Satyam Absorbs Currency Blow - Buy on Weakness

Ashish R. Thadhani (Gilford Securities) recently sent a note to clients on Satyam Computer Services Ltd. (SAY) advising they 'buy' shares on recent price weakness resulting from rupee appreciation. Excerpts follow:

• Investment Conclusion. Based on a firm demand environment and underlying profitability – plus delayed implementation of an RSU program into 4Q07 – we are raising our estimates as follows: fiscal 2007 GAAP diluted EPADS to $0.85 on revenue of $1.448 billion (32% YoY growth) from $0.83 on revenue of $1.443 billion; and fiscal 2008 GAAP diluted EPADS to $0.98 on revenue of $1.914 billion (32% YoY growth) from $0.95 on revenue of $1.876 billion. We are also introducing a fiscal 2009 GAAP diluted EPADS estimate of $1.15 on revenue of $2.526 billion (32% YoY growth). Our estimates imply 32%/16% compound revenue/EPADS growth in calendar 2006-08. To reflect the quarterly step-up in forward earnings, we are raising our target price from $26 to $28. In 12 months, this would correspond to 25x forward GAAP diluted EPADS of 1.11 – in line with the prevailing valuation (25x). Recent price weakness is attributed to slightly lower revenue guidance under Indian GAAP – in contrast to its peers – resulting from rupee appreciation. Longer term, differentiating attributes include a leading ERP Package Implementation practice; penetration of the Manufacturing sector and 150+ Fortune/Global-500 relationships; and recent growth across newer clients and higher value services that could translate into a meaningful margin lever – with valuation implications.

• 3Q07 Results. GAAP diluted EPADS of $0.21 vs. $0.17 a year ago on revenue of $375.6 million beat our $0.20 estimate on revenue of $373.1 million. Results were held back by a forex loss of $7.6 million (or $0.02 per ADS) – offset partially by lower stock compensation expense ($5.6 million positive variance). Excluding the impact of lower stock compensation expense, operating income (+6%) and margin (+90 bps) still exceeded our estimates. Highlights included 33% YoY and 6.7% QoQ revenue growth vs. our 32%/6.0% expectation; improved underlying profitability (21.4% operating margin before stock compensation expense vs. 20.8% a year ago and our 20.5% estimate); and gains across key metrics such as employee attrition and offshore revenue-mix. Management rejected recent takeover speculation and stated categorically that Satyam intends to remain independent.

• Takeaways. Top-10 clients recorded 14% QoQ growth driven by the ramp-up of recent wins. The pipeline of multi-year deals stands at 15 – with an aggregate value exceeding $1 billion. Adoption of offshore ERP implementation services is not expected to suffer on account of slower SAP/Oracle licensing activity. Satyam remains well positioned to capitalize on package-led business transformation initiatives and claims “qualitative” leadership in the rapidly emerging Engineering Services segment as well. The company has recently expanded its presence across China, Malaysia and Egypt. Fiscal 2007 guidance is based on volume-driven 32% YoY revenue growth, stable pricing, unchanged YoY operating margin despite a stock compensation drag, and an exchange rate of INR 44.30 per U.S. dollar vs. 45.30 in October.

• Revenue growth was driven by the Technology vertical (up 49% YoY), Consulting and Package Implementation practice (42%) and European region (37%). Top-client GE contributed 6% of revenue vs. 9% a year ago. Operating income of $77.6 million (20.7% margin) surpassed our $68.5 million estimate (18.4% margin). Profitability on a QoQ basis was impacted by rupee appreciation (3.7% = 120 bps) – offset by salary/related costs, offshore revenue-mix, employee- mix and management of fixed-bid projects. The new RSU program will take effect in 4Q07. Available levers for countering wage pressure comprise offshore revenue-mix, ramp-up of the BPO subsidiary (70 bps drag in fiscal 2006), lower-cost campus recruitment and pricing.

• Hourly price realizations averaged $56.47 for onsite work (flat QoQ and up 1% YoY) and $23.14 for offshore (flat QoQ and up 1% YoY). Billed volume rose 8.2% QoQ despite three fewer days. Offshore utilization (excluding trainees) stood at 77.6% vs. 79.7% a year ago. High-margin offshore work contributed 48.9% of IT Services revenue vs. 47.6% in the September quarter. Excluding BPO, headcount rose 9% QoQ and 47% YoY to 34,405 in December. Hiring plans call for the (gross) addition of 14,000 associates in fiscal 2007, up from the prior 13,000 figure. Attrition (LTM), which includes a 3-5% involuntary component, improved to 17.6% from 18.3% in 2Q07 and 18.0% a year ago. With mentoring/development programs and distributed/empowered leadership, Satyam is targeting a 12-14% range.

• By industry, Manufacturing ranked largest (27% of revenue), followed by Financial Services (26%), Technology (21%), Healthcare (8%) and Retail/Transportation/Others (19%). Top-10 clients accounted for 34.2% of total revenue, up from 33.9% in the September quarter. Satyam now has 54 clients (vs. 54 in the September quarter) with an annual revenue run-rate of $5+ million and 32 (vs. 32) with $10+ million. Satyam added 34 new clients compared with 35 in the immediately prior period. It exited the quarter with an active roster of 523, up from 504 in the September quarter.

• BPO subsidiary Nipuna posted a deficit of $1.2 million on revenue of $9.7 million, up 100% YoY and 8% QoQ. The fiscal 2007 revenue forecast has increased slightly to $37 million (up 86% YoY). Noteworthy developments include a $25 million Animation contract, shifting profile toward non-voice revenue (60%) and a step toward consolidating ownership in this unit.

• Satyam generated CFFO of $73 million ($0.22 per ADS) in the quarter. Proceeds from exercise of options totaled $9 million. Major outflows comprised dividends ($17 million) and capital expenditures ($23 million), budgeted to climb from $54 million in fiscal 2006 to $80 million in fiscal 2007. Satyam exited the quarter with net cash of $764.9 million (~$2.25 per ADS), up from $695.1 million on September 30. Accounts and unbilled receivables slipped to 82 DSOs from 79 in September.

click to enlarge

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