Satyam's Valuation Discounts Short-Term Outlook

Excerpts from Gilford Securities analyst Ashish R. Thadhani's recent note to clients on Satyam Computer Services Ltd. (SAY):

• • •

SAY: Valuation (14.5x Forward EPS) Discounts Subdued Short-Term Outlook; Reiterating $34 Target Price

• Investment Conclusion. Based on a more conservative revenue outlook – offset by recent rupee depreciation and a lower tax-rate – we are adjusting our estimates as follows: fiscal 2009 GAAP diluted EPADS remains at $1.45 on revenue of $2.667 billion (25% YoY growth but down from our prior $2.709 billion projection); and fiscal 2010 GAAP diluted EPADS drops slightly to $1.70 on revenue of $3.333 billion (25% YoY growth) from $1.72 on revenue of $3.481 billion. Our estimates imply 28%/19% compound revenue/EPS growth in calendar 2007-09 – after factoring a one-year extension in the “STPI” tax holiday to March 2010 – second only to Cognizant among offshoring majors. Recent price weakness can be attributed to renewed concern over the U.S. IT spending environment (60.3% of revenue). Nonetheless, we are reiterating our $34 target price. In 12-months, this would correspond to 20x forward EPS of $1.71 – a premium to the current depressed valuation (14.5x).

• 1Q09 Results. GAAP diluted EPADS of $0.37 vs. $0.27 a year ago on revenue of $637.3 million matched our $0.37 estimate on revenue of $634.8 million. Excluding currency volatility (+$13.5 million impact stemming from quarter-end and not realized exchange rates), Satyam posted a $7.7 million revenue shortfall attributed largely to the loss of BPO animation business (-$6.7 million QoQ). Results included a $6.2 million net currency translation/hedging gain (+1.6 cent EPADS impact) and $2.2 million Fringe Benefit Tax provision (-0.6 cents). Operating income advanced 49% YoY and exceeded our estimate by 5%. Highlights included 3.9% QoQ and 41% YoY revenue growth; further improvement in annualized quarterly attrition to 11.0% – among the best in the industry; three $50+ million wins and deepening penetration of European clients such as EADS and ArcelorMittal; and reaffirmation of fiscal 2009 EPADS guidance, implying very manageable 3% QoQ revenue growth (using quarter-end exchange rates).

• Takeaways. Satyam recorded slower growth in the Americas region (+3.4% QoQ and +38% YoY) and Financial Services segment (+1.7% QoQ and +27% YoY). Also, revenue included a $7.8 million contribution from Bridge Strategy Group, acquired in early-April. Meanwhile, increasingly diverse and complex engagements are the result of an enhanced global footprint and overall service capabilities.

Management noted the following: confidence in its ability to deliver on guidance despite uncertain economic conditions in key market segments, e.g., Financial Services plus other verticals such as Retail and Transportation that have been impacted by soaring energy costs and inflation; however, the company’s focus on transformation initiatives that offer near-term operational benefits is translating into a higher share of client IT spend; accordingly, the pipeline of larger opportunities remains healthy (~20); and there have not been significant client requests for lower pricing. Satyam plans to expand its SAP practice to 6,800 consultants by fiscal year-end, up 36% YoY. Separately, the Upaid Systems case is expected to be tried only in June 2009 and Satyam remains confident of defending its position.

Fiscal 2009 guidance is based on 25% YoY revenue growth, stable billing rates, annual salary increase (effective July 1) averaging 12-14% for offshore staff and 3-4% for onsite, ~50 bps rise in the operating margin (vs. a 50 bps decline previously), and an exchange rate of INR 42.88 per U.S. dollar vs. 40.00 in April.

• Revenue growth was driven by the Application Development & Maintenance practice (up 44% YoY and 45% of the total); European region (45% and 21%); and newer Retail, Transportation & Logistics vertical (114% and 10%). Operating income of $134.0 million (21.0% margin) surpassed our $127.3 million estimate (20.1% margin). Profitability on a QoQ basis was helped by 6.7% rupee depreciation – mitigated by seasonal visa expenses (80 bps). Available levers for countering salary-related pressures (300-350 bps in fiscal 2009) and potential rupee appreciation comprise offshore-mix (200 bps), pricing (150 bps), ramp-up of subsidiaries and other operating efficiencies.

• Hourly billing rates averaged $60.61 for onsite work (down 0.2% QoQ and up 5.1% YoY) and $24.53 for offshore (down 0.2% QoQ and up 3.9% YoY). Billed volume rose 3.0% QoQ. Offshore utilization (excluding trainees) stood at 75.0% vs. 79.9% a year ago. This decline is the result of a 12.5% increase in billable hours to conform to industry standards – and does suggest somewhat greater headroom vs. 84.4% under the old computation. Higher-margin offshore work contributed 52.7% of IT Services revenue, unchanged from the March quarter. Excluding BPO, headcount rose just 1.4% QoQ and 21% YoY to 46,620 in June. Hiring plans still call for the (gross) addition of 14-15K associates in fiscal 2009. Attrition (LTM) improved to 12.6% from 14.9% a year ago – attributed to professional development programs, early/empowered leadership and above-average salary increases.

• By industry, Manufacturing ranked largest (23% of revenue), followed by Technology/Media (22%), Financial Services (21%), Retail/Transportation (10%), Healthcare (7%) and Others (16%). Top-10 clients accounted for 30.6% of total revenue, down from 30.9% in the March quarter. Satyam now has 93 clients (vs. 85 in the March quarter) with an annual revenue run-rate of $5+ million and 52 (vs. 50) with $10+ million. Satyam added 34 new clients compared with 32 in the immediately prior period. It exited the quarter with an active roster of 631, up from 617 in March.

• Satyam BPO – a vendor of specialty engineering, animation, analytics, claims and helpdesk offerings with an integrated BPO+IT orientation – swung to a net loss of $5.2 million on revenue of $11.5 million, down 37% QoQ and 3% YoY. Despite a recent setback (page 1), management is hopeful that this subsidiary can break-even by 4Q09.

• Satyam generated CFFO of $123.2 million ($0.36 per ADS) in the quarter. Proceeds from the exercise of options amounted to $9.3 million. Major outflows comprised an acquisition payment ($19.1 million) and capital expenditures ($31.8 million), budgeted to climb from $96.7 million in fiscal 2008 to $125.0 million in fiscal 2009. Satyam exited the quarter with net cash of $1.048 billion ($3.08 per ADS), up from $1.040 billion on March 31. Accounts and unbilled receivables slipped to 91 DSOs from 87 in March. This figure is explained by an exchange rate distortion and ramp-up of unbilled revenue on larger/milestone deals – and is expected to revert to the 85-90 range.

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• SAY shares are suitable for aggressive investors. In our opinion, principal risks include the following: U.S. slowdown; 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.

ANALYST CERTIFICATION

I, Ashish Thadhani, certify that all the views expressed in this research report accurately reflect my personal views of the subject companies. I certify that I have not and will not receive compensation with respect to the issuance of this report.

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2008 Aug 02 03:02 AM