Syntel (NASDAQ:SYNT) has always held a comfortable and sizeable position in my portfolio, but it has unfortunately fallen into a category of neither being a winner nor a loser. Returns have largely tracked the S&P 500 since I took my position, and that isn't surprising given the rock solid balance sheet which has insulated the company from weaker results. Given it has been more than eight months since I last covered it here on Seeking Alpha, I think it is time to do a little post-mortem on my original thesis, where I went wrong, and what to do with the position from here.
Too Aggressive On Revenue Growth Expectations
Syntel has always been a quickly growing company, but that growth has unfortunately slowed down to a crawl. I built my models based off high single digit growth, and now we're unfortunately trending in the low single digits - with no expectations of acceleration. Given this is a high margin business (30% operating margins), this miss on revenue expectations has fundamentally impacted my original 2016 and 2017 estimates quite heavily.
I wasn't alone on this miss. Street analysts have been dragging down estimates for months, luckily with the market shrugging off the issues. Syntel blames this weakness on poor discretionary spending by customers, given a soft global macroeconomic outlook and tough regulatory environment. In particular, healthcare has been hamstrung by continued scrutiny by regulators over megamergers (Aetna/Humana, etc.) and banks have been hit as well (Brexit concerns, Dodd-Frank implementation, CCAR). Remember, Syntel fills the need for offshoring talent higher up the value chain, and since it is likely that customers are differing more expensive discretionary spending first, this spending will be impacted first. This is despite the obvious need for improvement given the bloated cost structure and aging legacy infrastructure present at most companies.
As a result, we're in a situation where Syntel is growing the top line less than (in my opinion) weaker firms like Wipro (NYSE:WIT) that provide talent way down the ladder from Syntel offerings. H1 2016 GAAP operating margins of 27.3% are with my expectations (28.4% back in December for full year 2016) given the back half usually sees some acceleration of projects as budgets get closed, resulting in higher margins (33% GAAP operating margins in 2H 2015 as a reference), so I didn't really miss the story here when it comes to margin retention. Syntel has been able to lever using its SyntBots and other automation software with higher margins over time, which can overcome some weakness from higher wage pressures in India increasing offshore provider costs. Employee pay is up high single digits y/y on average, yet attrition remains in the 20-25% range consistently. In a global economy, India was always going to see wage growth over time, which is why I felt (and still feel) that if you want offshore exposure, you need offshore exposure to a company that doesn't compete solely on price.
My original valuation expectation was built on a 14.5x multiple (excluding cash), in line with historical averages. Assuming $2.85/share in 2017 earnings and $1.2B in net cash (after repatriation costs), that shrinks my upside to 22% in my original model through the end of fiscal 2017. Market-beating returns? Probably, but I'm not left with a sizeable margin for error as it does continue to rely on further multiple expansion, which seems unlikely given shrinking earnings projections. The upside here is simply not as attractive as it once was, especially given the perseverance of the stock price. Clearly there might be some other opportunities for me elsewhere in the market.
Cash Policies Footnote
I'm a big fan of aggressive capital deployment. If you've got cash, you've got to spend it somewhere in this environment. M&A? Yes please, especially here as that dodges some of the tax implications related to repatriation. Dividends/share repurchases? Sign me up. Syntel, however, has always erred on the side of caution when it comes to cash deployment, which is a bit frustrating as a shareholder. It simply doesn't make too much sense to me to hoard forever. Remember, the company has no real capital expenditure needs to speak of and no debt. Net income is basically all retained on the balance sheet as cash. Trying to pressure management on policy, an analyst recently tried to take a firm position with management on the most recent earnings conference call:
"Great, thanks. I wanted to come back to cash, unfortunately it's really the only question I have. We've heard for years, cash has been a board discussion and it's evaluated every quarter. Can you share what reluctance has been from a board level to put the cash to work from an M&A perspective? And then given, there's been sluggish growth for a couple of years, has the board's attitude towards M&A change at all or is it still just as cautious as it has been in the past?"
Result? Complete shutdown from management - not surprising. Further, there is no chance of activist involvement here given founder Bharat Desai's stranglehold on ownership (owning two thirds of the common shares outstanding). This was of course something I knew going in, but it is something for investors to consider that are weighing their position in the company.
The tax implications are there as well. In order to repatriate in order to pay dividends, the company will owe 17.647% tax on the distribution under Indian tax law, then the balance on repatriation to the United States, net of foreign taxes paid. Total tax bill to repatriate all cash would be in the neighborhood of $330M at this point (taken into account in my valuation model).
This is a position I'm at the very least considering trimming given my miss on short term outlook, with the caveat being I just have to find a suitable alternative home for that cash. Investors in the company should take note of the more pessimistic tone from management, along with deteriorating earnings estimates.
Syntel is still the best in this space, and I do think that concerns over Indian wage growth and competition with other local firms is overstated. However, Q2 2016 GDP shows just how fearful businesses are amid a myriad of factors, from weak global sales, Brexit fear, foreign exchange impacts, terrorism, and political upheaval. Guidance remains cautious. It simply is a tough market out there, and for the company to get back to high single digit growth, businesses have to shift sentiment away from fear.
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Disclosure: I am/we are 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.