The following table summarizes the relevant financials of Patni Computer Systems Limited (NYSE:PTI-OLD) along with a few others for the year-end 2006. The other companies are listed to allow comparison of relative valuations to a representative big-cap outsourcer (Infosys (NASDAQ:INFY)), a big-cap US consultancy firm (Accenture (NYSE:ACN)), and a similar sized company in the same industry with comparable business prospects (Covansys (OTC:CVNS)):
Computer Sciences Corporation (CSC) acquired Covansys July 2007 for a premium of 27% to the closing stock price on April 25, 2007.
The P/E ratio for Covansys was calculated based on the stock price that CSC is paid for the acquisition - $34/share.
The P/E ratio for Patni, Infosys, and Accenture are based on the current stock price and earnings as of EOY 2006.
It is clear from looking at the Revenue per Employee column and the profitability column in the table that outsourcers have a cost advantage. Also, outsourcers are growing at a faster rate. Patni should benefit from both of these favorable attributes. Further, fundamental analysis of Patni also looks favorable with a projected growth rate of 17% and a year-end P/E of 18.
Computer Sciences Corporation’s acquisition of Covansys might give a good indication on what a US based consultancy firm may be willing to pay for Patni, should such a scenario occur. Covansys had better projected growth but less profitability at the time of the acquisition. It was acquired for roughly 3 times revenue and 38 times earnings. On revenue multiple basis, Patni might command a higher premium, given their profitability is more than two times better. On a P/E ratio basis, Patni might go for a lower premium, given the growth rate is slightly lower. Taking these two factors into consideration, an acquirer might consider 4 times revenue and/or 25 times earnings as reasonable. That would value the company at about 50% above the current price.
The company's core expertise is in the areas of Insurance, Financial, and Manufacturing services verticals. The company entered the IT services for Telecom Verticals with the acquisition of Cymbal Corporation in November 2004. In July 2007, it acquired another IT services Telecom Vertical "Logan-Orviss International (LOI)" and around the same time frame entered the Life Sciences area through the acquisition of "Taratec Development Corp.".
Business concentration is an area of concern for Patni - 80% of its business comes from US. One account (NYSE:GE) contributes to 20% of the total revenue. The company initiated a strategy to diversify the revenue base in 2003. As a result, the GE portion of the overall business came down from about 45% at the end of year 2003 to 20% at the end of 2006. The US portion of the revenue still stands at around 80%, down slightly from around 90% in 2003.
The company had negative news recently regarding an investigation by Department of Labor [DOL]. The issue was whether Patni paid less than the prevailing wages to H1B workers in the 2004-2005 timeframe. DOL announced a settlement in June 2007. The settlement amount was $2.4M and was to be distributed as back wages to roughly 600 affected workers. At the time, the press reported incorrectly that the DOL announcement said the amount, if distributed equally will be close $40K/worker. The actual amount, if you do the math, is close to $4K/worker. While it is curious that such a report came out from multiple sources, it is difficult to imagine any conspiracy, as there is no apparent beneficiary from an outsider’s point of view. The settlement is a victory for Patni, given that the amount is very small and no intention of wrongdoing was found - Patni blamed it on accounting error.
Exploiting H1B workers is common among employers, although the degree of exploitation varies. Outsourcers exploit such workers more because they usually hire the worker from a foreign country and so has more "control" over the employee. The crux of the problem is that H1B workers are tied to the company they work for until their green card applications come through. Employers realize they have the upper hand over such employees for a number of years and so are able to exploit such workers. It is common to see the salaries of such employees stagnate during these years. It is also true that the Department of Labor banned several outsourcers because of violations such as not paying the workers, employers filing fraudulent tax returns for employees without actually paying the employees the amounts quoted in the tax returns and the H1B labor certification form, etc.
From the public information available, it is clear that this issue is in the company's past. It is definitely true that a lot of technology companies were in violation of the law. Patni happened to be one of the companies that the DOL investigated. But, they got out of it rather lightly.
Another issue that needs to be looked at is the company ownership structure. The 3 Patni brothers hold roughly 45% of the outstanding shares. It is rumored that two of them have an interest in selling their stakes. Another 16% is held by General Atlantic Mauritius Limited, an investment firm that made a major investment in the company around 2002, well before the company's IPO in India in 2004. Insiders’ holding a significant percentage of the outstanding shares is usually a good thing, as they will have a direct interest in upholding shareholder value. However in Patni's case, it is not clear how much of a positive this is because of the rumor about the brothers wanting to sell their stakes.
Market capitalization matters big-time in this industry and so consolidation is the name of the game. So far the company is doing the right thing by growing through acquisitions. Further, organic growth may pick up. They should be able to achieve synergies through their Logan-Orviss International (LOI) acquisition. LOI expertise is in the area of IT Services Telecom Verticals where the company already has a strong presence in the US made possible with the acquisition of Cymbal Corporation in 2004. Also, EMEA (Europe, the Middle East, and Africa) is an untapped growth area and the LOI acquisition should get them in the door for many deals. However, given the enterprise value is below the $2B mark, the company has a long way to go before they are able to play in the big leagues.
A private equity [PE] stake, as is rumored, is not in the best interest of shareholders. The philosophy behind PE acquisitions is
a) Acquire undervalued assets at an attractive price,
b) Fund interest payments of the acquisition amount through cash flow from operations,
c) Sell out at a large premium when the market turns and becomes attractive, and
d) Pocket the difference.
PE taking a sizeable stake is considered undesirable since that distracts management. The idea behind big stakes is to influence management in a way that benefits the PE in the short-term. Again, private equity involvement is a bad deal for shareholders and it is no different in Patni's case. The rationale behind this rumor is that it is a relatively easy way for two of the three brothers who are rumored as wanting to cash out their ownership stake. If unloading their stake is indeed their primary concern, then the odds are low for them wanting to wait for a better deal later on.
An acquisition by a US based large consultancy firm, on the other hand, is a far better alternative. For such a firm, Patni has a lot to offer. A majority of these firms are trying to grow their outsourcing operations to realize the benefits of "following the sun", lower wages, decrease time to market, and growth in the third world areas. An established business with reasonable valuation gives such a firm immediate access to all of the above and a large labor pool. Further, a larger US based business can be expected to realize larger revenue per employee from Patni employees than Patni will be able to do on their own. This is so because big US consultancy firms charge more per billable hour.
Given the industry appetite for size, selling out at a sizeable premium is the most likely outcome!