Satyam Computers: Strong Earnings Growth To Continue

Ashish R. Thadhani (Gilford Securities) recently sent a note to clients encouraging them to buy Indian IT company Satyam Computer (SAY). Excerpts follow:

SAY: 9.5% QoQ Growth; 190 bps Improvement in LTM Attrition, Pricing Gains ... Plus Robust FY08 Guidance!

• Investment Conclusion. Based on strong market demand, surprisingly resilient margins and positive interest/taxation revisions – offset partially by slightly higher near-term stock compensation expense – we are raising our estimates as follows: fiscal 2008 GAAP diluted EPADS to $1.10 on revenue of $1.948 billion (33% YoY growth) from $0.98 on revenue of $1.914 billion; and fiscal 2009 GAAP diluted EPADS to $1.30 on revenue of $2.532 billion (30% YoY growth) from $1.15 on revenue of $2.526 billion. Our estimates imply 32%/24% compound revenue/EPADS growth in calendar 2006-08. Due to the meaningful step-up in forward earnings, we are raising our target price from $28 to $32.50. In 12 months, this would correspond to 25x forward GAAP diluted EPADS of 1.30 – a modest premium to the current valuation (23x). Longer term, differentiating attributes include a leading ERP Package Implementation practice; penetration of the Manufacturing sector and 160+ 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.

• 4Q07 Results. GAAP diluted EPADS of $0.26 vs. $0.19 a year ago on revenue of $411.3 million handily beat our $0.22 estimate on revenue of $398.1 million. The overage is attributed to positive variances across operating income ($5.4 million) and interest/other items ($7.0 million). Highlights included 37% YoY and 9.5% QoQ revenue growth vs. our 32%/6.0% expectation; firm underlying profitability (21.1% operating margin before stock compensation expense vs. 21.3% a year ago and our 21.0% estimate); gains across key metrics such as employee attrition (13.2% for the quarter vs. 21.9% a year ago), offshore revenue-mix (50.6% vs. 46.0%) and blended billing rate (unprecedented 0.7% QoQ growth); as well as fiscal 2008 U.S. GAAP guidance of 28-30% revenue and 27-29% basic EPADS growth. During the quarter, Satyam also signed a $200 million, five-year contract with semiconductor equipment manufacturer Applied Materials – adding to prior visibility-enhancing wins at Nissan, General Motors and Qantas.

• Takeaways. For fiscal 2007, Satyam recorded 33% YoY revenue growth vs. its original 25% guidance, while the operating margin was unchanged at 20.0% despite 100 bps of incremental stock compensation expense. Management credited this performance to superior relationship management, competencies and execution. Annual salary increases effective July 1 will average 16% for offshore staff and 5% for onsite. Fiscal 2008 guidance is based on volume-driven 28-30% YoY revenue growth, a 2-3% YoY billing rate improvement, unchanged YoY operating margin despite salary/RSU headwinds, and an exchange rate of INR 42.30 per U.S. dollar vs. 44.30 in January. Citing recent client interactions, Satyam does not view a U.S. slowdown as posing an imminent threat.

• Revenue growth was driven by the Technology vertical (up 63% YoY to 22% of the total), Consulting and Package Implementation practice (48% and 43%) and European region (46% and 20%). Top-client GE contributed 6% of revenue vs. 8% a year ago. Operating income of $81.0 million (19.7% margin) surpassed our $75.6 million estimate (19.0% margin). Profitability on a QoQ basis was hurt by rupee appreciation (1.5%) and new stock compensation expenses – offset partially by improved offshore revenue-mix, utilization and billing rates. Available levers for countering salary- related pressures (~400 bps in fiscal 2008) and rupee appreciation (200 bps) include pricing (200 bps), offshore revenue-mix (1% swing = 30+ bps), ramp-up of the BPO and other subsidiaries (25 bps), lower-cost campus recruitment and operational efficiencies.

• Hourly billing rates averaged $56.80 for onsite work (up 1% QoQ and 2% YoY) and $23.30 for offshore (up 1% QoQ and YoY). Billed volume rose 9.5% QoQ. Offshore utilization (excluding trainees) stood at 78.4% vs. 79.9% a year ago. High-margin offshore work contributed 50.6% of IT Services revenue vs. 48.9% in the December quarter – a reflection of client comfort and suitability of newer services for distributed delivery. Excluding BPO, headcount rose 3.7% QoQ and 35% YoY to 35,670 in March. Hiring plans call for the (gross) addition of 14-15K associates in fiscal 2008, unchanged from the prior year. Attrition (LTM), which includes a 3-5% involuntary component, improved to 15.7% from 17.6% in 3Q07 and 19.2% a year ago. With career development programs and early/empowered leadership, Satyam is targeting a 10-12% range.

• By industry, Manufacturing ranked largest (27% of revenue), followed by Financial Services (25%), Technology (22%), Healthcare (8%) and Retail/Transportation/Others (18%). Top-10 clients accounted for 36.3% of total revenue, up from 34.2% in the December quarter. Satyam now has 57 clients (vs. 54 in the December quarter) with an annual revenue run-rate of $5+ million and 35 (vs. 32) with $10+ million. Satyam added 35 new clients compared with 34 in the immediately prior period. It exited the quarter with an active roster of 538, up from 523 in December.

• BPO subsidiary Nipuna posted a deficit of $0.2 million on revenue of $11.5 million, up 51% YoY and 18% QoQ. The fiscal 2008 revenue forecast is $61 million (up 60% YoY). Noteworthy developments include a shifting profile toward non-voice revenue (60%).

• Satyam generated CFFO of $49 million ($0.15 per ADS) in the quarter. Proceeds from exercise of options totaled $39 million. Major outflows comprised capital expenditures ($20 million), budgeted to climb from $82 million in fiscal 2007 to $90-100 million in fiscal 2008. Satyam exited the quarter with net cash of $852.2 million (~$2.50 per ADS), up from $764.9 million on December 31. Accounts and unbilled receivables slipped to 88 DSOs from 82 in December.

• 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.