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Excerpts from Gilford Securities analyst Ashish R. Thadhani's recent note to clients on Syntel (NASDAQ:SYNT):

• • •

Investment Conclusion. Based on a currency-aided margin tailwind –
offset by delays in IT spending decisions amid the global financial crisis
and economic downturn – we are adjusting our estimates as follows:
2008 pro-forma EPS to $1.85 on revenue of $411 million (22% YoY
growth) from $1.70 on $422 million; meanwhile, 2009 pro-forma EPS
remains unchanged at $1.95 on $441 million (7% YoY growth but
down from $507 million previously). At this time, we are introducing a
2010 pro-forma EPS estimate of $2.15 on revenue of $516 million
(17% YoY growth) – or about one-half of the well publicized internal
goal of $1 billion. Our Hold rating remains in effect due to valuation,
fundamental and management reservations. SYNT is selling at 12x
forward EPS vs. 8% compound EPS growth in 2008-10E – and an
inexplicable premium to Tier-I players CTSH (4%), INFY (8%) and
SAY (37%) that offer superior growth, positioning and execution.

Recent results have reinforced our apprehension: 3Q08 revenue missed
our estimate with the BPO engine suffering a dramatic reversal (-6.7%
QoQ) as two other segments also contracted QoQ; Syntel abandoned
its 2008 hiring plan, which could leave year-end headcount up only 5%
YoY vs. 21% previously; we note that 2008 EPS guidance of $1.88-1.93
includes more than $0.10 of non-recurring gains; increasing exposure
with slowing growth at American Express and State Street Bank (39%
of revenue); vulnerability to the Financial Services segment (75% of
revenue); and recent stock sales by various insiders.

Our concerns include loss of market share in the largest segment,
doubtful sustainability of recent BPO momentum and profitability
(fueled by a narrow client base), depletion of cash by way of special
dividends (CEO Bharat Desai has been the primary beneficiary), ~400
bps drop in the operating margin during 2004-07 despite transfer of
substantial work from the U.S. plus ramp-up of major clients, senior
management turnover and an inability to attract seasoned talent. Proxy
materials also bare a lightweight board and obscure accounting firm.
For delivering 22% EPS growth in 2007, total compensation for the
top-three executives was 3x their base salary. Contrary to management
claims, we believe that Syntel possesses neither the scale nor domain
depth to withstand future competitive pressures.

Takeaways. EPS of $0.54 vs. $0.37 a year ago on revenue of $103.8 million (18% YoY and 0.3% QoQ growth) beat our $0.43 estimate on revenue of $107.1 million. Relative to our expectation, Syntel posted a significant operating income overage (+$5.8 million resulting largely from favorable currency translation
and deferred hiring, construction and equipment expenses) that was partially offset by other income and taxes (-$1.6 million variance includes hedging losses). Management noted the following: a cautious short-term outlook given increasingly conservative client behavior in a deteriorating economic environment; 41% YoY revenue drop at its second-largest BPO client (India-based brokerage firm); but an encouraging sales pipeline for cost-reduction initiatives.

  • Revenue increased 20% YoY and 5.3% QoQ in the Applications Outsourcing segment – driven by maintenance work – while reflecting the ramp-down of certain discretionary e-Business projects (up 19% YoY but down 9.5% QoQ). BPO revenue rose 27% YoY but fell 6.7% QoQ to 19% of the total.
  • Operating income of $26.2 million (25.2% margin) exceeded our $20.4 million estimate (19.1% margin). Profitability on a QoQ basis was aided by a weak rupee (~370 bps), improved utilization (100 bps) and fixed-price productivity (50 bps), as well as the aforementioned deferred expenses. Syntel will continue its investments in infrastructure, service offerings, training and branding.
  • By industry, Financial Services ranked largest (75% of revenue), followed by Healthcare (13%), Automotive (3%) and Others (9%). Top-10 clients accounted for 72% of total revenue, up from 70% in the June quarter. Syntel added 10 new clients compared with five in the immediately prior period. The offshore utilization rate stood at 71% vs. 68% a year ago. Offshore work represented 80% of total effort vs. 80% in the June quarter. Higher-margin offshore revenue contributed 49% of the total vs. 50% in the June quarter. Annualized quarterly turnover deteriorated to 14.3% vs. 14.1% a year ago. Total headcount rose 1.9% QoQ and 15% YoY to 12,277 in September. BPO headcount reached 4,273 or 35% of the total. Hiring plans call for exiting 2008 with no material headcount expansion above the current level, implying 5% YoY growth vs. 21% previously..
  • Syntel generated CFFO of $23.1 million (or $0.56 per share) in the quarter. Major outflows comprised capital expenditures ($8.0 million), budgeted to climb from $32.4 million in 2007 to $35 million in 2008
  • – but down from $50-60 million originally. Infrastructure initiatives encompass seat expansion plus construction of new facilities in Chennai (SEZ-approved 29-acre campus) and Pune (SEZ-approved 37-acre campus). Syntel exited the quarter with net cash of $118.7 million, up from $116.0 million onJune 30. Accounts and unbilled receivables improved to 58 DSOs from 63 in June.


SYNT shares are suitable for aggressive investors. In our opinion, principal risks include the following: U.S. slowdown; rising offshore salaries; appreciation of the Indian currency, which would translate into higher expenses; correction in the Bombay Stock Exchange and/or U.S. markets; political opposition in the U.S.; and geopolitical uncertainty in the Indian subcontinent.

Source: Gilford Securities Research

Source: Syntel: Competitive Pressures but Encouraging Pipeline