Satyam Strikes Purple Patch, Raising Target to $37.50

Ashish R. Thadhani (Gilford Securities) sent a note to clients following Satyam's (SAY) recent quarterly report, in which he raised his estimates and price target on SAY. Excerpts follow:

SAY: Strikes Purple Patch, Raising Target to $37.50

• Investment Conclusion. After factoring in continued volume/price momentum and a recent forex gain – offset partially by renewed rupee appreciation – we are raising our estimates as follows: fiscal 2008 GAAP diluted EPADS to $1.22 on revenue of $2.080 billion (42% YoY growth) from $1.15 on revenue of $2.001 billion; and fiscal 2009 GAAP diluted EPADS to $1.42 on revenue of $2.727 billion (31% YoY growth) from $1.35 on revenue of $2.601 billion. Our estimates imply 37%/29% compound revenue/EPS growth in calendar 2006-08.

In spite of investor apprehension over a weakening U.S. economy (58% of revenue) and an uncooperative currency environment, we are increasing our target price from $35 to $37.50. In 12 months, this would correspond to 25x forward GAAP diluted EPADS of 1.50 – a modest premium to the current valuation (23x). Meanwhile, differentiating attributes include a top-rated ERP Package Implementation practice enabling client engagement at a more strategic level; 170+ Fortune/Global-500 relationships plus a leading presence in the Manufacturing sector; and recent growth across newer clients and higher value services that could translate into a meaningful margin lever – with positive valuation implications.

• 2Q08 Results. GAAP diluted EPADS of $0.30 vs. $0.20 a year ago on revenue of $509.6 million easily beat our $0.26 estimate on revenue of $481.7 million. Results included a forex benefit of $0.03 per ADS. Operating income rose 37% YoY and exceeded our estimate by 5% (or $0.01 per ADS). Highlights included 45% YoY and 12.7% QoQ revenue growth vs. our 37%/6.5% expectation; firm profitability (17.7% operating margin vs. 18.8% a year ago despite unprecedented rupee appreciation); gains across key operating metrics such as billing rates (up ~4% YoY) and employee attrition (five straight quarters of improvement); a 6% step-up in the hiring goal for fiscal 2008; upgraded fiscal 2008 U.S. GAAP guidance of 36% basic EPADS growth; and two notable wins (an oil & gas major and Reuters) that rank among the largest multi-year deals for Satyam.

• Takeaways. Satyam credited its performance to recent wins and the ramp-up of ongoing business transformation engagements. It recorded reassuring growth in the closely watched Americas region (6.7% QoQ and 28% YoY) and Financial Services sector (13.0% QoQ and 21% YoY). Management stated that recent concerns in these segments have not touched its business. It also believes that any modest slowdown in U.S. discretionary spending will likely be accompanied by a greater emphasis on operating efficiency, i.e., IT budget reallocation in favor of offshoring initiatives. Separately, Satyam announced the niche acquisition of Nitor Global Solutions for $5.6 million in cash or ~2x revenue. Based in London, Nitor specializes in Microsoft technologies and will augment the Infrastructure Management practice with 20 consultants and valuable client relationships. Fiscal 2008 guidance is based on 42% YoY revenue growth, a 4% billing rate improvement, annual salary increases (effective July 1) averaging 16% for offshore staff and 5% for onsite, ~50 bps decline in the operating margin on account of rupee appreciation, and an exchange rate of INR 39.50 per U.S. dollar vs. 40.50 in July.

• Revenue growth was driven by the Package Implementation & Consulting practice (up 61% YoY and 45% of the total); newer Technology/Media vertical (67% and 24%); and Asia-Pacific region (85% and 21%). Top-client GE contributed 5.8% of revenue vs. 6.7% a year ago. Operating income of $90.3 million (17.7% margin) surpassed our $86.4 million estimate (17.9% margin). Profitability on a QoQ basis was hurt by scheduled salary hikes (450 bps impact), onsite-mix (70 bps) and rupee appreciation (30 bps) – mitigated by improved billing rates (120 bps), operating efficiencies (110 bps) and utilization (60 bps). Available levers for countering salary-related pressures (350 bps in fiscal 2008) and rupee appreciation comprise pricing, offshore-mix, ramp-up of the BPO and other subsidiaries, lower-cost campus recruitment and operating efficiencies.

• Hourly billing rates averaged $58.93 for onsite work (up 2.2% QoQ and 4.7% YoY) and $23.92 for offshore (up 1.3% QoQ and 3.5% YoY). Billed volume rose 9.1% QoQ. Offshore utilization (excluding trainees) stood at 81.5% vs. 78.8% a year ago. High-margin offshore work contributed 50.4% of IT Services revenue vs. 52.0% in the June quarter – explained by onsite starts. Excluding BPO, headcount rose 7.9% QoQ and 31% YoY to 41,423 in September. Hiring plans call for the (gross) addition of 16-17K associates in fiscal 2008, up from the prior 15-16K figure. Attrition (LTM), which includes a 3-5% involuntary component, improved further to 13.9% from 14.9% in 1Q07 and 18.3% a year ago. With career development programs, early/empowered leadership and above-average salary increases, Satyam is targeting a 10-12% range.

• By industry, Financial Services ranked largest (24% of revenue), followed by Manufacturing (24%), Technology/Media (24%), Healthcare (8%), Retail/Transportation (7%) and Others (14%). Top-10 clients accounted for 33.9% of total revenue, down from 34.4% in the June quarter. Satyam now has 75 clients (vs. 65 in the June quarter) with an annual revenue run-rate of $5+ million and 40 (vs. 36) with $10+ million. Satyam added 37 new clients – including eight from the Fortune/Global-500 -- compared with 29 in the immediately prior period. It exited the quarter with an active roster of 577, up from 551 in June.

• Satyam BPO is positioning itself as a vendor of specialty offerings -- engineering, animation, analytics, claims, helpdesk, etc. -- with an integrated BPO+IT orientation. This unit posted a deficit of $1.2 million on revenue of $15.1 million, up 68% YoY and 27% QoQ. The fiscal 2008 revenue forecast is unchanged at $61 million (up 60% YoY).

• Satyam generated CFFO of $94 million ($0.28 per ADS) in the quarter. Major outflows comprised purchase of the Nipuna minority stake ($51 million), dividend payments ($48 million) and capital expenditures ($21 million), budgeted to climb from $82 million in fiscal 2007 to $80-100 million in fiscal 2008. Satyam exited the quarter with net cash of $926 million ($2.70 per ADS), up from $923 million on June 30. Accounts and unbilled receivables slipped to 92 DSOs from 91 in June.

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• 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.