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Satyam: Top up, bottom down! - Views on News from Equitymaster

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Satyam: Top up, bottom down!
Oct 20, 2006

Performance summary
Satyam has announced its results for the second quarter and half-year ended September 2006. The topline has witnessed strong sequential growth, due mainly to impressive volume growth and also favourable exchange rate movements. Margins, however, saw a significant contraction of nearly 200 basis points (2%), due mainly to the salary increases carried out during the quarter. Due to the lower margins, as also considerably lower other income, the net profits declined on a sequential basis. For the half-year period, Satyam’s performance has been impressive on all fronts – revenue growth, margin maintenance and net profit growth.

Financial performance (Consolidated): A snapshot…
(Rs m) 1QFY07 2QFY07 Change 1HFY06 1HFY07 Change
Sales 14,429 16,019 11.0% 22,137 30,448 37.5%
Expenditure 10,879 12,394 13.9% 16,966 23,273 37.2%
Operating profit (EBDIT) 3,550 3,625 2.1% 5,171 7,175 38.8%
Operating profit margin (%) 24.6% 22.6%   23.4% 23.6%  
Other income 745 282 -62.1% 550 1,027 86.8%
Interest 26 27 6.7% 12 53 325.0%
Depreciation 362 375 3.7% 660 737 11.6%
Miscellaneous expenditure written off - -   1 -  
Profit before tax 3,908 3,505 -10.3% 5,048 7,413 46.9%
Tax 368 307 -16.6% 725 675 -7.0%
Minority interest (1) -   (3) (1)  
Share of loss in associate company - -   (50) -  
Profit after tax/(loss) 3,541 3,198 -9.7% 4,275 6,739 57.6%
Net profit margin (%) 24.5% 20.0%   19.3% 22.1%  
No. of shares (m) 337.9 673.9   329.8 672.8  
Diluted earnings per share (Rs)*         18.3  
P/E ratio (x)*         23.9  
* 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 (48% of 2QFY07 standalone 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 2QFY07?
Core business powers ahead: During 2QFY07, Satyam recorded a strong 11.0% QoQ growth in its consolidated topline. This was a result of a 9.5% QoQ growth in volumes billed, a marginal 0.4% QoQ increase in billing rates and a 1.1% favourable movement in exchange rates. Thus, core volume growth continues to impress, a result of the ever-increasing trend of offshoring, led by a strong demand environment. A greater part of discretionary spending (spending on new projects to effect increases in capacities/sales) is now being directed towards the global delivery model and this factor is clearly a key one for top-tier software companies like Satyam.

As regards delivery-based revenues, Satyam continues to see a shift towards offshore revenues. These saw a slight shift this quarter (on a QoQ basis), and accounted for 47.6% of the quarter’s standalone revenues, growing at a smart 11.8% QoQ, on the back of 12.9% QoQ growth in 1FY07. Onsite revenues, on the other hand, also grew at a strong 10.0% QoQ. When viewed from a year-on-year perspective, the offshore contribution in 2QFY06 was at 44.2%. Thus, Satyam’s conscious efforts to move work offshore appear to be paying off, which is a clear positive.

As regards service lines, Consulting and Enterprise Business Solutions (CEBS, package implementation) continues to be the key growth driver of revenues for the company, clocking an impressive 11.3% QoQ growth, on the back of a 12.8% QoQ growth in 1QFY07. This business accounted for 42% of the incremental revenues for the quarter. Satyam continues to grow this business at a strong pace, and is undoubtedly among the leaders amongst Indian IT service firms along with TCS. The CEBS business now accounts for 40.4% of Satyam’s revenues, and while its strong growth is a positive, such a high concentration of just one service lines in revenues could pose a risk to the company going forward, particularly in the event of a US slowdown, the effect of which, if such an event actually occurs, remains to be seen. The application development and maintenance service (ADMS) business grew at a stable 9.7% QoQ, and infrastructure management services (IMS), which has significant untapped potential, powered ahead by 10% QoQ (on the back of a 57.6% QoQ growth in 1QFY07). When viewed on a year-on-year basis, this service grew at as much as 84%.

As regards Satyam’s subsidiaries, Nipuna, the BPO subsidiary, recorded revenues of Rs 416 m (US$ 9.0 m) in 2QFY07, recording a QoQ growth of 14.3%. The company continues to make losses, which stood at Rs 47.7 m (US$ 1.0 m) this quarter. Other subsidiaries, such a Citisoft, which Satyam acquired in FY05, managed to record a slight net profit this quarter.

Satyam added a total of 35 new customers in 2QFY07 (34 new clients during 1QFY07). The company’s active client base now stands at 504 (521 including subsidiaries). As regards headcount, Satyam’s total headcount including its subsidiaries stood at 34,908 at the end of September. This signifies a strong addition of 5,065 people during the quarter, while on a standalone basis.

A redeeming feature of this quarter has been a notable decrease in the attrition rate, which reduced to 18.3% on a trailing 12-month basis (19.6% in 1QFY07). On an annualised basis, the attrition rate stood at 15.9%. This reflects some success in Satyam’s efforts to keep this rate under check. Satyam had, at its analysts’ conference held in Mumbai last month, alluded to monetary and non-monetary measures that it is taking to reduce this rate, and this has paid off this quarter. However, the key factor to watch out for will be the sustainability of this fall, and it should be noted that despite this fall, Satyam’s attrition rate is still considerably higher than its top-tier peers like Infosys and TCS (12.9% and 10.6% respectively).

Higher employee costs depress margins: In 2QFY07, Satyam saw a significant 200 basis points (2%) fall in its EBITDA margins. This was entirely a result of the salary raises given during the quarter, and employee costs as a percentage of sales (standalone) have increased to as much as 61.3% (57.6% in 1QFY07). Efficiencies at the operating level in terms of lower operating and administrative costs (down to 16.0% of revenues as compared to 17.7% in 1QFY07) have mitigated the impact of this rise. The rupee depreciation, maintenance of utilisation rates despite the strong hiring (71.1% including trainees, as compared to 71.2% in 1QFY07) and a slight offshore shift were the other factors that limited the pace of margin decline.

Lower margins, other income reduce net profits: In 2QFY07, Satyam recorded a 9.7% QoQ fall in its net profits, due mainly to the lower margins, as well as a significant fall in other income (down 62.1% QoQ). The lower other income was primarily a factor of forex losses to the tune of Rs 13.3 m during the quarter (profit of Rs 450 m in 1QFY07). Excluding the impact of forex profits/losses, the net profits would have been up by 4.0% QoQ.

Performance in the recent past
  3QFY06 4QFY06 1QFY07 2QFY07
Sales (QoQ growth, %) 9.6 3.8 9.8 11.0
Employee costs (% of sales) 58.3 57.1 57.6 61.3
Operating margins (%) 24.9 25.5 24.6 22.6
Profits (QoQ growth, %)* 13.7 5.5 24.4 (9.7)
Employees (Nos, incl. subsidiaries) 23,432 28,624 29,843 34,908
* Excluding extraordinary item in 3QFY06

What to expect?
At the current price of Rs 437, the stock is trading at a price to earnings multiple of 18.6 times our estimated FY08 earnings. The board has declared an interim dividend of Re 1 per share (dividend yield of 0.2%). The management has revised upwards its guidance for FY07 again. Satyam is now expected to grow revenues at around 35% YoY in FY07 (earlier estimate of 30% YoY), while the earnings per share growth is expected to be around 36% YoY (earlier estimate of 28% YoY).

Given the fact that the offshoring environment continues to remain strong, we expect Satyam to be a major beneficiary. The company has continued 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. While we have no problems with respect to topline growth, we certainly expect margin pressure to impact not just Satyam, but the entire sector. As regards Satyam in particular, even though the attrition rate reduced this quarter, it is still higher than its top-tier peers, and while the reduction this quarter is an encouraging sign, we do not expect this trend to sustain, given the various demand and supply-side issues impacting this variable.

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