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Satyam: Another billion dollar baby! - Views on News from Equitymaster

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Satyam: Another billion dollar baby!
Apr 21, 2006

Performance Summary
Satyam has announced results for the fourth quarter and full-year ended March 2006. The topline in FY06 grew at a strong pace, driven mainly by good volume growth, particularly offshore, and strong traction in key service lines. Margins, however, witnessed a slight contraction, mainly due to higher employee costs. Due to higher other income and a lower effective tax rate, the bottomline grew at a faster pace than operating profits. It should be noted that this performance is excluding the extraordinary item of profits earned on sale of Satyam’s stake in its erstwhile associate company, Sify.

Consolidated financial performance: A snapshot
(Rs m) 3QFY06 4QFY06 Change FY05 FY06 Change
Sales 12,653 13,136 3.8% 35,208 47,926 36.1%
Expenditure 9,507 9,791 3.0% 26,527 36,264 36.7%
Operating profit (EBDIT) 3,146 3,345 6.3% 8,682 11,662 34.3%
Operating profit margin (%) 24.9% 25.5%   24.7% 24.3%  
Other income 330 289 -12.4% 868 1,168 34.6%
Interest 27 17 -37.9% 9 55 508.8%
Depreciation 341 372 9.0% 1,133 1,373 21.2%
Profit before tax 3,108 3,246 4.4% 8,408 11,402 35.6%
Tax 386 397 2.9% 1,176 1,509 28.3%
Extraordinary items - -   22 1  
Share of loss in associate companies 29 -   95 73  
Minority interest (5) 2   - -  
Profit after tax/(loss)* 2,697 2,847 5.5% 7,116 9,819 38.0%
Net profit margin (%) 21.3% 21.7%   20.2% 20.5%  
No. of shares (m) 334.4 334.4   324.4 334.8  
Diluted earnings per share (Rs)       21.3 29.3  
P/E ratio (x)         27.8  
* Excluding profits on sale of stake in Sify

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 (51% 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 FY06, Satyam has grown its revenues and profits at compounded rates of 28% and 30% respectively.

What has driven performance in FY06?
Strong volumes power the US$ 1 bn topline: While the pricing environment was largely stable with a slight up-tick, volume-led growth was the ‘mantra’ for Satyam’s strong topline growth of 36% YoY in FY06. The company has achieved the hallowed mark of US$ 1 bn in revenues this fiscal, the fourth company to do so after TCS, Infosys and Wipro. Offshore revenues, in particular, clocked an impressive 40% YoY growth, as compared to a 29% YoY growth in onsite revenues (standalone). Thus, due to this performance, an offshore shift was observed, with offshore revenues contributing to 44.3% of total standalone revenues in FY06 (42.5% in FY05).

As regards Satyam’s subsidiaries, Nipuna, the BPO subsidiary, recorded revenues of US$ 20 m in FY06 (US$ 10 m in FY05), as compared to the guidance of US$ 18 m. The company achieved cash break-even during the fourth quarter, in line with what Satyam expected. Overall, the company’s subsidiaries grew at a strong rate of 180% YoY, increasing their contribution to total consolidated revenues to 3.3% in FY06 (1.6% in FY05).

As regards service lines, once again, the Consulting and Enterprise Business Solutions (CEBS, package implementation) business grew at a rate of nearly 50% YoY, contributing to over 50% of the incremental revenue growth (standalone). The contribution of this business to total revenues now stands at nearly 39% (35% in FY05). Satyam continues to see good traction in this business, and has been ranked as a leader in packages like SAP, one of the world’s largest ERP companies and a key part of the enterprise business practice for most software companies.

In terms of geographies, Europe continues to witness strong growth for most software companies, and for Satyam, this geography grew at a rate of 47% YoY. The US geography, on the other hand, grew at a steady pace of nearly 28% YoY, remaining the main region for Satyam (nearly 66% of FY06 standalone revenues).

Satyam added a total of 22 new customers in the fourth quarter (35 new clients during 3QFY06). The company’s active client base now stands at 469, compared to 390 at the end of FY05. As regards headcount, Satyam added 3,079 employees during 4QFY06 (950 in 3QFY06). This is the highest-ever addition in any quarter. The total headcount now stands at 28,624 at the end of FY06 (including subsidiaries). Utilisation rates increased in FY06 to 73.8% compared to 70.5% in FY05 (including trainees). One of the highlights of the quarter was the winning of part of the General Motors’ deal, worth US$ 150 m for Satyam (sub-contracted by CapGemini and HP). Satyam also won a five-year deal with Nissan NA (North America), which, while no value has been assigned to the deal by Satyam, could be over US$ 100 m.

However, a negative for FY06 is the fact that attrition rates have increased to 19.2% (from 16.5% in FY05). This is certainly a cause for concern, as employees are the key ‘asset’ in a resource-intensive industry like software. The company, from FY06, will introduce ‘restricted stock units’ (RSUs) in order to curb attrition rates. The management has said that at current levels, the attrition is not at levels that it considers as suitable. In FY07, the company is planning to hike offshore salaries by nearly 20%, apart from introducing the RSUs. Thus, margin pressure could be seen going forward.

Higher employee costs pressurise margins: In FY06, Satyam’s margins took a slight hit to the tune of 33 basis points. This was due to higher employee costs, which increased as a percentage of sales from 57.5% in FY05 to 58.5% this fiscal. However, further leverage on operating and administrative (O&A) costs, which reduced as a percentage of sales from 17.8% in FY05 to 17.1% this year, led to margin pressure being countered to some extent. However, going forward, as we mentioned above, the company could see some margin pressure in the near-term, due to increase in employee costs. In fact, the near-20% increase in offshore salaries in FY07 is considerably higher than what its peers like Infosys (15%) have announced. This is a clear indication that Satyam is facing pressure to control attrition and bring it down to lower levels in order to compete effectively against its larger Indian and MNC peers.

Higher other income, lower tax rates drive the bottomline: Despite the lower margins in FY06, higher other income and a lower effective tax rate led to the bottomline growth outperforming the growth in operating profits. The higher other income was primarily due to lower losses on account of exchange fluctuations, and excludes profits on sale of Satyam’s stake in its erstwhile associate company, Sify. Overall, the bottomline grew at a fairly robust pace of 38% YoY.

Performance in the recent past
  1QFY06 2QFY06 3QFY06 4QFY06
Sales (QoQ growth, %) 9.0 9.1 9.6 3.8
Employee costs (% of sales) 60.4 58.7 58.3 57.1
Operating margins (%) 22.7 23.9 24.9 25.5
Profits (QoQ growth, %)* (7.7) 24.8 13.7 5.5
Employees (Nos.) 20,505 22,482 23,432 28,624
* Excluding extraordinary item in 3QFY06

What to expect?
At the current price of Rs 815, the stock is trading at a price to earnings multiple of 15.4 times our estimated FY08 earnings. The board has recommended a final dividend of Rs 5 per share, taking the total dividend for FY06 to Rs 7 per share (dividend yield of 0.9%). A bonus issue in the ratio of 1:1 (one new share for every existing share held) has also been recommended. The management has guided for a revenue growth of between 25.2% and 27.3% YoY, and expects earnings per share (EPS) growth to be between 18% and 20% in FY07.

Satyam has performed well in FY06. While the revenues of Rs 47.9 bn exceeds that of our expectations by a marginal 0.5%, the EBITDA margins of 24.3% are below our estimates of 25.0%. As regards the bottomline of Rs 9.8 bn achieved, this exceeds out estimates by 3.3%. Going forward, the environment for offshoring appears fairly strong, as pointed out by the other top-tier software companies as well. Satyam’s revenue visibility seems strong, with the General Motors and Nissan deal wins propelling the company into the ‘Big deal’ league. This is a good sign, and Satyam will need to win more such deals in order to maintain strong growth in its topline. The number of clients giving the company in excess of US$ 1 m in annual revenues has also increased from 130 at the end of FY05 to 150 at present.

However, a key concern to watch out for Satyam is the attrition rate. This has always been higher than its other top-tier peers, and at nearly 20%, this is an issue that the company will need to address properly. Undoubtedly, with the RSU scheme in place this year, and the upcoming hike in salaries, margin pressure is a virtual certainty. To that extent, we will need to revise our margin estimates for Satyam.

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