Syntel: Price Has Changed, Business Hasn't

| About: Syntel, Inc. (SYNT)

Summary

Syntel is a well-managed business that is now selling for less than its intrinsic value.

Insider purchasing indicates now is a good time to buy.

Although the future contains risk, Syntel's current margin of safety provides an adequate risk/return profile.

Syntel, Inc. (NASDAQ:SYNT) is an international provider of IT, knowledge process outsourcing (KPO) and digital modernization services. It is an industry-specific partner that focuses on the Banking and Finance, Healthcare and Life Science, Insurance, Manufacturing, Retail, Logistics, and Telecom sectors, with Banking and Finance being the largest source of revenue.

While I usually try to stay away from technology companies, there are exceptions. Syntel has a sustainable and predictable cash flow history while requiring very little capital expenditure. It adopts the customer for a "whole life approach" and tries to view them more as partners. The technology industry is defined by rapid change, which causes the disruption and obsolescence of seemingly entrenched and profitable companies. Although I cannot guarantee Syntel will always exist, its history shows that it provides an invaluable service to its customers. During the global financial crisis, its largest and most affected clients, Banking and Finance, didn't cut back on their spending enough to even cause a drop in revenue. While growth slowed, the lag was not large enough to cause any real problems. Shortly into the recovery, growth resumed at a substantial rate.

This was the worst economic situation for the financial sector since the Great Depression and could possibly be the worst in my lifetime. The fact that the slowdown in growth was so minute indicates that Syntel's services are an essential and irreplaceable part of the companies they serve. I do not know what new technologies will come along or which companies will be rendered obsolete by them, but I do know that a vast amount of the remaining competition will have to adapt to these changes, and that is where Syntel comes in.

Syntel also seems to be on the forefront of new innovations in its industry. Its SyntBots automation technology has been recognized as a top performer in the industry and has been an integral driver of transformation in what the former CEO Nitin Rakesh called the "two speed world". It's not hard to see why SyntBot's automation of repetitive manual back office and IT processes frees up employees to work on the core competency of its business while still keeping up with the digital modernization that this environment demands. It doesn't hurt that it cuts costs and increases savings in the meantime.

All this is to say that Syntel appears to be a good business to own. It's average free cash flow return on equity for the last four years is about 62%. This is the shareholders' equity with cash and short-term investments excluded. Free cash flow is calculated by adding back and subtracting non-cash expenses and gains to net income; this is also before changes in working capital. Syntel's average FCF margin for the last seven years is 22% and it steadily increased to around 25% in the last four. Free cash flow for 2016 is also adjusted for a one-time tax expense, so, instead, I used the 24% tax rate that was applied in 2015.

This is a business I would expect to have to pay up for, but as of the first of the year 2017, it trades a good deal lower than its average price over the past three years. Let's try to look at why this is happening.

There was an expected drop in share price after almost all the cash on the balance sheet was returned to shareholders through a special dividend of $15 a share in October 2016. This invoked a high one-time tax expense for the year, causing earnings to retreat into negative territory. I can see how the cash sitting on the balance sheet could create a premium in the share price, but in my mind, nothing has changed.

Syntel's revenue growth has also slowed to only 2% for the first nine months of 2016 while revenue and earnings took a hit in the third quarter, with revenue down about 5% and operating income down about 30%. This could further help to explain the drop in share price, but I believe it is overdone. Syntel has also accumulated about $480 million in debt related to the one-time dividend. This is unusual for it, as Syntel usually funds everything with its strong cash flow and small loans if needed. I expect this to be paid off fairly quick with FCF expected to be around $200 million per year or higher in the future.

Valuation

This leads me to the valuation. Price to FCF for the first nine months of 2016 stands at about 10x, lower than where it has been for the entire year in the past. I expect FCF for the year to be around $200 million, possibly lower, probably not higher. This is around a 15% to 20% decline from last year, and it seems reasonable given the current performance and management's guidance for the year. This puts the P/FCF for the year around 7x to 8x, which is much lower than its other competitors and much lower than it has been in the past at Syntel.

Because this is an asset-light business, I believe Syntel should be valued by its future cash flows. The biggest asset on the balance sheet was cash. With this gone, I think Syntel could be worth about the same as it was with the cash on its balance sheet. In reality, nothing has changed with the way the business operates. It doesn't take a DCF model to show that Syntel is worth more now than the last time it was trading at $20 in 2011. Revenue was around $650 million compared to an expected full-year revenue of $960 to $970 million for 2016. FCF was at $93 million compared to around $200 million now.

Using an estimated growth rate of 5% for the next five years along with a discount rate of 10%, I will try to get a range of values for the company:

  • Using a conservative 20% FCF margin and a terminal value of 13x the fifth year's FCF value per share comes out to about $32.
  • Using the same margin and a TV of 15x, we come up with about $36 per share.
  • Switching to a FCF margin of 22%, which is the average of the last seven years, and a TV of 13x, we get around $35.
  • Upping the TV multiple to 15x with the same margin brings us to about $39 per share.

Going a bit further, let's say Syntel's FCF stays at a steady $200 million with no growth for the next five years. Applying the same terminal value multiple of 13x brings us to about $26 per share. I can't predict with any certainty that any of this will happen, but I feel comfortable with an estimated range of the mid to high 30s, with the chance of a much higher price if growth resumes its past performance. This is a company that has shown steady growth and strong FCF in every year of its operations and looks poised to capitalize on the heavy corporate spending for digital modernization in the upcoming years.

Another indicator that this is a good time to buy is insider purchasing. According to Morningstar, insider buying has been at its strongest in years after the massive drop in share price earlier this year. This indicates confidence in the long-term performance of the company despite its near-term weakness. The chairman and his wife also own a substantial stake in the company, so their goals seem to be aligned with shareholders.

Risks

One of the biggest risks for Syntel is the risk of technological disruption. One of its competitors could very well create a new form of technology that could have a significant impact on Syntel's future cash generation abilities. Outside of this possibility, it looks as if the threat of increasing competition could have a minor effect on Syntel. The company and its three largest customers, the source of much of its revenue, have had a great relationship for years, and it doesn't look like any other competitors will be able to lure them away based solely on price or other metrics. Syntel has developed a deep understanding of its businesses that cannot be easily replicated.

Another major risk could be the misallocation of capital. Syntel has obviously not had great opportunity for reinvestment, illustrated by the fact that it chose to take a large tax expense to return cash to shareholders instead of use it in some other way. Pressure in the future from shareholders or mistakes by management could cause an inappropriate acquisition or destructive capital investment. I for one would be perfectly fine with letting the cash build up on the balance sheet again or using it to buy back shares once the debt is dealt with.

On that note, Syntel has announced a $10 million share repurchase program that looks like a step in the right direction. Another development late in the year was the resignation of Syntel's CEO, Nitin Rakesh, who has been in the position since 2014. Rakesh Khanna has taken over as the interim CEO. He was previously Syntel's COO and the president of the banking and finance operation before that. His long history with Syntel is encouraging as is the fact that he has recently purchased a stake in the company, so his incentives appear to be reasonably aligned with shareholders.

Rising wages and currency fluctuations are also risks but appear to be less pressing than the ones mentioned above. Also, the fact that a significant amount of revenue is derived from three customers could have a substantial impact on revenue if one or more is lost. Outsourcing has also come under attack, especially during the recent presidential race. While there are inherent risks involved for Syntel, it seems that the majority of the focus has been on the outsourcing of manufacturing.

Conclusion

Syntel has historically been a fast growing company that has recently seen a large drop in price without a noticeable drop in value. While the technology sector is a rapidly changing landscape, Syntel is a supplier of services to firms in need of adapting to this rapid change. It can expand its services while using a limited amount of capital. Because almost all expenses appear to be variable, Syntel is also able to scale down its spending during a time of reduced revenue. I also believe SYNT possesses a competent and experienced board of directors and management team who have their interests aligned with shareholders. While the future presents significant risks, I believe Syntel's current price indicates there is a margin of safety for a well-managed and well-positioned business.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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