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Satyam 3QFY06 results: Our view

Jan 20, 2006

Performance Summary
Satyam has announced its results for the third quarter and nine-month period ending December 2005. Topline for the quarter has witnessed a near-double digit sequential growth, driven by volumes and also owing to the benefits arising from the rupee movement. Due to savings in personnel and administration costs, operating margins witnessed a healthy 100 basis points expansion. This, coupled with lower depreciation, resulted in the bottomline expanding at 14% QoQ, excluding the extraordinary item of profit on sale of the company’s stake in Sify. The performance for the nine-month period has also been good.

Financial performance (Consolidated): A snapshot…
(Rs m) 2QFY06 3QFY06 Change 9mFY05 9mFY06 Change
Sales 11,550 12,653 9.6% 25,493 34,790 36.5%
Expenditure 8,786 9,507 8.2% 19,194 26,473 37.9%
Operating profit (EBDIT) 2,764 3,146 13.8% 6,299 8,317 32.0%
Operating profit margin (%) 23.9% 24.9%   24.7% 23.9%  
Other income 316 330 4.5% 571 879 54.1%
Interest 8 27 246.1% 7 39 480.0%
Depreciation 347 341 -1.7% 833 1,001 20.2%
Profit before tax 2,725 3,108 14.1% 6,030 8,156 35.3%
Tax 333 386 16.0% 893 1,678 87.8%
Extraordinary items (0) 1,598   (23) 2,164  
Share of loss in associate companies 19 29   59 79  
Minority interest 1 5   - 7  
Profit after tax/(loss) 2,373 4,295 81.0% 5,055 8,571 69.6%
Net profit margin (%) 20.5% 33.9%   19.8% 24.6%  
No. of shares 330.6 334.4   323.1 333.0  
Diluted earnings per share* (Rs)         31.9  
P/E ratio (x)*         23.7  
* On a trailing 12-month basis

Fourth largest software services exporter
Satyam is one of the leading players in the Indian software services space and its offerings include software development and maintenance (50% of revenues), consulting and enterprise business solutions (39%), 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 FY05, Satyam has grown its revenues and profits at compounded rates of 26% and 28% respectively.

What has driven performance in 3QFY06?
Volume-led growth plus rupee benefit: As has been the case for most of the top-tier software companies for the past few quarters, volume growth has proved to be the main kicker for Satyam’s topline growth in this quarter. The company also benefited from the rupee movement to the extent of 3.7%. Volumes grew at 5.5% sequentially, lower than the previous quarter’s 7.1% QoQ. This could be partly explained by the fact that this quarter saw a lesser number of working days.

As regards service lines, once again, the main Consulting and Enterprise Business Solutions (CEBS, package implementation) business grew at 9.5% sequentially, contributing to 39.8% of the incremental revenue growth (standalone). Satyam has consistently grown this business at a CAGR of over 60% since FY01. The company has been rated as having the strongest, most global SAP offerings in a study conducted by Forrester. SAP is one of the largest global ERP companies and a key part of the CEBS practice for most software companies.

In terms of geographies, Europe grew at a double-digit sequential rate of 10.3%, while the US geography also showed strength, growing at 5.5% despite decreasing as a percentage of revenues. Japan also showed double-digit sequential growth at 11.3%, albeit on a much smaller base.

Satyam added 35 new clients during 3QFY06 (32 in 2QFY06), the highest-ever in a quarter. The company’s active client base now stands at 452, compared to 429 at the end of the previous quarter. Satyam’s BPO subsidiary, Nipuna, recorded revenues of Rs 220.6 m (US$ 4.86 m) during the quarter, a sequential growth of 21.2%. The company made losses of Rs 95.8 m (US$ 2.1 m). Satyam expects Nipuna to break-even this year. It added two clients during the quarter, from the US and Europe in the media and animation verticals.

Satyam added 950 employees during the quarter (1,977 in 2QFY06). Utilisation rates reduced to 74.3% compared to 74.7% in 2QFY06 (including trainees). Satyam standalone had 23,432 employees, while Nipuna had 1,639 employees at the end of December 2005. This was lower than at the end of the previous quarter and is a possible indication that Nipuna is facing high attrition rates. This has been reflected in the overall attrition rates, which have increased from 16.2% in 2QFY06 to 18.0% in 3QFY06. This is certainly a cause for concern, as employees are the key ‘raw material’ in a resource-intensive industry like software. Going forward, Satyam will need to take effective steps to curb this to lower levels.

Cost leverage aids margin expansion: In 3QFY06, Satyam managed to leverage on key cost items. The company’s employee costs reduced as a percentage of revenues from 58.7% in 2QFY06 to 58.3% this quarter. Operating and administration expenses also reduced from 17.4% to 16.8%. This was the primary reason for the 100 basis points margin expansion. This has been the second successive quarter of margin expansion for Satyam and is a heartening feature of the performance.

Higher margins, lower depreciation power bottomline: Due mainly to the higher margins this quarter, as also lower depreciation charges, the bottomline expanded by an impressive 13.7% sequentially. The other income component was slightly higher. In fact, Satyam recorded a profit of Rs 23.7 m on exchange fluctuations, quite the opposite of what has been the case for the top-tier companies, which have seen forex losses restrict bottomline growth. It should be noted that this growth excludes an extraordinary item. Satyam had divested its stake in Sify, profits from which stood at Rs 1,598 m.

Performance in the recent past
  4QFY05 1QFY06 2QFY06 3QFY06
Sales (QoQ growth, %) 7.1 9.0 9.1 9.6
Employee costs (% of sales) 58.1 60.4 58.7 58.3
Operating margins (%) 24.5 22.7 23.9 24.9
Profits (QoQ growth, %)* 25.0 (7.7) 24.8 13.7
Employees (Nos.) 19,164 20,505 22,482 23,432
* Excluding extraordinary item in 3QFY06

What to expect?
At the current price of Rs 758, the stock is trading at a price to earnings multiple of 16.2 times our estimated FY08 earnings. The management has raised its revenue and profit guidance upwards for FY06. This is the third consecutive quarter in which the management has raised its guidance and now expects revenues to hit between Rs 47.80 bn and Rs 47.86 bn, a YoY growth between 35.7% and 35.9% (compared to 33.5% to 34.0% growth in revenues at the end of 2QFY06). EPS is expected to be in the range of Rs 30.31 to Rs 30.36, a YoY growth of 35.3% to 35.5% (compared to a growth of between 30.0 % and 30.5% at the end of the previous quarter). This is above our estimates of Rs 29.3 EPS for FY06, which implies a 33.8% growth over FY05.

Satyam’s performance has been on the mend over the past two years, before which it was plagued with volatility. Going forward, the improving performance of its subsidiaries, such as Nipuna is also expected to contribute in a more meaningful manner to the bottomline.

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