Excerpts from Gilford Securities analyst Ashish R. Thadhani's recent note to clients on Syntel, Inc. (SYNT):
• • •
SYNT: Revenue / EPS Miss, BPO Slows & IT Headcount Falls
Investment Conclusion. Based on lower revenue in the key Applications Outsourcing & BPO segments and a higher tax-rate – masked by currency translation gains and scaled-back hiring – we are adjusting our estimates as follows: 2008 pro-forma EPS remains at $1.70 on revenue of $422 million (25% YoY growth but down from our prior $425 million projection); and 2009 pro-forma EPS stays unchanged at $1.95 on revenue of $507 million (20% YoY growth and down from $512 million previously). We also believe that Syntel will miss its well publicized 2010 internal revenue goal of $1 billion by nearly $400 million. Our Hold rating remains in effect due to valuation, fundamental and management reservations. SYNT is selling at 18x forward EPS vs. 16% compound EPS growth in 2007-09E – and an inexplicable premium to Tier-I players CTSH (9%) and SAY (28%) that offer superior growth, positioning and execution.
Recent results have reinforced our apprehension: 2Q08 results fell short of our underlying revenue and EPS estimates; the BPO engine suffered a dramatic deceleration (6.2% QoQ vs. 17.2% LTM); IT headcount dropped for the second straight quarter; 2008 EPS guidance of $1.74-1.82 includes $0.12 of non-recurring gains; excluding well- penetrated clients American Express and State Street Bank (35% of revenue), Syntel posted only 11% compound growth in 2005-07 (table on page 2); it remains vulnerable to the Financial Services segment (74% of revenue); and various insiders have recently sold stock.
Our longstanding concerns include rapid loss of market share in the largest 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), ~400 bps drop in the operating margin over three years despite transfer of substantial work from the U.S. plus ramp-up of major clients, senior management turnover and an inability to attract seasoned talent. Proxy materials also bare a lightweight board and obscure accounting firm. For delivering 22% EPS growth in 2007, total compensation for the top-three executives was 3x their base salary. Contrary to management claims, we believe that Syntel possesses neither the scale nor domain depth to withstand future competitive pressures.
Takeaways. Excluding a non-recurring “balance sheet revaluation” gain, pro-forma EPS of $0.38 vs. $0.32 a year ago on revenue of $103.4 million (29% YoY and 5.0% QoQ growth) missed our $0.40 estimate on revenue of $103.8 million. Relative to our expectation, Syntel posted an operating income overage (+$3.2 million resulting entirely from favorable currency translation and a hiring freeze) that was offset by other income and taxes (-$3.9 million variance due to hedging losses and the expiration of certain tax benefits). Syntel noted the following: ongoing economic uncertainty and questionable timing of client spending decisions; diverging behavior by mature vs. newer clients; its favorable positioning toward cost-reduction services (two-thirds of revenue); a healthy sales pipeline and stable pricing outlook over the foreseeable future.
Revenue included 21% YoY and 0.7% QoQ growth in the Applications Outsourcing segment – driven by maintenance work – and a spike in discretionary e-Business project activity (up 25% YoY and 28.6% QoQ). BPO revenue advanced 89% YoY and 6.2% QoQ to 21% of the total. Excluding non-recurring items, operating income of $20.8 million (20.1% margin) exceeded our $17.6 million estimate (16.9% margin). Profitability on a QoQ basis was aided by a weak rupee (250 bps), improved utilization and fixed-price productivity – mitigated by a scheduled salary increase for offshore staff (+14% YoY). Syntel will continue its investments in infrastructure, service offerings, training and branding.
By industry, Financial Services ranked largest (74% of revenue), followed by Healthcare (12%), Automotive (6%) and Others (8%). Top-10 clients accounted for 70% of total revenue, down from 73% in the March quarter. Syntel added five new clients compared with 11 in the immediately prior period. The offshore utilization rate stood at 68% vs. 72% a year ago. Offshore work represented 80% of total effort vs. 80% in the March quarter. Higher-margin offshore revenue contributed 50% of the total vs. 50% in the March quarter. Annualized quarterly turnover deteriorated to 14.5% vs. 13.9% a year ago. Total headcount fell 0.4% QoQ and rose 30% YoY to 12,045 in June. BPO headcount reached 4,205 or 35% of the total. Based on a new just-in-time approach, hiring plans call for exiting the year with 2,500 additional employees vs. December 2007, implying 21% YoY expansion but down from 2,800-3,500 previously.
Syntel generated CFFO of $26.5 million (or $0.64 per share) in the quarter. Major outflows comprised capital expenditures ($13.9 million), budgeted to climb from $32.4 million in 2007 to $35-45 million in 2008 – down from $50-60 million previously. Infrastructure initiatives encompass seat expansion plus construction of new facilities in Chennai (SEZ-approved 29-acre campus) and Pune (SEZ- approved 37-acre campus). Syntel exited the quarter with net cash of $116.0 million, up from $108.9 million on March 31. Accounts and unbilled receivables improved to 63 DSOs from 66 in March.
SYNT 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; correction in the Bombay Stock Exchange and/or U.S. markets; political opposition in the U.S.; and geopolitical uncertainty in the Indian subcontinent.
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.