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Satyam: A happy ending? - Views on News from Equitymaster
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Satyam: A happy ending?
Jun 20, 2005

Satyam Computer Services (Satyam) is India’s fourth-largest software services exporter. Global IT spending, a key metric for Satyam and its peers like Infosys, TCS and Wipro, was in the range of US$ 600 bn in 2004. Given that Indian software services exports and domestic revenues in FY05 were at US$ 16.2 bn as per NASSCOM, a market share of a mere 2.7%, growth potential is massive. Given that Satyam is the fourth-largest software services exporter in the country, a large portion of the benefits are expected to go to it. However, in the past, the company has turned out a string of highly inconsistent performances, unlike industry bellwether Infosys, whose middle name has been ‘consistency’. As a result, the company gets considerably lower valuations on the bourses as compared to Infosys, TCS and Wipro, the top-rung players in the industry. Recently, however, the company appears to have turned around its performance and started to show a bit of consistency. We reason as to whether this is for real, or is it only a temporary mirage and the company will once again disappoint investors with a poor performance, going forward.

So, what has happened over the past few years?

A roller-coaster ride, that’s what! The company’s performance graph in terms of profit growth has been not too dissimilar to a roller coaster, one time up and the next time down. Highly inconsistent performances dogged the company in FY02, when profits crashed by a massive 70%. In fact, the company was able to make profits in the first place only because of the minority interest it had in its affiliate companies! At the PBT level, Satyam suffered a massive Rs 2.2 bn loss. The major reason for such a shocking performance was the fact that the company incurred a massive 159% increase in depreciation costs and a gargantuan 469% jump in provisions for diminution in investments. The management had made questionable investments in loss-making affiliates and subsidiaries such as VisionCompass Inc., IndiaWorld Communications (Pvt.) Ltd. and Cricinfo Ltd. and in FY02, the company had to write off part of the value of these investments – not an investor-friendly move by any stretch of the imagination.

The next year, in FY03, the company increased its net profit by a whopping 342%! Aided by the considerably lower base of the previous year, as well as a massive 70% drop in depreciation costs and provision for diminution of investments, the company managed to post a strong come back from the previous year’s disappointments. However, the fact that it displayed such tremendous volatility in performance was a matter of great concern for investors and as a result, due to these and promoter issues, the stock is valued at a considerable discount to its top-rung peers, as we mentioned above.

Hope floats!

However, Satyam appears to have put these inconsistent performances behind it, as in the past two years, it has shown a good amount of consistency in its performances on the profit front. In FY04, the company grew profits by a robust 48%, even though revenues grew at a much slower pace of 15%. The performance was aided by a drop in operating and administrative expenses (O&A), both, in absolute terms as well as a percentage of revenues. The company also incurred a 36% lower depreciation charge and earned a 90% higher other income. Thus, even though the effective tax rate increased, profit growth was robust.

In FY05, aided by a strong growth in volumes, revenues grew by a healthy 38%. Even though employee costs as a percentage of revenues increased from 52.5% to 57.5%, due to a good growth in other income and a lower effective tax rate, the company managed a 39% jump in net profit. Continued reduction in O&A expenses as a percentage of revenues also helped the company in controlling its costs.

But what will the future hold?

As we have seen, the company has managed to get back on track as far as consistency in performance is concerned. However, given the fact that it has been inconsistent in the past, the main question that arises is, will the company maintain the consistency shown in the past two years? We attempt to list a few factors that will show us as to what we can expect, going forward.

Greater control on employee costs

The company’s employee costs as a percentage of revenues have increased dramatically, from 41.5% in FY01 to 57.5% on FY05. The main reason for this has been the growth in the high-end package implementation business, which requires a major presence onsite, as well as higher salaries to be paid to skilled domain experts. As a result, employee costs grew at a faster rate than revenues. However, going forward, given transfer of an increasing proportion of work offshore and increasing number of freshers to be employed as a proportion of total employees, we expect the company to be able to control its employee costs. This will also have the beneficial impact of improving Satyam’s margins.

SG&A leverage

We expect continued leverage on the SG&A front, given the 90%-plus proportion of revenues coming from repeat business and improved client mining efforts. These expenses have reduced dramatically over the years, from 39% of revenues in FY01 to 18% in FY05. This will aid the margin expansion.

Better client concentration

Satyam has succeeded in de-risking its business model to the extent where its largest client, GE, now contributes around 10% of revenues. Clients in the US$ 1 m basket have increased to 130.

Positive steps taken by the management

As we mentioned above, the management had made some ill-advised investments in the past, which ended up bleeding the company significantly. However, since then, the management has taken prudent steps of cutting down the number of subsidiaries and unrelated businesses under its fold, as well as reducing investments in loss-making affiliates. The share of losses in affiliates/associate companies has reduced in FY05 compared to FY04 and constitutes just 1% of profits.

What to expect?

At the current market price of Rs 491, Satyam’s stock trades at a price to earnings multiple of 13.7 times our estimated FY07 earnings. We had given a BUY on Satyam with a price target of Rs 640 for a two-year investment horizon. We maintain our recommendation. We believe that the company has proved its ability to come back from adversity, given the strong performance shown since FY03. Given the factors mentioned above, we are positive on the company from a long-term perspective and believe that the consistency shown in the past couple of years will be maintained, going forward.

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