I've been watching the price action on Syntel (NASDAQ:SYNT) for a few weeks now, waiting for a decent entry point. Possibly due to the tepid guidance, the stock price has seen a significant drop since early March, well off its 52-week highs:
Given the company's history of reliable EPS growth, low PEG < 1, and sound financial footing (CR 7.8), I was intrigued, and decided to dig a little further to see if the price action was justified or if this recent sell-off represented an opportunity.
What does Syntel do?
The company, which is based in India, provides information technology outsourcing solutions in a variety of areas. The company has focused on 4 different service lines:
- Applications Outsourcing (75% historical consolidated revenues): this segment provides customer-oriented solutions to cover software applications, including development, maintenance, migration, and infrastructure;
- Knowledge Process Outsourcing (13% historical consolidated revenues): this segment assesses business processes with proprietary tools to identify those best suited for outsourcing, focusing on middle and back-office processes for a variety of industries (such as brokerage and fund accounting for banking, and records management and claims for healthcare);
- E-Business (8% historical consolidated revenues): this segment develops, deploys, and maintains technology solutions for data analytics and management, enterprise-level software integration, and other software architecture projects; and
- TeamSourcing (4% historical consolidated revenues): provides IT consulting services for customer IT departments.
These service lines were vertically integrated starting Q1 2014, based upon industry focus. The company now divides its efforts into 5 segments: Banking & Financial Services, Healthcare & Life Sciences, Insurance, Retail / Logistics / Telecom, and Manufacturing. As the company did not reformat previous revenue breakdowns to account for this structure change, data are limited:
|Revenue by Business Segment||Q1 2014||Q4 2013||Q3 2013||FY 2013||FY 2012|
|Banking & Financial Services||49.2%||49.2%||49.7%||51.3%||55.0%|
|Healthcare & Life Sciences||17.5%||17.1%||17.8%||16.8%||17.5%|
|Retail, Logistics, & Telecom||15.8%||15.9%||14.6%||13.4%||9.1%|
|Gross Margin by Business Segment||Q1 2014||Q4 2013||Q3 2013||FY 2013||FY 2012|
|Banking & Financial Services||44.1%||48.3%||47.1%||45.6%||44.8%|
|Healthcare & Life Sciences||50.0%||49.3%||52.1%||47.5%||46.2%|
|Retail, Logistics, & Telecom||45.9%||50.5%||46.9%||44.2%||41.4%|
Source: Syntel Investor Fact Sheet
Syntel is a direct beneficiary of globalization, which has forced corporations to manage costs while improving service quality. The company leverages proprietary processes and in-depth, vertically integrated industry-specific expertise to customize client solution sets, and recently has been moving toward more technical fields such as cloud and mobile computing. Like many such companies, Syntel benefits from a degree of "stickiness" by striving to partner closely with its customers through the entire IT/KPO lifecycle, and is working hard to expand its global footprint in Asia, North America, and Europe.
The company's model certainly appears to have been working. More than 97% of the company's revenue comes from repeat clients, though it should be noted that the company's top 3 customers continued to generate the bulk of company revenue (about 45%). The company's broad scope of KPO services should give it solid positioning for attracting new customers and establishing long-term growth. That said, the company's small size (132 total customers, compared to Wipro's 900+) and concentrated client base remains a significant risk, though the company still has a long runway for growth.
Returns on equity have been solid for the past decade, and EPS growth has been steady, even during the most recent economic downturn.
Recent EPS growth has come with both top-line growth and operating margin expansion:
Though Syntel's still respectable ROIC lags that of its more established competitors like IBM (NYSE:IBM) and Accenture (NYSE:ACN), it still has better profitability metrics than its more growth-ier competitors like Infosys (NASDAQ:INFY), while its price is still reasonable for its prospects for continued growth:
At the year-end conference call, Syntel managed year-over-year revenue and earnings growth of 16% and 25%, respectively, though these were down 2% and 12% sequentially from Q4 2013. Though gross margins were in-line with historical averages (43.7% compared to 41.8%), they were down Y/Y on the back of increased SG&A expenses and capital expenditures. Most recently, on the Q1 2014 conference call, Syntel grew Y/Y EPS 25.2% from $1.11 to $1.39, with revenue growth and stable margins providing the bulk of accelerating profits. Excluding the sale of mutual fund units, income from operations grew 22.5% Y/Y.
Despite operating margins improving 5% from 27.5% to 29% for the quarter, guidance was muted, as management projected Y/Y revenue growth but flat to mildly depressed operating margins to the 26-28% range, and flat to decreased EPS from $5.10-5.28, based upon an increase in on-site hiring and increased facility costs and investments. The company remained in solid financial position, over $712 million in cash and a current ratio of 7.80.
Ben Graham outlines seven criteria for Defensive Investors and Enterprising Investors.
- Adequate size of enterprise (>$500 m in sales, >$250 m in assets): PASS
- Sufficiently strong financial condition (Current ratio > 2): PASS
- Earnings stability (no net loss over past 10 years): PASS
- Dividend Record (Dividends paid over past 20 years): FAIL
- Earnings Growth (Net income increases by >1/3 on per-share basis over 10 years): PASS
- Moderate P/E Ratio (Price < 15x average earnings over trailing 3 years): FAIL
- Moderate Ratio of Price to Assets (Multiplier of P/B x P/E < 22.5): FAIL
Based upon these criteria, SYNT doesn't quite meet Ben Graham's criteria for Defensive Investors.
- Adequate size: PASS
- Strong Financial Condition: PASS
- Earnings Stability: PASS
- Dividend Track Record: FAIL
- Earnings Growth > 3%: PASS
- P/E in lower 10% of similar stocks: PASS
- P/B < 1.2: FAIL
Based upon these criteria, SYNT meets Graham's criteria for Enterprising investors. It doesn't currently pay a dividend (it suspended dividends in 2013), and its price-to-book ratio remains unacceptably high. Other than that, though, the company seems suitable for an enterprising investor.
Though Syntel remains subject to the same risks as its competitors, including uncertainty in worldwide economic markets, currency fluctuations, and personnel hiring and retention, among the largest risks facing the company is its client concentration. The company's 10 largest clients generated approximately 77% of the company's revenues over the past 3 years, and the company's largest client, American Express, was responsible for nearly 27% of the total revenue base. State Street Bank, Syntel's second largest customer, generated about 17% of revenues during this time. The company banks upon its ability to retain clients through the sticky nature of its business-- moving from one outsourcing provider to another carries significant switching costs-- but nevertheless an abrupt termination of these contracts (which is allowable under the contract terms) would essentially halve the company's revenues. Moreover, the nature of the company's business entails a significant amount of employee turnover. Though voluntary attrition has been on the downswing over the past 3 years, it is likely that increasing competition for such workers will result in either higher wage costs or, just as risky, higher turnover of less qualified personnel. The IT/KPO market remains highly fragmented and competitive, and despite the company's historical record, it may fail to compete against its more robust competitors, like Wipro and Accenture.
Given the recent change in company organization, a model based upon its current reporting structure would be difficult to construct, and I've settled on using its historical reporting structure for the time being, assuming that trends in product mix between fixed-price and non-fixed-price engagements as well as mix between AO and KPO will remain largely intact. The effect of vertical integration remains to be seen, but based upon limited data there doesn't seem to be a large effect yet. As a conservative base assumption for DCF analysis, I assume that total revenues will exhibit more muted growth at 10.9% yearly CAGR (down from 16%) as competition increases in the IT/KPO space. I model a decrease in operating margins over the near and intermediate terms to 20-25% (down from 30%) as the company continues to invest heavily in hiring, facility expansion, and as wage costs continue to increase in India and elsewhere, before recovering to the 30% range. Doing so gives a 10-year DCF fair value of $84 (implying 10y EPS CAGR of 11.2%), a mild premium to today's closing price of $80.32.
An even more conservative bear case, modeling 9% yearly CAGR revenue growth and permanent compression of operating margin to 20% gives a downside to $61 (implied fPE of 12, 10y EPS CAGR 3%). Finally, a bull case, using historical revenue growth of 13% yearly CAGR, operating margin of 26%-29% over years 1-4, and 30% thereafter, with resultant 14.7% EPS CAGR, gives a FV of $122. Averaging the 3 gives a fair value estimate of $89, about a 10% premium to today's closing price. This implies a forward PE of 17.5 based upon the low end of management's 2014 EPS guidance. I use a WAC of 15.2%.
I should note that I personally favor the bull scenario, as the revenue growth and margin expansion fit with management's recent guidance, and as the company's small size gives it a longer runway for growth relative to its larger peers. However, client concentration remains a significant risk, and I think a more conservative reckoning is warranted. Recent price action suggests that the market has more muted expectations for the company's prospects. A back-of-the-envelope reverse DCF calculation suggests that, based upon forward EPS of $5.10, EPS would need to grow at a 10y CAGR of 7.3% to justify today's price, which seems an easy hurdle to clear. Very short term, the RSI looks moderately oversold at 36, and the MACD remains in bearish territory. I would anticipate additional volatility in the share price in the near term.
Amongst its peers, Syntel looks to be trading at an attractive valuation. I note that Morningstar rates ACN (0.99 P/FV), WIT (1.2 P/FV), IBM (0.93 P/FV), CTSH (0.87 P/FV) and INFY (0.91 P/FV) as trading near or above fair values. Despite the recent pullback, the company remains on sound financial footing overall, and I expect the company's investments to pay off in the long run. The recent 17% dip looks like a case of market over-reaction, and shares look modestly but materially undervalued based upon a conservatively positioned fair value estimate. I retain confidence that the company can easily pass this hurdle and am optimistic about its prospects moving forward, and recently initiated a small position.
Disclosure: I am long SYNT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am not a professional investment adviser, and this article reflects my own opinions. Please do your own due diligence and happy investing!