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Mahindra Satyam(SCS)
Technology
1Q/2QFY11 results – start of the expectation reset process. A quick look at
Satyam’s current state of business reveals revenue stability albeit at the cost of margins.
The quarterly revenue run-rate of US$270 mn is creditable given the post-fraud turmoil;
however, reported OPM performance (5.9% EBITDA margin in 2QFY11) is weaker than
expected and likely to drive a lower reset of margin and EPS estimates. We cut our EPS
estimates for FY2011/12E to Rs2.7/4.1 and target price to Rs70/share (Rs80 earlier).
A quick look at the current state of business
Key highlights from Mahindra Satyam’s 1Q/2QFY11 earnings report:
Revenues of US$273 mn for 1QFY11 and US$268 mn for 2QFY11. The 2% sequential decline
in revenues in the strong quarter for the industry is a tad surprising, possibly highlighting that
Mahindra Satyam’s business trends continue to be company-specific rather than industry-linked.
Nevertheless, revenue stability is clearly apparent and creditable.
Reported margin trajectory came in weaker than market expectations. The company
reported an EBITDA margin of 7.8% for 1HFY11; more importantly, margins at 5.9% for
2QFY11 were 380 bps lower than 9.7% for 1QFY11. We also note that – (1) OPM for 1HFY11
was lower than the 8.7% for FY2010 – expected margin recovery has not panned out, and (2)
there are no one-off cost items that impacted margins. The management indicated that they
have chosen to sacrifice some margins to keep the core employee base intact while continuing
to invest in capabilities and S&M engine.
Satyam derived 59% of its revenues onsite in 2QFY11, clearly higher than larger peers.
Among service lines, the management indicated strong traction in the traditionally (for erstwhile
Satyam) strong areas of EAS and PE; ADM and BPO are tracking relatively weaker.
Satyam had a total headcount (including sub-contractors) of 28,068 at end-Sep 2010, a net
headcount addition of 1,068 from the 27,000 base reported at end-FY2010. Quarterly
annualized attrition at 25% for 2QFY11 was high, but reasonable given the tight supply
situation in the industry.
Satyam indicated 270 active (annual revenue run rate of >US$250K) clients at end-Sep 2010.
Reported tax rate of 27.8% for 1HFY11 came in higher than our expectation. The company
attributed the same to higher onsite profitability. We believe high tax rates could sustain.
Net cash of Rs25 bn at end-Sep 2010.
Mahindra Satyam remains a work in progress; significant challenges ahead
A quick glance at the base current financial status of Mahindra Satyam suggests that the
post-fraud turnaround of the company remains a work in progress. The new management
team has done a good job in holding the organization together and protecting a reasonable
revenue base, but we believe a lot more remains to be done before Mahindra Satyam starts
participating in broader industry revenue growth and regains industry-average levels of
profitability. We detail our thoughts on Mahindra Satyam’s revenue and margin outlook
below.
Revenues – well begun is half done, a challenging half remains
Even as reported revenues for 1QFY11 were better than our expectations, the fact that
Mahindra Satyam failed to participate in the strong growth quarter for the industry clearly
suggests that Mahindra Satyam’s revenue battle remains company-specific. The company
has just made available its financials for 1Q/2QFY2011 — a good sign. However, regaining
its market position, especially in the weaker service line of ADM and weaker verticals like
BFSI is likely to be a long haul, in our view. Nevertheless, we expect the company to sustain
strong traction in its strength areas of package implementation and product engineering
(aided in part by a supply crunch in these areas) and build in better-than-industry-average
revenue growth for the company in FY2012/13E.
Margins outlook more challenging; Street expectations likely to be reset
significantly lower
We believe the company has already captured the low hanging fruit such as elimination of
excess headcount and aggressive cut in non-manpower expenses – margin expansion from
here-on will have to be revenue growth led. Satyam also finds itself in a difficult highattrition,
supply-constrained environment, yielding little control on wages and making
revenue growth all the more critical to margin performance.
We see a substantial lower reset of the Street’s margin estimates for Mahindra Satyam.
Mahindra Satyam’s 1Q/2QFY11 reported margin levels of 9.7%/5.9% serve as a sound
reality check to the assumption that the company’s exit (4QFY10) margins for FY2010 were
meaningfully higher than the average 8.3% reported for the full year. We cut our lowerthan-
Street margin estimates for FY2011E and FY2012E meaningfully (discussed in detail
below) and expect sharper cuts across the Street.
Earnings revision – we now forecast EPS of Rs2.7 for FY2011E and Rs4.1 for
FY2012E
We broadly maintain our FY2011E, 12E, and 13E revenue estimates for the company at
US$1.11 bn, US$1.35 bn, and US$1.6 bn, respectively. However a sharp 240-550 bps cut in
our EBITDA margin estimate drives a 19-47% cut in our EPS estimates. Our revised EBITDA
margin estimates now stand at 8.7% for FY2011E, 12.3% for FY2012E, and 13.7% for
FY2013E. Consequently, out revised EPS estimates now stand at Rs2.7 for FY2011E (Rs5
earlier), Rs4.1 for FY2012E (Rs5.4 earlier), and Rs5.5 for FY2013E (Rs6.8 earlier). We also
reduce our target price on the stock to Rs70/share (Rs80 earlier) and note that a slowerthan-
expected margin turnaround poses downside risks to our estimates.
Contingent liabilities can be significant
Satyam management had indicated earlier that all legal liabilities, barring a class action
lawsuit, have been adequately provided for. Satyam had cash balance of Rs25 bn at end-Sep
2010, which would reduce to Rs21.6 bn after settlement of Upaid litigation (Rs3.4 bn for
the settlement has been placed into an escrow account). We believe a class action suit
liability is a certainty, though the timing and quantum is difficult to estimate. Exhibit 3
details the various law suits against Satyam.
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