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MAHINDRA SATYAM LTD (MSL)
RECOMMENDATION: ACCUMULATE
TARGET PRICE: RS.71
FY12E P/E: 15.4X
MSL's results for 3QFY11 were above our estimates. The volume growth of
2.5% was higher than our expectations. EBIDTA margins were also
marginally better than what we had assumed. However, the volume growth
is much below what peers have reported and reflects the likely challenges in
scaling up existing clients. The number of active clients also increased
marginally from 214 in 2Q to 217 during the quarter. The 50bps
improvement in margins was brought about by higher utilization levels and
lower provision for gratuity. While we expect revenue growth to gain
traction and margins to improve in FY12, the low base of 2QFY11 may
impact overall growth rates in FY12. We have assumed a 16% volume
growth in FY12 and a 281bps improvement in margins. Our FY12E EPS
stands at Rs.4.2 (Rs.3.5), which is discounted 15x at CMP. We believe that,
Satyam will have to overcome several operational challenges before it
returns to industry growth and margins. The near term performance may
remain subdued. The stock price may also be influenced by the potential
merger ratio (with Tech Mahindra). We upgrade the stock to ACCUMULATE
in the backdrop of an improving macro scenario and post the recent
correction in stock prices. Our DCF based fair price stands at Rs.71 (Rs.68),
based on FY12 earnings. A delayed recovery in developed economies and a
sharper-than-expected appreciation in rupee are the major risks.
Revenues up 3% QoQ
n MSL's revenues in 3QFY11 were up by 3%, on the back of a 2.5% volume
growth.
n While the volume growth of 2.5% is encouraging, it is much lower than peers.
n The relatively lower growth likely indicates lack of scale up from existing clients.
Moreover, the number of active clients increased marginally from 214 to 217
during the quarter, once again providing few avenues for revenue growth during
the quarter.
n We understand that, over the past year, MSL faced various operational issues
like attrition of senior resources, possible scale down and exit of reference accounts,
consequent lack of scale and lack of new accounts (due to unavailability
of current financials). These factors have likely impacted revenue growth.
n However, on the positive side the company has added three significant deals
during the quarter.
n Also, according to the management, there has been a reverse flow of talent into
the company. We believe that, the most significant is the return of the head of
Oracle practice.
n MSL has added 764 employees on a net basis, taking the tally to 28,832 employees
as at December 2010.
n While we believe that, the worst may be over for the company, the scale up will
be slow from the current levels. The company may have to overcome several
operational hurdles before it matches up to the industry growth rates.
n We have assumed a 16% volume growth for FY12E.
n In terms of geographic break-up, US contributed 52% (59%) of overall revenues
while Europe brought in 30% (26%) of revenues.
n Europe grew at a fast pace of about 19% QoQ, on the back of ramp up in a
couple of accounts.
n However, revenues from USA were flat in USD terms.
n The company is seeing traction in the US markets also with some significant
deals coming from that geography.
n The company has 217 active clients. Satyam counts a customer active if it has an
annual run-rate of more than 250000.
n The company had about 121 (118) $1mn accounts and 45 (44) $5mn accounts.
n In 3QFY11, 41% (42%) of revenues came from off-shore operations and the
balance from on-site business.
n While the IMS business employs >1800 people, BPO has >2500 employees.
n Average realizations improved marginally due to the change in mix and also an
increase in proportion of on-site revenues.
n According to the management, there was no like-to-like improvement in billing
rates over 2Q.
Crucial data unavailable
n We do not have some crucial data-points relating to the average realizations and
the efforts on-site and off-shore.
n Thus, our estimates do have some approximation as far as projections are concerned.
n We believe that, the average realizations of MSL may be lower than the industry
average.
Margins improved
n EBIDTA margins in 3QFY11 were marginally higher than our estimates and also
improved QoQ.
n The improvement came in largely due to an improvement in employee utilization
rates (73.5% v/s about 71% QoQ) and also due to lower provisioning for gratuity.
n In the previous quarter, MSL had given salary hikes. MSL had increased on-site
salaries by 3% and off-shore salaries by 13%, on an average.
n In our opinion, MSL has few levers which can be immediately deployed to improve
margins significantly. Revenue growth is the biggest driver of margins in
the near term, in our opinion.
n The employee utilization rate does provide some cushion to margins apart from
the benefits expected from broadening the employee pyramid.
n We believe that, the company has not recruited many freshers and doing so,
may reduce the average employee costs for MSL.
Contingent liabilities
n MSl faces the prospects of financial outgo in case any of the several litigations
are decided against the company.
n With reference to the understated liability of `Rs.12.3bn, the Company received
legal notices from thirty seven companies claiming repayment. The Company
has not acknowledged any liability
n In connection with the lawsuit, Upaid has filed an application before the Authority
for Advance Rulings seeking a binding advance ruling under the Income Tax
Act, 1961 (IT Act), regarding taxability of the payment made by MSL to Upaid.
The order of the Authority for Advance Rulings has not been delivered till date.
n There are class action suits pending against the company, filed by the holders of
ADS of the erstwhile Satyam.
n The Company had filed a petition before CBDT requesting for stay of demands
for Financial Years (FY) 2002-03 to FY 2007-08 aggregating Rs.5.03bn till the
correct quantification of income and taxes payable is done for the respective
years.
n These may impact the cash balance over a period of time, if decisions do not
come in Satyam's favour.
Future financials
n Based on 9mFY11 numbers, we have modified our FY11 and FY12 numbers.
n We expect MSL to achieve revenues of Rs.51.15bn in FY11. For FY12, we have
built in a 16% volume growth and a marginal improvement in average realizations.
n This translates into a 15% growth in revenue as the rupee is expected to average
45 to USD in FY12E.
n EBIDTA margins are expected to gradually improve over the next 5 quarters subject
to seasonality and salary hikes.
n We have assumed margins to improve to nearly 12% by 4QFY12.
n We have assumed tax at 23% of PBT in FY12 as we believe that, minimal SEZ
cover will be available to MSL’s revenues.
n Consequently, FY12E EPS works out to Rs.4.2 v/s Rs.2.96 in FY11E, a growth of
43%.
Valuations and recommendation
n We have valued MSL based on DCF, which leads us to a fair price of Rs.71.
n At Rs.71, our FY12E EPS will be discounted by 17x, which is lower than larger
peers but higher v/s mid-caps.
n As per our estimates, MSL will have net cash of Rs.28 per share as at FY12E
end.
n The management has indicated that, MSL will be merged with Tech Mahindra
(or vice-versa) in the next 15 – 18 months.
n We believe that, MSL will have to overcome several operational hurdles before it
reaches industry growth and margins.
n In the intermediate term, we expect growth rates to lag behind industry leaders
and also several mid-cap companies.
n Thus, we believe that, the stock may under-perform over the near –to-medium
term. The stock price may also be influenced by the potential merger ratio (with
Tech Mahindra).
n However, the macro scene has improved and this may help MSL in reporting
improved growth rates.
n Also, the stock price has corrected over the past few weeks. Thus, looking at the
near 10% upside, we upgrade the stock to ACCUMULATE. However, we continue
to prefer large caps to MSL.
Concerns and risks
n A sharp appreciation in the rupee against various currencies will impact our earnings
estimates.
n Delay in the economic recovery of major user economies will likely impact future
revenue growth of the company.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
MAHINDRA SATYAM LTD (MSL)
RECOMMENDATION: ACCUMULATE
TARGET PRICE: RS.71
FY12E P/E: 15.4X
MSL's results for 3QFY11 were above our estimates. The volume growth of
2.5% was higher than our expectations. EBIDTA margins were also
marginally better than what we had assumed. However, the volume growth
is much below what peers have reported and reflects the likely challenges in
scaling up existing clients. The number of active clients also increased
marginally from 214 in 2Q to 217 during the quarter. The 50bps
improvement in margins was brought about by higher utilization levels and
lower provision for gratuity. While we expect revenue growth to gain
traction and margins to improve in FY12, the low base of 2QFY11 may
impact overall growth rates in FY12. We have assumed a 16% volume
growth in FY12 and a 281bps improvement in margins. Our FY12E EPS
stands at Rs.4.2 (Rs.3.5), which is discounted 15x at CMP. We believe that,
Satyam will have to overcome several operational challenges before it
returns to industry growth and margins. The near term performance may
remain subdued. The stock price may also be influenced by the potential
merger ratio (with Tech Mahindra). We upgrade the stock to ACCUMULATE
in the backdrop of an improving macro scenario and post the recent
correction in stock prices. Our DCF based fair price stands at Rs.71 (Rs.68),
based on FY12 earnings. A delayed recovery in developed economies and a
sharper-than-expected appreciation in rupee are the major risks.
Revenues up 3% QoQ
n MSL's revenues in 3QFY11 were up by 3%, on the back of a 2.5% volume
growth.
n While the volume growth of 2.5% is encouraging, it is much lower than peers.
n The relatively lower growth likely indicates lack of scale up from existing clients.
Moreover, the number of active clients increased marginally from 214 to 217
during the quarter, once again providing few avenues for revenue growth during
the quarter.
n We understand that, over the past year, MSL faced various operational issues
like attrition of senior resources, possible scale down and exit of reference accounts,
consequent lack of scale and lack of new accounts (due to unavailability
of current financials). These factors have likely impacted revenue growth.
n However, on the positive side the company has added three significant deals
during the quarter.
n Also, according to the management, there has been a reverse flow of talent into
the company. We believe that, the most significant is the return of the head of
Oracle practice.
n MSL has added 764 employees on a net basis, taking the tally to 28,832 employees
as at December 2010.
n While we believe that, the worst may be over for the company, the scale up will
be slow from the current levels. The company may have to overcome several
operational hurdles before it matches up to the industry growth rates.
n We have assumed a 16% volume growth for FY12E.
n In terms of geographic break-up, US contributed 52% (59%) of overall revenues
while Europe brought in 30% (26%) of revenues.
n Europe grew at a fast pace of about 19% QoQ, on the back of ramp up in a
couple of accounts.
n However, revenues from USA were flat in USD terms.
n The company is seeing traction in the US markets also with some significant
deals coming from that geography.
n The company has 217 active clients. Satyam counts a customer active if it has an
annual run-rate of more than 250000.
n The company had about 121 (118) $1mn accounts and 45 (44) $5mn accounts.
n In 3QFY11, 41% (42%) of revenues came from off-shore operations and the
balance from on-site business.
n While the IMS business employs >1800 people, BPO has >2500 employees.
n Average realizations improved marginally due to the change in mix and also an
increase in proportion of on-site revenues.
n According to the management, there was no like-to-like improvement in billing
rates over 2Q.
Crucial data unavailable
n We do not have some crucial data-points relating to the average realizations and
the efforts on-site and off-shore.
n Thus, our estimates do have some approximation as far as projections are concerned.
n We believe that, the average realizations of MSL may be lower than the industry
average.
Margins improved
n EBIDTA margins in 3QFY11 were marginally higher than our estimates and also
improved QoQ.
n The improvement came in largely due to an improvement in employee utilization
rates (73.5% v/s about 71% QoQ) and also due to lower provisioning for gratuity.
n In the previous quarter, MSL had given salary hikes. MSL had increased on-site
salaries by 3% and off-shore salaries by 13%, on an average.
n In our opinion, MSL has few levers which can be immediately deployed to improve
margins significantly. Revenue growth is the biggest driver of margins in
the near term, in our opinion.
n The employee utilization rate does provide some cushion to margins apart from
the benefits expected from broadening the employee pyramid.
n We believe that, the company has not recruited many freshers and doing so,
may reduce the average employee costs for MSL.
Contingent liabilities
n MSl faces the prospects of financial outgo in case any of the several litigations
are decided against the company.
n With reference to the understated liability of `Rs.12.3bn, the Company received
legal notices from thirty seven companies claiming repayment. The Company
has not acknowledged any liability
n In connection with the lawsuit, Upaid has filed an application before the Authority
for Advance Rulings seeking a binding advance ruling under the Income Tax
Act, 1961 (IT Act), regarding taxability of the payment made by MSL to Upaid.
The order of the Authority for Advance Rulings has not been delivered till date.
n There are class action suits pending against the company, filed by the holders of
ADS of the erstwhile Satyam.
n The Company had filed a petition before CBDT requesting for stay of demands
for Financial Years (FY) 2002-03 to FY 2007-08 aggregating Rs.5.03bn till the
correct quantification of income and taxes payable is done for the respective
years.
n These may impact the cash balance over a period of time, if decisions do not
come in Satyam's favour.
Future financials
n Based on 9mFY11 numbers, we have modified our FY11 and FY12 numbers.
n We expect MSL to achieve revenues of Rs.51.15bn in FY11. For FY12, we have
built in a 16% volume growth and a marginal improvement in average realizations.
n This translates into a 15% growth in revenue as the rupee is expected to average
45 to USD in FY12E.
n EBIDTA margins are expected to gradually improve over the next 5 quarters subject
to seasonality and salary hikes.
n We have assumed margins to improve to nearly 12% by 4QFY12.
n We have assumed tax at 23% of PBT in FY12 as we believe that, minimal SEZ
cover will be available to MSL’s revenues.
n Consequently, FY12E EPS works out to Rs.4.2 v/s Rs.2.96 in FY11E, a growth of
43%.
Valuations and recommendation
n We have valued MSL based on DCF, which leads us to a fair price of Rs.71.
n At Rs.71, our FY12E EPS will be discounted by 17x, which is lower than larger
peers but higher v/s mid-caps.
n As per our estimates, MSL will have net cash of Rs.28 per share as at FY12E
end.
n The management has indicated that, MSL will be merged with Tech Mahindra
(or vice-versa) in the next 15 – 18 months.
n We believe that, MSL will have to overcome several operational hurdles before it
reaches industry growth and margins.
n In the intermediate term, we expect growth rates to lag behind industry leaders
and also several mid-cap companies.
n Thus, we believe that, the stock may under-perform over the near –to-medium
term. The stock price may also be influenced by the potential merger ratio (with
Tech Mahindra).
n However, the macro scene has improved and this may help MSL in reporting
improved growth rates.
n Also, the stock price has corrected over the past few weeks. Thus, looking at the
near 10% upside, we upgrade the stock to ACCUMULATE. However, we continue
to prefer large caps to MSL.
Concerns and risks
n A sharp appreciation in the rupee against various currencies will impact our earnings
estimates.
n Delay in the economic recovery of major user economies will likely impact future
revenue growth of the company.
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