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Satyam: Stability in sight?

Mar 4, 2005

Satyam Computers is India's fourth largest software services exporter. Its offerings include software development and maintenance (54% of revenues), consulting and enterprise business solutions (35%) and engineering solutions (7%). Apart from these 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.Financial ratios: How has the company progressed over the years?
In order to analyse a software company, or any other company for that matter, ratio analysis is one of the most important tools that any investor has at his/her disposal. The ratios that should be used for comparison differ from industry to industry. Since Satyam is operating in the software industry, we consider a few key ratios that we feel need to be analysed by any investor before taking a call on that company.

(1) Sales growth
Sales growth is a very important parameter in the sense that it reflects the size of the industry, growth prospects, and performance relative to its peers in the industry. When compared to Infosys, considered as the benchmark for the IT industry, Satyam finishes a distant second-best, as can be seen from the table below. Sales growth, though decent by most standards, is very ordinary compared to Infosys, which has maintained a 37% CAGR in sales from FY01 to FY04, compared to Satyam's 22% CAGR.

Satyam v/s Infosys: Nowhere close!
(Rs m)FY01FY02ChangeFY03ChangeFY04ChangeCAGR
Satyam14,126 19,668 39%22,220 13%25,605 15%22%
Infosys19,006 26,036 37%36,400 40%48,530 33%37%

Another aspect that Satyam compares unfavorably is on the consistency side. As can be seen from the table above, there is a high element of volatility in performance, which increases the risk profile. In our view, quality of growth is more important from a long-term standpoint, which in the context of the software sector, is the ability to move up the value chain and de-commoditise revenues. Though Satyam has taken concrete steps, as compared to Infosys, it has been a laggard.

(2) Operating profit margins
The operating margins enjoyed by a software company indicate the level of bargaining power that it has with regards to billing rates charged. The higher the operating margins, the higher the rates that the company is able to extract from its clients. It also reflects a relatively higher share of offshore services in total business of the company, since the margins that the company earns on offshore services (overseas) are higher than margins for onsite services (domestic).

As can be seen from the table below, the company's operating margins have been improving each year. This can in part be attributed to the higher share of offshore services in total revenues. The proportion of offshore services has consistently been above 50%. At the end of FY04, it was around 57.3%. Another reason for this is the fact that operating and administration (O&A) expenses have reduced steadily as a percentage of sales, from 39% in FY01 to 21% in FY04. Operating profits have grown at a CAGR of around 44%.

Operating margins: Going up, up, up…
(Rs m)FY01FY02FY03FY04CAGR
Sales14,126 19,668 22,220 25,605 22%
Operating profit (EBDITA)2,522 5,339 5,989 7,523 44%
Operating profit margin (%)18%27%27%29%

(3) Profit growth over the years
Satyam's profit growth, as can be seen from the table below, has been highly volatile. Despite this volatility, the company has, over the period FY01 to FY04, managed to grow its profits at a CAGR of around 25%. One of the main reasons for the huge fall in profits in FY02 was the diminution in value of Satyam's investments in its subsidiary company Satyam Infoway. The company has taken steps to prune the number of subsidiaries, divest non-core businesses, and increase focus on high-end services. These seem to be taking effect, as Satyam has posted a healthy 47.9% growth in profits in FY04, and in the 9mFY05 period, has almost equalled its entire year's profit of FY04.

Profit growth: Up one year, down the next…
(Rs m)FY01FY02FY03FY04CAGR
Profit after tax/(loss)2,653 785 3,470 5,134 25%
Profit growth rate (%)104.1%-70.4%342.1%47.9%

(4) Return on equity (RoE)
The return on equity is another important parameter on which an investor should judge a software company. It reflects the returns that the management is able to generate for its shareholders, and is an important measure of profitability. In FY02, the main reason for the big fall in RoE was the huge provisions for goodwill and write-off of investments in subsidiaries. This situation was corrected in FY03 and FY04, and as the profits of the company witnessed an upturn, the RoE also surged, and seems to be back on track. But as compared to its peers, the return ratios are not favorable.

FY01FY02FY03FY04
Return on Equity22%4%16%19%

(5) Cash flow
Simply looking at earnings alone is not enough. For any company, it is very important to understand where the money is coming from, where it is being invested, and what sort of returns the company is able to generate on its investments. Thus, an understanding of the net cash that the company earns through its various activities (operating, investing and financing flows) is an undeniably important measure to assess a firm's capacity to pay off current liabilities, and fund future investments for growth.

One figure that needs to be watched carefully is the cash from operations, which is basically cash earned by the company from its core business operations. The company's performance has been a bit inconsistent on this front, as can be seen from the table. As far as cash from investing activities is concerned, most of it has gone towards the purchase of fixed assets to fund expansion, which is a favourable decision in the long term. In the case of financing activities, Satyam has increased dividend payments over the period, which is a move in keeping with investor's interests. The net cash and cash equivalents at the end of FY04 available with Satyam were around Rs 18.4 bn, a fairly substantial amount, which will help the company in scaling up its operations as and when the need arises.

(Rs m)FY01FY02FY03FY04
Cash from operations 181 5,155 4,813 4,106
Cash from investing activities(4,021) (1,886)(13,221) (2,516)
Cash from financing activities(1,644)5,086 (357)(489)
Exchange differences232.09 391 (157)(181)
Net Cash inflow/(outflow)(5,252) 8,746 (8,922)919

So what does the future look like?
The management, in recent times, has taken a critical look at its past investments, and has gone about divesting non-core businesses and subsidiaries, thus rationalising the number of subsidiaries under its control. The focus on the core business has also improved, and the share of the high-end business of package implementation has gone up to 30% of total revenues. This approach seems to be working well for Satyam, and in FY04, and the period 9mFY05, the sales and profits of the company have shown a healthy growth rate, and more importantly, a little consistency. We believe that this increased focus on core business, especially high-end business, will stand the company in good stead going forward, and be a key driver of future growth, and an enabler to getting the company to move higher up in the software value chain.

But to us, the risk profile of the company remains higher for the reasons mentioned above like inconsistency and past investments in unrelated businesses. To that extent, investors have to exercise caution.

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