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Satyam: Are valuations tracing growth?
Oct 3, 2005

Satyam is India’s fourth-largest software services exporter. The company reported revenues of Rs 35 bn in FY05, growing by a robust 37.5% YoY. Profits were at Rs 7 bn, recording an equally impressive 38.6% YoY growth. The company has been a slightly inconsistent performer in the past, particularly after the tech meltdown. The management had resorted to investor-unfriendly measures, such as investments in unrelated businesses, such as Cricinfo and subsequently had to write off these investments, hitting the company’s performance badly. However, in the recent past, the company appears to have got back some consistency in its performance. The management has reduced investments in unrelated businesses and pruned investments in loss-making subsidiaries and associates. This has reflected in a good performance in the past couple of years and also in 1QFY06. The company has increased revenues from high-end businesses such as package implementation, which now form 37.7% of revenues (1QFY06). In this write-up, we analyse the performance of the company over the past five years with the performance of the stock price.

Theory …
The thumb rule is that the stock price should ideally track the earnings growth over the long term. It must be noted that we are specifically mentioning ‘long term’, because in the short term, the stock price is governed largely by sentiment and news flow (positive or negative). Thus, if company ‘X’ grows its earnings at a CAGR of 20% over a period of five years, then the stock should ideally be trading at a similar price to earnings valuation, i.e., 20 times earnings.

Of course, it must also be noted that the markets do take this into account earlier than when the company actually announces results. This can, of course, be partly put down to the ‘Efficient Market Theory’ by Burton Malkiel, a part of which says that all relevant information about a company is already reflected in its stock price and any new information is very rapidly factored in. Therefore, the markets form their own opinion about what the company’s results are likely to be, based on their information and accordingly, the stock price adjusts.

…and practice!
As can be seen from the table below, over the period FY01-FY05, Satyam has managed to grow its revenues and profits at CAGRs of around 26% and 28% respectively. This is clearly an under-performance vis-à-vis industry bellwether, Infosys, for whom the figures were 39% and 32% respectively. Apart from this, the profit performance has been highly volatile. In FY02, due to massive depreciation charges and provisions for investments, the company’s profits crashed by over 70%. In fact, Satyam was actually able to make a profit purely because of the contribution of its minority interest in its associate companies!

Satyam: Performance over five years
(Rs m) FY01 FY02 FY03 FY04 FY05
Revenues 14,126 19,668 22,220 25,605 35,208
Profits 2,653 785 3,470 5,134 7,116

Continuing with its volatile performance in FY03, Satyam’s profits grew at a massive 342%. While this was a very strong comeback after the setback in FY02, the major factor of concern was the volatility in performance. In contrast, Infosys has performed consistently, even in the difficult period after the tech meltdown. The end result has been that Satyam has received considerably lower valuations than Infosys over the past few years, due to concerns about the management’s ability to turn in consistent performances and the ‘investor-unfriendly’ measures taken in past years.

As can be seen from the chart alongside, Satyam’s stock price has been fairly volatile over the years. Of course, one can say that equity shares are, by nature, volatile due to the higher degree of risk attached to them. As far as Satyam is concerned, the fact that it is a company within a high-growth industry, the volatility tends to be enhanced. Investors, by and large, expect the company to grow at a good pace. Even Infosys, which has been a consistent performer, has seen a high amount of volatility in its stock performance, with periods of massive upsurges as well as of big crashes.

The stock has given CAGR returns of around 13.9% since FY01, clearly under-performing its profit growth. This can be partly attributed to market expectations about the company’s performance. To explain further, markets generally factor in the next year’s earnings growth well in advance. As can be seen from the chart, towards the middle of FY02 (around September-October 01), the stock had fallen substantially, possibly due to realisations that it was going to be a difficult year post the tech meltdown. That was exactly what happened, which was also partly due to the company’s diversification into unrelated businesses. It must be noted that ‘slowdown’ is relative, as the company, in FY01, grew revenues by 110%, while in FY02, it was 39%.

But if we take the period from which the company started showing stability in its business and compare the stock price, the returns do not deviate that much from profit growth. Given that markets tend to factor in two years’ forward earnings by around half-year (for example, by around October-November’05, FY07 earnings would start being factored into the stock price), Satyam’s stock price from October 2002 till October 2004 gave around 44% CAGR returns, while earnings grew at around 43% CAGR.

Thus, it is possible that markets have started to think that Satyam can actually record a consistent performance in future. Of course, it needs particular mention that in an over-the-top bull market such as the one we are in currently, numerous stocks trade at valuations that factor in two and sometimes even three years’ forward earnings! The upside potential is very limited in such stocks, while downside risk is high.

Another point to be noted is that Satyam’s valuations have increased. On a one-year forward earnings basis, Satyam has traditionally traded at around 16.4 times. At present, it trades at around 19.9 times our estimated FY06 earnings, which is higher by over 20%. Of course, one must take this with a slight amount of caution, given the kind of euphoric bull market we are in, where often, cases of ‘irrational exuberance’ abound.

But as far as Satyam is concerned, this upward re-rating might not be entirely unjustified. Over the past couple of years, the company’s financial performance has improved and most importantly, the consistency factor has come in. Therefore, if the company is able to maintain this kind of performance in future, such a revaluation of the stock may well be in order and the gap between the top three (TCS, Infosys and Wipro) and Satyam could decrease further.

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