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Satyam: It's volumes and exchange rates - Views on News from Equitymaster
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Satyam: It's volumes and exchange rates
Jul 21, 2006

Performance summary
Satyam has announced its results for the first quarter ended June 2006. Topline has witnessed strong sequential growth, due to good volume growth and favourable exchange rate movements. Margins, however, fell by 86 basis points, mainly due to higher employee costs because of the salary revisions carried out in April this year. However, despite lower margins, considerably higher other income, lower depreciation and a lower effective tax rate has led to the bottomline growth strongly outperforming both revenue and operating profit growth during the quarter.

Financial performance (Consolidated): A snapshot…
(Rs m) 4QFY06 1QFY07 Change
Sales 13,136 14,429 9.8%
Expenditure 9,791 10,879 11.1%
Operating profit (EBDIT) 3,345 3,550 6.1%
Operating profit margin (%) 25.5% 24.6%  
Other income 289 745 157.8%
Interest 17 26 54.5%
Depreciation 372 362 -2.7%
Profit before tax 3,246 3,908 20.4%
Tax 397 368 -7.5%
Minority interest 2 (1)  
Profit after tax/(loss) 2,847 3,541 24.4%
Net profit margin (%) 21.7% 24.5%  
No. of shares (m) 334.8 337.9  
Diluted earnings per share (Rs)*   33.9  
P/E ratio (x)*   20.6  
* 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 application development and maintenance services (49% of revenues), consulting and enterprise business solutions (40%), 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 1QFY07?
Volume growth and rupee movements power the topline: During 1QFY07, Satyam recorded a strong 9.8% sequential growth in its topline. This was a result of 2 major factors – a 7.2% sequential volume growth and a 3.4% impact of favourable exchange rate movements. As is known, during the quarter, the rupee has depreciated by around 3% against the US dollar, 9% against the pound and around 7% against the euro. Billing rates, on the other hand, were largely stable, with onsite rates showing a 0.3% QoQ up-tick, while offshore rates grew at 0.2% QoQ.

As regards delivery-based revenues, Satyam saw a strong shift towards offshore revenues. These accounted for over 47% of the quarter’s revenues, growing at 12.9% QoQ. Onsite revenues, on the other hand, grew at 7.7% QoQ. When viewed from a year-on-year perspective, the offshore contribution in 1QFY06 was at 43%. Thus, there has been a clear shift offshore, and this is undoubtedly a positive for Satyam. This is due to the fact that offshore revenues have better margins, and is a clear reflection of the ability of the company to move more work offshore for its major clients, thus delivering value for them.

As regards service lines, Consulting and Enterprise Business Solutions (CEBS, package implementation) grew at a strong 12.8% QoQ, and accounted for as much as 50% of the incremental revenues for the quarter. Satyam continues to grow this business at a strong pace, and is among the leaders amongst Indian IT service firms along with TCS. The application development and maintenance service (ADMS) business grew at a stable 5.4% QoQ, and infrastructure management services (IMS), which has significant untapped potential, saw a 57.6% QoQ growth. When viewed on a year-on-year basis, this service grew at nearly 70%, signifying that Satyam, which has been a bit of a laggard in this service, appears to be seeing some strong traction.

As regards Satyam’s subsidiaries, Nipuna, the BPO subsidiary, recorded revenues of Rs 364 m (US$ 7.9 m) in 1QFY07. The company continues to make losses, which stood at Rs 62 m (US$ 1.3 m) this quarter. Satyam has reiterated its guidance of US$ 36 m for FY07. Nipuna is expected to achieve break-even at the net profit level during 4QFY07 (already achieved cash break-even during 4QFY06).

Satyam added a total of 34 new customers in 1QFY07 (22 new clients during 4QFY06). The company’s active client base now stands at 489 (520 including subsidiaries). As regards headcount, Satyam’s total headcount including its subsidiaries stood at 29,843 at the end of June. This signifies a relatively small addition of 1,219 people during the quarter. When compared to peers like Infosys and TCS, which added 5,694 and 4,698 employees respectively, this appears to be fairly low.

Attrition rates, however, continue to inch upwards, and now stand at 19.6%. This is the biggest concern that any investor considering Satyam as an investment must take into account. This rate is considerably higher than peers like Infosys and TCS (attrition rates of 11.9% and 10.6% respectively). We expect wage inflation to continue to impact margins of software companies in future, given various demand and supply-side issues impacting this variable. Thus, margin pressure could be seen going forward.

Higher employee costs impact margins: In 1QFY07, Satyam saw an 86 basis points decline in its operating margins. This was primarily due to higher employee costs. The company has indicated that it increased salaries for its offshore staff by nearly 20% in April for FY07, which is amongst the highest pay revisions that any software company has given this fiscal. The company also introduced restricted stock units (RSUs) as an employee-retention tool. Operating and administrative (O&A) costs also increased as a percentage of sales to 17.7% (17.4% in 4QFY06).

Higher other income, lower tax rates power net profit: In 1QFY07, Satyam recorded a 158% QoQ increase in its other income component. This largely consisted of forex profits in the region of Rs 450 m, due to favourable exchange rate movements during the quarter. Lower depreciation charges and lower effective tax rate also led to a strong sequential bottomline growth, which outperformed the growth in topline and operating profits.

Performance in the recent past
  2QFY06 3QFY06 4QFY06 1QFY07
Sales (QoQ growth, %) 9.1 9.6 3.8 9.8
Employee costs (% of sales) 58.7 58.3 57.1 57.6
Operating margins (%) 23.9 24.9 25.5 24.6
Profits (QoQ growth, %)* 24.8 13.7 5.5 24.4
Employees (Nos, incl. subsidiaries) 22,482 23,432 28,624 29,843
* Excluding extraordinary item in 3QFY06

What to expect?
At the current price of Rs 697, the stock is trading at a price to earnings multiple of 14.8 times our estimated FY08 earnings. The management has revised upwards its guidance for FY07, given the significant outperformance recorded this quarter. Satyam is now expected to grow revenues at a rate between 29.2% YoY and 31.2% YoY in FY07, while the earnings per share (EPS) growth is expected to range between 27.5% YoY and 29.5% YoY. This is as compared to an expected revenue growth between 25.2% YoY and 27.3% YoY, and an EPS growth between 18% YoY and 20% YoY at the end of FY06. This is in line with what its major peer, Infosys, has done.

Given the fact that the offshoring environment continues to remain strong, we expect Satyam to be a major beneficiary. The company continues to impress with its financial performances, which have been consistently improving over the past 3 years now, a welcome change from the past, wherein volatility used to dog the company. Nonetheless, as we have always mentioned in the past, 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 on an urgent basis. With the RSU scheme in place this year, margin pressure is a virtual certainty. Nonetheless, we will be revisiting our projections for Satyam, given the outperformance seen in 1QFY07.

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