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Satyam Computer
Not out of the woods yet
We believe achieving industry average revenue growth will be an uphill task for
Satyam even in FY12 (post likely decline in FY11). Neither do we expect its
margin to match that of its peers in the medium to long term. We expect
downgrades in consensus estimates and initiate with a Hold rating.
Revenue growth challenges to persist beyond FY11F
We believe Satyam will find it tough to achieve revenue growth in line with its Indian peers
even in FY12 given: 1) the lack of scalable large clients within its portfolio, 2) supply-side
issues with recruiting/retaining the right mix of talent to achieve high revenue growth and
3) its deteriorating position in key markets, including the US and Europe. However, Satyam’s
increased participation in large deals hereon should yield results from the latter part of FY12.
In FY11, we expect revenues to decline due to the turmoil caused by the erstwhile
management.
Margin recovery near peers’ level is unlikely
We believe the company’s 2QFY11 margins already reflect most of the big challenges.
However, material margin catch-up near its peers’ levels looks challenging in the medium to
long term, in our view, considering: 1) supply-side issues, as Satyam employees are prone to
being poached by peers given that their salaries are not materially higher than employees of
peers (despite the company’s higher revenue contribution from enterprise solutions and
onsite) and given its high dependence on laterals, where attrition is the highest in the
industry; 2) its lower revenue per employee; and 3) low headroom in employee right-sizing.
Initiate with a Hold rating
We initiate coverage on the stock with a Hold rating and a target price of Rs60 based on 5.8x
FY13F EV/EBITDA, which is at about 60% discount to our target multiple for Infosys, the
Indian IT industry benchmark (which we believe is fair, considering the challenges on
revenue growth, a huge gap in margins even beyond FY11F and Satyam’s relatively lower
cash-flow-generating capability). We believe EV/EBITDA is a better multiple to value the
company given the high volatility on items below EBITDA due to ongoing litigations, which
could cause volatility in tax provisions and have an impact on cash flows and other income.
The basics
Catalysts for share price performance
We expect the key near term catalysts to be:
Continuing challenges on revenue as well as margins in the coming quarters. We expect
material downgrades in Bloomberg consensus estimates on revenues and EBITDA that are
significantly higher than our estimates.
Cognizant’s guidance for CY11 (in February 2011) and Infosys’s guidance for FY12 (in April
2011). While building in its typical conservatism, we expect Infosys to take a more confident
stance on FY12 guidance. However, considering various micro risks specific to Satyam, we
expect the company to face several revenue growth challenges.
CY11F IT budget finalisation (we expect this to be positive) and renewals of large outsourcing
deals over the next eight quarters starting 4QCY10. We believe Satyam will struggle to
achieve industry-average growth in FY12, considering the challenges the company faces.
We do not believe Satyam would benefit much from a pick-up in discretionary spend for the
industry. Despite Satyam’s focus on enterprise solution (~40% of revenues), we believe
competitive pressures will be higher (especially from Infosys and HCL Tech through AXON)
and given Satyam’s inability to scale up at least in the short to medium term.
Earnings momentum
We believe Satyam’s revenues will continue to underperform that of its peers’ in FY12 (we
expect a revenue decline in FY11).
Satyam is likely to struggle to achieve industry-average margins over the medium to long term
and hence the chances of negative earnings surprise remain high, in our view.
We forecast revenue (in USD), EBITDA (in INR) and EPS (in INR) for FY11-13F at CAGRs of
17%, 44% and 43%, respectively. EBITDA and EPS growth looks higher due to the significant
low base effect after restructuring and restatement of accounts.
Valuation and target price
Our target price of Rs60 is based on an EV/EBITDA target multiple of 5.8x FY13F, about a 60%
discount to our target multiple for Infosys, the Indian IT industry benchmark (which we believe is
fair, considering the challenges Satyam faces on revenue growth, the huge gap in margins
between the two even beyond FY11F, and Satyam’s relatively low cash-flow-generating
capability). We believe EV/EBITDA is a better multiple to value the company given the high
volatility on items below EBITDA due to various ongoing litigations, which we believe may cause
volatility in tax provisions and have an impact on the company’s cash flows and other income.
How we differ from consensus
Our FY12 and FY13 EPS estimates are 30-31% lower than the Bloomberg consensus estimates.
This is because our revenue and EBITDA margin estimates are lower, given our view that
challenges related to high revenue growth still persist and margin recovery closer to peer levels is
unlikely even beyond FY11. We expect downgrades to consensus estimates going forward.
Risks to central scenario
Higher-than-expected wallet share of Satyam within its existing and new clients.
Higher-than-expected margin improvement; lower-than-expected settlement of US class
suit/other litigations.
Merger of Tech Mahindra and Satyam – the risk relates to the merger ratio and resulting
impact on stock price.
A sharp depreciation of INR vs USD would benefit Satyam and its peers.
Faster-than-expected economic recovery in the US/Europe would benefit Satyam and its
peers.
Significant revenue growth challenges
We forecast Satyam’s FY11 USD revenues falling 6% and expect its revenue growth to
continue to lag its peers’ in FY12 given challenges in scaling-up large clients and
recruiting/retaining talent, and given the deterioration in key markets.
We believe it will be tough for Satyam to achieve revenue growth in line with its Indian peers even
in FY12F (we expect revenues to decline in FY11 due to the turmoil caused by the erstwhile
management). Satyam faces a number of challenges: i1) it lacks scalable large clients, 2) it faces
supply-side issues with recruiting/retaining the right mix of talent to achieve high revenue growth,
and 3) its positions in key markets, including the US and Europe, are deteriorating.
We believe any increased participation in large deals hereon will yield results only from the latter
part of FY12. Our estimate of a 5.5% revenue decline (in USD) for FY11 is not conservative, in
our view, as it assumes qoq growth of 2.3% in 3QFY11F and 4QFY11F
We believe Satyam might struggle to achieve our revenue growth estimate of 14.2% in FY12: it
will need to register more than 19% yoy growth in 4QFY12F over our 4QFY11F estimate (see
Chart 2). To achieve this, it will have to add US$650m-1,100m of new business (assuming threefive
year tenure with linear execution per annum for new business signings) . This, we believe, is
a tall task for the company, which is still grappling with its past and we thus see a downside risk to
our estimates, which are already lower than consensus estimates.
Right employee mix – another challenge to profitable revenue growth
Acquiring the right talent mix to cater to demand growth will be the next big challenge for Satyam,
in our view, despite the company having nearly completed its employee rationalisation. We
believe this is due to Satyam’s high attrition rate, possible deterioration in training infrastructure
and also due to the increasing lateral attrition in the industry. The company’s utilisation rate was
about 71% in 2QFY11, not materially different from its peers’. Besides this, currently, the
proportion of laterally hired employees at Satyam is much higher than at peers. Therefore, with
low headroom for employee right sizing and with a deteriorated training infrastructure, we believe
Satyam’s dependence on lateral employees will remain high in the foreseeable future. Besides
this, attrition rates for lateral employees are likely to remain high for the industry. We expect this to
not only hurt Satyam’s existing revenues but to also make it hard for it to ramp up new business.
Our expectation of a pick-up in USD revenue growth from FY12 onwards already factors in an
improvement in utilisation rate to about 75% in FY12 and FY13 which we believe will be in line
with similar-sized peers. However, large-cap peers are likely to continue operating at higher
utilisation rates, given their much larger size, superior control on attrition and better training
infrastructure.
Unlikely to achieve industry average margins
We expect Satyam’s margins are unlikely to recovery in line with its peers’ after FY11 given
our expectation that Satyam will continue to suffer from its deteriorated pricing power and
high attrition.
We believe the company’s 2QFY11 margins already reflect most of the big challenges. However,
material margin catch-up to near its peers’ levels looks challenging in the medium to long term, in
our view, considering: 1) supply-side issues, as employees of Satyam are prone to being poached
by peers given their salaries are not materially higher than employees of its peers’ (despite
Satyam’s higher revenue contribution from enterprise solutions and onsite locations) and given its
high dependence on laterals, where attrition is the highest in the industry; 2) its lower revenue
productivity per employee; 3) low headroom in employee right-sizing.
We expect Satyam’s personnel cost per employee will be higher in FY11 versus FY10,
considering the cut in variable pay (constituting 10-30% of CTC) for part of FY10 and wage
inflation for FY11. Despite the company’s higher dependence on lateral and onsite delivery, its
average employee-cost per headcount is not materially higher than its peers’ (in 2QFY11A). We
believe this could lead to employees being poached from Satyam in a rising demand scenario.
Despite: 1) Satyam’s utilisation rates of around 72% (not materially different than peers), 2) its
higher contribution from enterprise revenues (contribute ~40% of revenues), and 3) its high on-site
base (contribute ~60% of revenues), Satyam’s revenue per employee is lower than its peers’. This
indicates that pricing power of Satyam has been deteriorated
We believe that our below-consensus estimates are not conservative and estimate about 17%
USD revenue CAGR over FY11-13F. We expect EBITDA margin to improve from 7.3% in FY11F
to 11.3% in FY13F. Our margin estimates build in cost efficiencies within other operational costs
(non-personnel costs) as well as some benefits from the employee pyramid, with higher intake of
campus hires over medium to long term. However, we believe that any significant margin
improvement beyond our estimates will require a material increase in pricing, better than expected
execution on the employee pyramid and increased offshore delivery – all of which we believe will
be challenging for the company in the next 12-18 months.
Initiate with a Hold rating
We expect consensus estimate downgrades given our expectation of fundamental
challenges on revenues growth and margin recovery. Hence, any positive valuation rerating
seems unlikely hereon and we initiate coverage on the stock with a Hold rating.
We initiate coverage on Satyam with a Hold rating and target price of Rs60 based on an
EV/EBITDA target multiple of 5.8x FY13F, which is at about a 60% discount to our target multiple
for the Indian IT industry benchmark Infosys. We believe this is fair, considering the challenges on
revenue growth, huge gap in margins even beyond FY11F and Satyam’s relatively lower cash
flow generating ability.
We believe EV/EBITDA is a better multiple to value the company given the high volatility on line
items below EBITDA and the large amount of cash on its books. The lack of clarity on the maturity
of its outstanding hedge covers and pending litigations, including tax arbitration, could cause
volatility on items falling below EBITDA, such as other income and tax provision, in our view. We
believe, this, in turn could significantly impact the company’s qoq EPS.
Our target price also assumes the settlement of the US class action suit and some of the other
litigations, which we estimate at US$100m in FY12F (shown as extraordinary expenses for
FY12F). Any settlement lower or above this amount as well as any difference in the timing of the
settlement could impact our target price.
Management indicated Tech Mahindra-Satyam merger will be prioritised
We believe post re-statement of Satyam’s accounts and largely cleaned-up balance sheet,
Mahindra & Mahindra’s management will consider merging Tech Mahindra (TechM) and Satyam.
Management expects to announce this over the short to medium term. Our estimates (at the
current market price of TechM and Satyam) value Mahindra group’s stake in TechM (excluding
TechM’s stake in Satyam) at >US$525m and in Satyam at >US$300m. Further, we believe the
brand identity will also be taken into account while merging the two companies. However with lot
of challenges relating to Satyam’s steady state of financials as discussed above, we expect that
ambiguity relating to the merger ratio will remain high.
Management team
The Tech Mahindra group acquired a 42.7% equity stake in Satyam Computers after the turmoil
(including major accounting fraud) caused by Satyam’s erstwhile management in January 2009.
The Tech Mahindra group won a bid to potentially acquire majority ownership, consequent to the
Indian Government-appointed Board of Directors’ decision to induct new promoters into Satyam.
With this stake, Tech Mahindra got an opportunity to diversify its own IT/BPO services business
which is concentrated on the telecom vertical. The group restructured and streamlined accounts
and the operations of the Satyam Computers by inducting a team of professionals after Satyam’s
erstwhile management disclosed the fraud. Mr Vineet Nayyar (who is the Vice Chairman, MD and
CEO of Tech Mahindra) is the chairman of Mahindra Satyam. Under his leadership Satyam
Computers has now inducted a team of professionals with Mr CP Gurnani as the CEO and other
senior managers. Management believes it will take the company 12-15 more months to achieve
industry average growth rates on a consistent basis, considering the turmoil it has been through in
CY09/10.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Satyam Computer
Not out of the woods yet
We believe achieving industry average revenue growth will be an uphill task for
Satyam even in FY12 (post likely decline in FY11). Neither do we expect its
margin to match that of its peers in the medium to long term. We expect
downgrades in consensus estimates and initiate with a Hold rating.
Revenue growth challenges to persist beyond FY11F
We believe Satyam will find it tough to achieve revenue growth in line with its Indian peers
even in FY12 given: 1) the lack of scalable large clients within its portfolio, 2) supply-side
issues with recruiting/retaining the right mix of talent to achieve high revenue growth and
3) its deteriorating position in key markets, including the US and Europe. However, Satyam’s
increased participation in large deals hereon should yield results from the latter part of FY12.
In FY11, we expect revenues to decline due to the turmoil caused by the erstwhile
management.
Margin recovery near peers’ level is unlikely
We believe the company’s 2QFY11 margins already reflect most of the big challenges.
However, material margin catch-up near its peers’ levels looks challenging in the medium to
long term, in our view, considering: 1) supply-side issues, as Satyam employees are prone to
being poached by peers given that their salaries are not materially higher than employees of
peers (despite the company’s higher revenue contribution from enterprise solutions and
onsite) and given its high dependence on laterals, where attrition is the highest in the
industry; 2) its lower revenue per employee; and 3) low headroom in employee right-sizing.
Initiate with a Hold rating
We initiate coverage on the stock with a Hold rating and a target price of Rs60 based on 5.8x
FY13F EV/EBITDA, which is at about 60% discount to our target multiple for Infosys, the
Indian IT industry benchmark (which we believe is fair, considering the challenges on
revenue growth, a huge gap in margins even beyond FY11F and Satyam’s relatively lower
cash-flow-generating capability). We believe EV/EBITDA is a better multiple to value the
company given the high volatility on items below EBITDA due to ongoing litigations, which
could cause volatility in tax provisions and have an impact on cash flows and other income.
The basics
Catalysts for share price performance
We expect the key near term catalysts to be:
Continuing challenges on revenue as well as margins in the coming quarters. We expect
material downgrades in Bloomberg consensus estimates on revenues and EBITDA that are
significantly higher than our estimates.
Cognizant’s guidance for CY11 (in February 2011) and Infosys’s guidance for FY12 (in April
2011). While building in its typical conservatism, we expect Infosys to take a more confident
stance on FY12 guidance. However, considering various micro risks specific to Satyam, we
expect the company to face several revenue growth challenges.
CY11F IT budget finalisation (we expect this to be positive) and renewals of large outsourcing
deals over the next eight quarters starting 4QCY10. We believe Satyam will struggle to
achieve industry-average growth in FY12, considering the challenges the company faces.
We do not believe Satyam would benefit much from a pick-up in discretionary spend for the
industry. Despite Satyam’s focus on enterprise solution (~40% of revenues), we believe
competitive pressures will be higher (especially from Infosys and HCL Tech through AXON)
and given Satyam’s inability to scale up at least in the short to medium term.
Earnings momentum
We believe Satyam’s revenues will continue to underperform that of its peers’ in FY12 (we
expect a revenue decline in FY11).
Satyam is likely to struggle to achieve industry-average margins over the medium to long term
and hence the chances of negative earnings surprise remain high, in our view.
We forecast revenue (in USD), EBITDA (in INR) and EPS (in INR) for FY11-13F at CAGRs of
17%, 44% and 43%, respectively. EBITDA and EPS growth looks higher due to the significant
low base effect after restructuring and restatement of accounts.
Valuation and target price
Our target price of Rs60 is based on an EV/EBITDA target multiple of 5.8x FY13F, about a 60%
discount to our target multiple for Infosys, the Indian IT industry benchmark (which we believe is
fair, considering the challenges Satyam faces on revenue growth, the huge gap in margins
between the two even beyond FY11F, and Satyam’s relatively low cash-flow-generating
capability). We believe EV/EBITDA is a better multiple to value the company given the high
volatility on items below EBITDA due to various ongoing litigations, which we believe may cause
volatility in tax provisions and have an impact on the company’s cash flows and other income.
How we differ from consensus
Our FY12 and FY13 EPS estimates are 30-31% lower than the Bloomberg consensus estimates.
This is because our revenue and EBITDA margin estimates are lower, given our view that
challenges related to high revenue growth still persist and margin recovery closer to peer levels is
unlikely even beyond FY11. We expect downgrades to consensus estimates going forward.
Risks to central scenario
Higher-than-expected wallet share of Satyam within its existing and new clients.
Higher-than-expected margin improvement; lower-than-expected settlement of US class
suit/other litigations.
Merger of Tech Mahindra and Satyam – the risk relates to the merger ratio and resulting
impact on stock price.
A sharp depreciation of INR vs USD would benefit Satyam and its peers.
Faster-than-expected economic recovery in the US/Europe would benefit Satyam and its
peers.
Significant revenue growth challenges
We forecast Satyam’s FY11 USD revenues falling 6% and expect its revenue growth to
continue to lag its peers’ in FY12 given challenges in scaling-up large clients and
recruiting/retaining talent, and given the deterioration in key markets.
We believe it will be tough for Satyam to achieve revenue growth in line with its Indian peers even
in FY12F (we expect revenues to decline in FY11 due to the turmoil caused by the erstwhile
management). Satyam faces a number of challenges: i1) it lacks scalable large clients, 2) it faces
supply-side issues with recruiting/retaining the right mix of talent to achieve high revenue growth,
and 3) its positions in key markets, including the US and Europe, are deteriorating.
We believe any increased participation in large deals hereon will yield results only from the latter
part of FY12. Our estimate of a 5.5% revenue decline (in USD) for FY11 is not conservative, in
our view, as it assumes qoq growth of 2.3% in 3QFY11F and 4QFY11F
We believe Satyam might struggle to achieve our revenue growth estimate of 14.2% in FY12: it
will need to register more than 19% yoy growth in 4QFY12F over our 4QFY11F estimate (see
Chart 2). To achieve this, it will have to add US$650m-1,100m of new business (assuming threefive
year tenure with linear execution per annum for new business signings) . This, we believe, is
a tall task for the company, which is still grappling with its past and we thus see a downside risk to
our estimates, which are already lower than consensus estimates.
Right employee mix – another challenge to profitable revenue growth
Acquiring the right talent mix to cater to demand growth will be the next big challenge for Satyam,
in our view, despite the company having nearly completed its employee rationalisation. We
believe this is due to Satyam’s high attrition rate, possible deterioration in training infrastructure
and also due to the increasing lateral attrition in the industry. The company’s utilisation rate was
about 71% in 2QFY11, not materially different from its peers’. Besides this, currently, the
proportion of laterally hired employees at Satyam is much higher than at peers. Therefore, with
low headroom for employee right sizing and with a deteriorated training infrastructure, we believe
Satyam’s dependence on lateral employees will remain high in the foreseeable future. Besides
this, attrition rates for lateral employees are likely to remain high for the industry. We expect this to
not only hurt Satyam’s existing revenues but to also make it hard for it to ramp up new business.
Our expectation of a pick-up in USD revenue growth from FY12 onwards already factors in an
improvement in utilisation rate to about 75% in FY12 and FY13 which we believe will be in line
with similar-sized peers. However, large-cap peers are likely to continue operating at higher
utilisation rates, given their much larger size, superior control on attrition and better training
infrastructure.
Unlikely to achieve industry average margins
We expect Satyam’s margins are unlikely to recovery in line with its peers’ after FY11 given
our expectation that Satyam will continue to suffer from its deteriorated pricing power and
high attrition.
We believe the company’s 2QFY11 margins already reflect most of the big challenges. However,
material margin catch-up to near its peers’ levels looks challenging in the medium to long term, in
our view, considering: 1) supply-side issues, as employees of Satyam are prone to being poached
by peers given their salaries are not materially higher than employees of its peers’ (despite
Satyam’s higher revenue contribution from enterprise solutions and onsite locations) and given its
high dependence on laterals, where attrition is the highest in the industry; 2) its lower revenue
productivity per employee; 3) low headroom in employee right-sizing.
We expect Satyam’s personnel cost per employee will be higher in FY11 versus FY10,
considering the cut in variable pay (constituting 10-30% of CTC) for part of FY10 and wage
inflation for FY11. Despite the company’s higher dependence on lateral and onsite delivery, its
average employee-cost per headcount is not materially higher than its peers’ (in 2QFY11A). We
believe this could lead to employees being poached from Satyam in a rising demand scenario.
Despite: 1) Satyam’s utilisation rates of around 72% (not materially different than peers), 2) its
higher contribution from enterprise revenues (contribute ~40% of revenues), and 3) its high on-site
base (contribute ~60% of revenues), Satyam’s revenue per employee is lower than its peers’. This
indicates that pricing power of Satyam has been deteriorated
We believe that our below-consensus estimates are not conservative and estimate about 17%
USD revenue CAGR over FY11-13F. We expect EBITDA margin to improve from 7.3% in FY11F
to 11.3% in FY13F. Our margin estimates build in cost efficiencies within other operational costs
(non-personnel costs) as well as some benefits from the employee pyramid, with higher intake of
campus hires over medium to long term. However, we believe that any significant margin
improvement beyond our estimates will require a material increase in pricing, better than expected
execution on the employee pyramid and increased offshore delivery – all of which we believe will
be challenging for the company in the next 12-18 months.
Initiate with a Hold rating
We expect consensus estimate downgrades given our expectation of fundamental
challenges on revenues growth and margin recovery. Hence, any positive valuation rerating
seems unlikely hereon and we initiate coverage on the stock with a Hold rating.
We initiate coverage on Satyam with a Hold rating and target price of Rs60 based on an
EV/EBITDA target multiple of 5.8x FY13F, which is at about a 60% discount to our target multiple
for the Indian IT industry benchmark Infosys. We believe this is fair, considering the challenges on
revenue growth, huge gap in margins even beyond FY11F and Satyam’s relatively lower cash
flow generating ability.
We believe EV/EBITDA is a better multiple to value the company given the high volatility on line
items below EBITDA and the large amount of cash on its books. The lack of clarity on the maturity
of its outstanding hedge covers and pending litigations, including tax arbitration, could cause
volatility on items falling below EBITDA, such as other income and tax provision, in our view. We
believe, this, in turn could significantly impact the company’s qoq EPS.
Our target price also assumes the settlement of the US class action suit and some of the other
litigations, which we estimate at US$100m in FY12F (shown as extraordinary expenses for
FY12F). Any settlement lower or above this amount as well as any difference in the timing of the
settlement could impact our target price.
Management indicated Tech Mahindra-Satyam merger will be prioritised
We believe post re-statement of Satyam’s accounts and largely cleaned-up balance sheet,
Mahindra & Mahindra’s management will consider merging Tech Mahindra (TechM) and Satyam.
Management expects to announce this over the short to medium term. Our estimates (at the
current market price of TechM and Satyam) value Mahindra group’s stake in TechM (excluding
TechM’s stake in Satyam) at >US$525m and in Satyam at >US$300m. Further, we believe the
brand identity will also be taken into account while merging the two companies. However with lot
of challenges relating to Satyam’s steady state of financials as discussed above, we expect that
ambiguity relating to the merger ratio will remain high.
Management team
The Tech Mahindra group acquired a 42.7% equity stake in Satyam Computers after the turmoil
(including major accounting fraud) caused by Satyam’s erstwhile management in January 2009.
The Tech Mahindra group won a bid to potentially acquire majority ownership, consequent to the
Indian Government-appointed Board of Directors’ decision to induct new promoters into Satyam.
With this stake, Tech Mahindra got an opportunity to diversify its own IT/BPO services business
which is concentrated on the telecom vertical. The group restructured and streamlined accounts
and the operations of the Satyam Computers by inducting a team of professionals after Satyam’s
erstwhile management disclosed the fraud. Mr Vineet Nayyar (who is the Vice Chairman, MD and
CEO of Tech Mahindra) is the chairman of Mahindra Satyam. Under his leadership Satyam
Computers has now inducted a team of professionals with Mr CP Gurnani as the CEO and other
senior managers. Management believes it will take the company 12-15 more months to achieve
industry average growth rates on a consistent basis, considering the turmoil it has been through in
CY09/10.
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