Turnarounds often give an impression of satisfaction well before their true potential gets widely appreciated. You can count Satyam Computers (NYSE: SAY; $4.65; INR 90.75) as one of them. Satyam was involved in a massive misrepresentation of financials earlier this year, and was subsequently bailed out by Tech Mahindra (INR 924.05).
From its January lows, Satyam had almost quadrupled vs. under 100% appreciation in BSE Sensex, before witnessing a 10%+ drop on Wednesday after CBI filed a fresh charge-sheet detailing how ex-promoters and certain key executives siphoned cash from the company. What is truly amazing is 1. How Mahindra Satyam’s stock still reacts to misdeeds of ex-promoters, and 2. Why such a grossly mismanaged entity be valued on current fundamentals ?. Promoters may clearly have siphoned funds off Satyam but it’s not as if Tech Mahindra’s decision to acquire Satyam was really contingent on it’s at the time cash position. Estimated cash on Satyam’s books was just about a tenth of Tech Mahindra's open offer.
Satyam’s financials are in the process of getting restated by KPMG, which is required to conclude the exercise by June 2010. This is one stock that is certainly not discounting a “dramatic” turnaround. If anything, as my argument goes, it may not be discounting a whole lot of potentially achievable things. Also note that potential valuation scenarios (outlined later in this post) attribute no value to cash in hand.
Satyam’s excess roster by itself must have been a 5%-9% drag on EBIT margins. Assuming that Satyam’s break-up of offshore/onsite revenues wasn’t too far off-track, I estimate that Satyam was carrying 5%-9% extra employees, to justify inflated revenues. That by itself may have been dragging down EBIT by about 400-700 bps, suggesting that EBIT could potentially move up in the high single digits by simply rationalizing headcount.
Lawsuit settlements may drain $100 mil+. I estimate that settlement of the 13 class action lawsuits (from ADS investors) and ongoing lawsuit with Upaid might end up costing the company northwards of $100 mil, with more than $60 mil likely going towards settling the class action lawsuits (~3.5% of estimated investor losses, which is the average over the last 13 years, across class-action lawsuits). That said, the likely settlement with ADS investors is unlikely to take place soon. Since US doesn't fall under "reciprocating territory" as defined by the Indian Code of Civil Procedure, any judgment on Satyam in US is not directly enforceable in India. Such judgments in US will only be used as evidence, if fresh lawsuits are filed in India within three years of such judgments being passed in the US. This is unlikely to be a pre-2011 event.
Misplaced gaiety or underappreciated turnaround ?. Satyam’s utilization rate was likely in the high 60s to low 70s in C3Q last year (as opposed to the reported figure of 76%). Based on Satyam’s onsite/off-shore break-up and recent unaudited indications of headcount, it appears that Satyam’s annual sales run-rate is now likely in the $1.1-$1.2 bil range. Ex-pricing (which Gurnani had recently suggested is in line with the industry), EBIT margin can potentially be a high single-digit figure, driven by headcount rationalization. But there is way more realistic room for improvement than just that, even for a standalone Satyam that may not yet have the luxury of eliminating cost redundancies with Tech-Mahindra. Across a range of operating expense lines, Satyam was materially ahead of industry averages, particularly in case of operating leases, receivable provisions, professional charges and marketing, which by themselves dragged true EBIT down by about 300 bps. Between head count reduction and overhead restructuring, Mahindra Satyam has every shot of being a 15%+ EBITDA platform. In fact, there are indications that some of the above may already have been partly achieved – For instance, the company had recently recalled more than a fifth of its benched employees while lifting its hiring freeze and has already gone on record saying that it is saving on lease rentals.
If Satyam does ramp up to low double digits EBIT over the next year, something I certainly don’t see as a stretch, then this stock effectively has no further incremental operational upside priced in it, be it through further cost control (and there is ample room for that), price negotiations or incremental contract signings (see Exhibit 1).
Exhibit 1 – Projected FTM Earnings and associated valuation scenarios
Note: Earnings are capitalized at a mid-teen multiple; Disclosed OBS liabilities are brought back on book; All scenarios are independent of cash in hand and are built on low double-digits EBIT margin; Current utilization rate is assumed at 70%, below the C3Q09 industry average of 73%.
Sources: Internal estimates; Company filings
Disclosure – Preferring to wait and watch, I missed Satyam’s amazing run this past year. Today’s selloff provided me with an opportunity to move in. As of the date of this post, author had a long position in SAY.
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