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Research meeting extracts: Satyam - Views on News from Equitymaster
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Research meeting extracts: Satyam
Dec 9, 2004

We had a conference call with Satyam’s management yesterday to get a feel of what is happening in the Indian IT industry and how do they read the situation from here on. We got some useful insights into the company’s prospects, which we now share with you.

On Indian IT industry…
The impression that we got from this meeting was that the past 3-4 quarters of strong volume growth is not an aberration but a consistent factor. The management believes that optimism towards the Indian offshoring story is likely to continue over the long-term in the future. Also, the re-election of George Bush as the US President is favourable news for the Indian IT industry considering the opposition that John Kerry displayed against the offshoring of IT services to low-cost countries like India. Also, post the elections in the US, there has emerged a greater clarity on the clients’ side with regards to their outsourcing strategies and budgets. We believe that these remarks are clearly indicative of the momentum that top managements of Indian IT companies are seeing over the long-term with respect to India maintaining its status as the most favoured destination for offshoring.

On threat from China…
Satyam’s management is of the belief that China poses no danger for the growth of Indian IT companies because of three basic reasons –
  1. Costs in China are higher by around 20% as compared to India;

  2. Chinese IT companies lack project management skills; and

  3. China lags on the English-speaking quality manpower front.

Key excerpts…
Riding high on package implementation: The management believes that the strategy of moving up the value chain has started paying dividends in terms of faster growth in volumes and stability in margins. The company is betting big on the package implementation business where it has seen revenue contribution rising from 6% in FY01 to almost 28% in 2QFY05. This has proved beneficial for the company as a greater onsite component (high end services like package implementation have a high onsite component, at least to start with), has helped the company in building close relationships with clients.

During the period between FY04 and FY07, we expect Satyam’s topline to grow at CAGR of 32.0%, slightly above our earlier estimates of a 31.3% CAGR growth. This projection is based on assumptions of stronger growth in volumes countered by a weaker US dollar.

Satyam has a policy to cover 100% of the expected dollar inflows in the ensuing three months. In addition, it also covers 50% of expected inflows of the 4th, 5th and 6th month. As of September 30, 2004, the company had a forex cover of US$ 102 m.

Factors affecting margins: The depreciation in the value of US dollar vis-à-vis the Indian rupee is likely to exert some pressure on Satyam’s margins in FY05. The management states that for every 1% depreciation of the US dollar, Satyam’s operating margins are impacted by around 30 basis points. Further, our calculations show that at the EPS levels, the impact is anywhere around 1% to 1.3%.

To counter threat to margins from the rising rupee and otherwise, the company is using certain levers for margin expansion / maintenance. These are –

  1. Productivity enhancement: Rising contribution of package implementation and other high-value services to the total revenues is expected to boost Satyam’s employee productivity levels. This will further aid margins. We expect revenue per employee to increase from the current levels of Rs 1.8 m to around 2.1 m by FY07, a CAGR of 4.8%. This is, however, expected to be lower than Infosys’ FY07 expected revenue per employee level of Rs 2.3 m, CAGR of 7% from FY04 levels.

  2. Hiring freshers: Like all other Indian software majors, Satyam is hiring more of freshers, who come at lower incremental costs as compared to experienced personnel. For example, of the 1,200 new additions in 2QFY05, more than 1,000 were freshers. However, despite this fact and considering that the company, in its move up the value chain, would have to pay higher salaries to consultants/domain experts, we expect employee costs to be the fastest rising element of the company’s cost statement. From 52.5% of sales in FY04, we expect employee costs to reach 56.0% of FY07 expected sales.

  3. Control on G&A: While the company would continue to expend aggressively on the selling and marketing (S&M) fronts, it is taking measures on the general overheads (G&A) front. In FY04, the company expended around 21.0% of its revenues towards operating and administrative expenses. Assuming higher S&M and lower G&A, we expect this proportion to increase marginally to around 21.5% by FY07.

  4. Utilisation: While these levels dropped to around 74% in 2QFY05, the management was of the view that not much should be read into the same. The company has operated at around 78% utilisation levels in the past few quarters and consistency in the same will be a cushion for Satyam’s margins.

After this meeting with the management, and after considering all the above factors, we lower our expected FY07 operating margins to 22.5%, from our earlier estimates of 23%. As a matter of fact, Satyam’s FY04 margins were 26.5%.

Other key details…
  1. Large cash balance (around Rs 20 bn at the end of 2QFY05) maintained for acquisitions in the US and Europe. These acquisitions are likely to be in the BFSI and telecom verticals. Satyam is looking at small size companies as potential targets.

  2. The BPO subsidiary, Nipuna, to leverage existing client relationships and cross-sell services. The unit is expected to achieve cash break-even by the end of this fiscal. It currently has 1,350 employees now, which is expected to increase to around 2,200 employees by the end of this year. Billing rate are around US$ 12 per hour and 80% of revenues are from non-voice services, which is a positive.

  3. H1-B visas – Comfortable inventory of 2,000.

  4. Capex of Rs 1.3 - 1.5 bn in FY05 to expand facilities at Hyderabad, Chennai, Bangalore and Pune. Aims to add 5,000 seats in FY05, out of which 2,800 are already done. Remaining likely to be added in 2HFY05.

What to expect?
At the current price of Rs 408, the stock is trading at a price to earnings multiple 13 times our expected FY07 earnings, which seems fairly valued. After this research meeting with Satyam’s management, we expect the company’s profits to grow at a CAGR of 25.1% through FY07. This is marginally lower than our earlier estimates of 25.3% CAGR during the period.

While we are positive about Satyam’s forays into the high-end package implementation business, our concerns lie in the fact that the company has consistently underperformed its peers in the past. As a matter of fact, while Infosys has grown its revenues at a CAGR of 37% during the tough years of FY01 to FY04, Satyam’s relative performance is lower at 22%. Moreover, while we expect the company’s consolidated revenues to grow at CAGR of 32% during the period between FY04 and FY07, Infosys is likely to grow by around 41%.

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