Friday, December 30, 2011

>MAHINDRA SATYAM (MSat; erstwhile Satyam Computer Services): Resolution of the major litigations has paved the way for the potential merger of MSat and Tech Mahindra

■ Business momentum continues: The MSat management has indicated business momentum has improved with increased client mining and new deal wins from existing clients. Besides, the company is seeing invitation for new requests for proposal (RFPs) gaining momentum. In the last five quarters, MSat’s revenues grew at a compounded quarterly growth rate (CQGR) of 4.3%.

  • Focus on client mining: MSat is increasingly focusing on deepening its relationship with its existing clients and getting new business from its existing pool of customers. Currently 98% of its revenues come from repeat business from the existing customers. The company plans to mine its existing clients and move up the value chain in terms of service offerings. This can be witnessed in the growth in the contribution from the top 20 clients—the same has increased from 54% in Q4FY2011 to 57% in Q2FY2012. Also, the number of $20-million clients has increased from 12 to 16 in the same period. Currently, of 228 total active clients about 65-70 clients are Fortune 500/Global 500 companies.
  • Finalisation of accounts aiding sales pitching and invitation for new RFPs: Till last year the company was facing difficulty in pitching for new business as its financials had not been finalised. However, the restatement of accounts for the last three years and better understanding of the company’s capabilities have led to MSat increasingly participating in the new RFPs.
  • Tech Mahindra—MSat joint go-to-market strategy a winwin for both: Tech Mahindra and MSat have initiated a joint go-to-market strategy, which has started showing traction and MSat has already won ten clients. Going forward, the management is optimistic of winning more business through strong domain expertise of both the companies - MSat (enterprise solutions practice) and Tech Mahindra (managed services practice).
  • Margin to range in 15-17%: MSat has seen a smart improvement in its EBITDA margin from 5.6% in Q2FY2011 to 15.3% in Q2FY2012. The margin improvement has been possible due to an improving volume growth (1.5% to 4% in the same period), cost rationalisation, increase in fixed price projects, higher offshoring and flattening of employee pyramid. The percentage of employees in the 0-3 years experience category has increased from 18% in Q2FY2011 to 27% in Q2FY2012. The management expects the margin to remain in the range of 15- 17% (ex currency impact) backed by the available levers like further flattening of the employee pyramid, higher offshoring and improvement in utilisation.

On a visible path to recovery

■ Business outlook remains soft on the back of macro uncertainties: The escalation of the sovereign debt crisis in the euro zone has kept the business outlook uncertain and affected the lead time for closure of deals (the lead time has gone up in the recent months).  Nevertheless, the management foresees a decent revenue growth in the coming quarters (ex currency impact). However, it expects lower discretionary spend owing to the macroeconomic uncertainties.

  • Cut in discretionary spends to have lower impact: On account of the current uncertain environment discretionary spends would be under pressure. MSat is a focused player in the enterprise solutions (ES) space contributing about 43% of the revenues of the company. Of the ES revenues, about 60% comes from the maintenance &; support services, which are largely annuity based.

  • Billing rates comparable to mid-tier players: As per the management, the current billing rates are comparable with that of the mid-tier Indian IT companies like Patni Computers but are much lower than that of the big IT companies like Infosys. However, as per the management MSat is getting higher rates on new deals.
  •  CY2012 budgets flat to down: In mid November 2011 the company did a survey of its top 30 clients. The survey pointed to a flat to marginally down IT budget for CY2012. However, offshoring is expected to increase. Also, there are no major worries regarding the budgeting cycle. There would be pressures on clients’ discretionary spends.

■ Q3FY2012 expectation: The management expects the revenues to grow at 2.0-2.5% in US dollar terms with a volume growth of about 3-4% whereas cross-currency movement would adversely affect by 1.5%. The EBITDA margins are expected to be lower by 20-30 basis points. The margins would be affected by a wage hike (an impact of 250-300 basis points) whereas the rupee’s depreciation would lower the adverse impact. The company expects a
net gain in its foreign exchange transactions in Q3FY2012; at the end of Q2FY2012 the company had total hedges of $221 million.

■ Manufacturing and TME remain the stronger verticals: For the company manufacturing and telecommunications, media and entertainment (TME) would remain the focus verticals. The company has strong offerings in the two verticals as well as proprietary solutions to cater to these verticals. Though the two verticals would be affected by the uncertain macro environment, the management expects the two verticals to be steady on an overall basis. The banking, financial services and insurance (BFSI) vertical would see volatility on a quarter-on-quarter basis due to lumpiness of business. The management is looking at acquisitions to grow in the BFSI vertical.

  Major litigations resolved paving way for merger with Tech Mahindra: MSat has seen the resolution of major litigations: both the class action suit and the Upaid litigation have been resolved. The company has not provided for the Aberdeen class action suit whereas for the IT demand the company has provided for about Rs400 crore. The resolution of the major litigations has paved the way for the potential merger of MSat and Tech Mahindra.
Tech Mahindra-MSat merger expected by December 2012: The merger process of the two companies has begun with MSat initiating the winding down of its American depository shares (ADS) which is expected to be completed by March 2012. The management had earlier indicated the merger would get complete by May 2012. However, the delay in resolving the other litigations would delay the merger process till December 2012.

MSat has come a long way from its tainted past with rechristened Mahindra Satyam, much improve financials and better business prospects. Going forward, to recapture the growth prospects MSat would be leveraging its own legacy in the enterprise part of the business and Tech Mahindra’s expertise in the area of managed services. We remain optimistic on the revival of MSat in the coming years. However, intermittent hurdles cannot be ruled out. On valuation parameters, MSat currently trades at 8.3x FY2013E consensus earnings estimate whereas relatively comparable companies like Patni Computer and Mphasis trade at 12.8x CY2012E and 7.6x FY2013E consensus earnings estimates.

Patni Computer’s superior valuation has more to do with the anticipation of a higher open offer price than with the fundamentals of the company whereas Mphasis finds it difficult to recover its lost ground owing to a series of lacklustre performance in recent quarters. Among these three mid-tier IT companies, we prefer MSat owing to its better growth visibility with earnings
compounded annual growth rate (CAGR) of 35% over FY2011-13E as compared to negative earnings CAGR of 13% in Patni Computer and flat earnings in Mphasis over the same period. Currently, we do not have any active rating on MSat but we remain positively biased.