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Excerpts from Gilford Securities analyst Ashish R. Thadhani's recent note to clients on Syntel, Inc. (SYNT):

Investment Conclusion: Our Hold rating remains in effect due to valuation, fundamental and management reservations (summarized below). Driven by non-core TeamSourcing revenue, non-operating income and lower taxation, we are adjusting our estimates as follows: 2008 pro-forma EPS goes to $1.65 on revenue of $422 million (25% YoY growth) from $1.60 on revenue of $418 million; and 2009 pro-forma EPS remains unchanged at $1.85 on revenue of $508 million (20% YoY growth) vs. $505 million previously. SYNT shares are selling at 19x forward EPS vs. 13% compound EPS growth in 2007-09E – or an unwarranted PEG of 1.5x vs. 0.9-1.2x at Tier-I players offering superior growth, positioning and execution.

Our concerns include: rapid loss of market share in the largest/core segment, doubtful sustainability of recent BPO momentum and profitability (fueled by a single client), depletion of cash by way of special dividends (CEO Bharat Desai has been the primary beneficiary) despite the knowledge that clients place significant faith on balance sheet strength, senior management turnover and an inability to attract seasoned talent, as well as various instances of poor judgment, e.g., at the time of its opening, the Pune campus (9,000-seat capacity) was eligible for less than three years of STPI and no SEZ tax benefits. Also, 2007 proxy material bares embarrassing CEO club membership expenses approved by a lightweight board. Contrary to management claims, we believe that Syntel possesses neither the scale nor domain depth to withstand recent currency and competitive pressures.

Quarterly results have reinforced our apprehension: 4Q07 EPS benefited from non-operating hedging/investment gains (2.4 cents) and lower-than-projected taxation (1.6 cents); operating margin plummeted 230 bps QoQ and 300 bps YoY to the lowest level in several years – consequently, operating income increased just 9% YoY and missed our estimate by 7%; with no explanation, Syntel restated/lowered 3Q07 depreciation (a rising expense category); revenue growth in 2007 was 44% for the top-3 clients but only 14% across all others; and Syntel remains vulnerable to the Financial Services segment (71% of revenue). That SYNT is still selling at a premium to INFY and SAY is entirely inappropriate, in our view.

4Q07 Takeaways: Pro-forma EPS of $0.39 vs. $0.32 a year ago on revenue of $94.0 million (29% YoY and 7.0% QoQ growth) beat our $0.36 estimate on revenue of $93.0 million. Excluding hedging/investment gains and lower-than-projected taxation, EPS would have missed our estimate. The delayed release of 4Q07 results is attributed to external auditors requiring a $5 million increase in prior year tax reserves, which was taken as an adjustment to retained earnings. Management is of the view that “challenging economic conditions will force organizations to prioritize their IT investments and (the company is) confident that global sourcing will continue to be regarded as a key enabler of operating efficiency.” According to a recent Syntel survey, 53% of respondents plan to increase their spending on global outsourcing in 2008 – despite a weak economy. This compares with 38% in 2006 and 48% in 2007. According to management, clients view Syntel as an alternative to unresponsive Tier-I organizations.

Revenue reflected 18% YoY and 5.5% QoQ growth in the Applications Outsourcing segment – driven increasingly by maintenance work – and a lull in e-Business project activity (up 4% YoY and down 1.3% QoQ). Operating income of $15.6 million (16.6% margin) failed to meet our $16.7 million estimate (18.0% margin). Profitability on a QoQ basis was hurt by rupee appreciation, new facility costs, a marketing event and reserve for doubtful accounts – offset partially by pricing. Syntel will continue to invest in infrastructure, service offerings, training and branding.

BPO revenue jumped 132% YoY and 12.2% QoQ to 19% of the total. Syntel is focusing on non-commoditized work for 10 Financial Services and Healthcare clients, e.g., trade settlement and insurance processing. Gross margin dropped 610 bps YoY due to currency and wage pressures. By industry, Financial Services ranked largest (71% of revenue), followed by Healthcare (13%), Automotive (7%) and Others (9%). Top-10 clients accounted for 75% of total revenue, up from 73% in the September quarter. Syntel added four new clients compared with eight in the immediately prior period. The offshore utilization rate stood at 66% vs. 64% a year ago. Offshore work represented 79% of total effort vs. 78% in the September quarter. Higher-margin offshore revenue contributed 51% of the total vs. 51% in the September quarter. Annualized turnover slipped to 14.5% vs. 13.4% a year ago. Total headcount rose 9.7% QoQ and 40% YoY to 11,709 in December – but fell short of a recently lowered year-end goal. BPO headcount reached 3,602 or 31% of the total. Hiring plans call for exiting the year with 2,800-3,500 additional employees vs. December 2007, implying 24-30% YoY expansion. Syntel generated CFFO of $35.8 million (or $0.87 per share) in the quarter. Major outflows comprised capital expenditures ($9.9 million), budgeted to climb from $32.4 million in 2007 to $50-60 million in 2008. Infrastructure initiatives encompass seat expansion plus construction of new facilities in Chennai (SEZ-approved 5,000-seat campus) and Pune (second 37-acre campus). Syntel exited the quarter with net cash of $116.2 million, up from $93.0 million on September 30. Accounts and unbilled receivables improved to 57 DSOs from 73 in September.

SYNT 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; correction in the Bombay Stock Exchange and/or U.S. markets; political opposition in the U.S.; and geopolitical uncertainty in the Indian subcontinent.

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Source: Syntel Misses Operating Income Estimates, Margin Plunges