQ during 3QFY07.

Performance in the recent past
  3QFY06 4QFY06 1QFY07 2QFY07 2QFY07
Sales (QoQ growth, %) 9.6 3.8 9.8 11.0 3.7
Employee costs (% of sales) 58.3 57.1 57.6 61.3 58.2
Operating margins (%) 24.9 25.5 24.6 22.6 24.7
Profits (QoQ growth, %) 13.7 5.5 24.4 (9.7) 5.4
Employees (Nos, incl. subsidiaries) 23,432 28,624 29,843 34,908 38,188

What to expect?
At the current price of Rs 489, the stock is trading at a multiple of 15.6 times our estimated FY09 earnings. While the management has marginally downgraded its FY07 revenues estimates citing the pressure on account of rupee appreciation, the earnings estimates have been raised slightly. The company’s nine-months performance is in line with our FY07 estimates.

While the offshoring environment is expected to be strong for larger players like Satyam, investors need to keep a close tab on the company’s attrition rate, which we believe will be a foremost challenge for the management as well. We are already seeing companies across the sector reporting increasingly higher number of employees leaving for other opportunities. As such, companies that will be able to keep a tight leash on the same will be the key beneficiaries in the long term.

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