Satyam Computer Services: Risk bearing: Buy (Medium term); Risk averse: Hold

Recommendation: Risk bearing: Buy -- Medium term

Risk averse: Hold

Krishnan Thiagarajan

AS THE US economy heads towards a recession, especially post-September 11, there is clear evidence of growing uncertainty and possible deterioration in the fundamentals of most frontline software service companies for the next two quarters.

And Satyam Computer Services (Satyam Computers), as the fourth largest player in the software services industry, is no exception.

Before the September 11 attacks, the overall slowdown in technology spending in the US was expected to retard revenue/earnings outlook in 2001-02 first half and crossing that phase held the key to future growth. However, post-September 11, the overall earnings outlook has changed for the software industry as a whole.

Unveiling the second quarter earnings performance this week, Satyam Computers revised the management guidance downwards from that made in the first quarter ended June 30, 2001. The revised financial projections for 2001-02 in the second quarter over the first are:

* Income from software services to grow at 30-33 per cent in dollar terms in the second quarter. The management had merely said this income will grow at 40 per cent year-on-year (without specifying whether in dollar or rupee terms) in the first quarter.

* The operating profit margins revised to 32-33 per cent from 34-35 per cent.

* The per share earnings revised downwards to Rs 13.75-14.25 from Rs 14.75-15.25.

Based on the second quarter earnings performance and the visibility provided by the first half (ended September 30, 2001) figures, Business Line examined the management guidance and came to the following conclusions:

Revenues: Given the visibility of income from software services available based on the first half performance for the period ended September 30, 2001, even if the sequential revenue growth remains flat over the next two quarters, Satyam Computers may still be able achieve close to 40 per cent growth in 2001-02. Unless new business acquisitions come to a halt or existing projects are scaled down dramatically, the projected growth in revenues may not pose a big problem.

In the second quarter, the contribution of software design and development offerings declined to 52.15 per cent from 58.82 per cent in the first. Going forward, with the prolonged delay in the closure of orders and growing uncertainty on offshore outsourcing, landing new contracts in high value added services may be difficult.

Second, despite clocking the lowest average blended (a combination of offshore-onsite) billing rates among frontline companies, the management has indicated continued pressure on billing rates. With the contribution of software maintenance revenues going up to 32.15 per cent in the second quarter from 29.76 per cent in the first, indications are that the fierce competition among all the frontline players to secure stable maintenance contracts will push down billing rates further. This is apart from the pressure on the billing rates evident among high value added services over the last couple of quarters across the tech sector.

From a growth in the onsite proportion of revenues to 45.11 per cent in the second quarter from 41.38 per cent in the first, it appears that newer clients may prefer "short term" outsourcing in these uncertain times. And probably wait for a stable external environment to resort to long-term offshore engagements.

Operating margins: The projected decline in operating margin by two percentage points is a cause for concern. Early indications of this were available from the decline in the operating profit margins to 34.51 per cent in the second quarter from 36.15 per cent in the first. This decline in OPM can be attributed to pressure on both revenue and expenditure. On the former, the higher proportion of onsite revenues may lead to a decline in OPM, and going forward, the pressure is likely to be felt on both volume and billing rates. On the latter, while the slowdown may help Satyam rein-in personnel costs in the coming quarters, expenditure on aggressive sales and marketing effort may bloat the operating expenditure.

There are visible signs of an increase in operating and administrative expenditure as a percentage of income from software services by 2.7 per cent offsetting the 1.06 per cent decline in personnel costs in the second quarter vis-a-vis the first. This is slated to rise with greater thrust on opening marketing offices in Europe and the Asia-Pacific region in the coming quarters.

The near-debt-free status attained by Satyam Computers using the proceeds of the American Depository Share (ADS) share offering made in May 2001 has left the earnings stream of Satyam less vulnerable to revenue declines. But the combination of flat revenue growth and lower operating margins appear to have forced a downward revision in the per share earnings guidance.

Looking ahead, the future valuation of Satyam Computers is likely to be dictated by the following risk factors and commitments made by the management:

Client/geographic concentration: For the third quarter, the company has projected flat revenue growth, operating lower profit margin of 32-33 per cent and a sharp drop in per share earnings of Rs 3.2-3.4 (compared to an EPS of Rs 4.26 -- with foreign exchange fluctuations -- and Rs 3.57 -- even without forex fluctuations for the second quarter and even the first quarter of 2001-02). The preliminary pointers to the enhanced risk levels are available in the earnings performance for the second quarter.

The contribution of the top 10 customers to revenues of Satyam has increased to 52.03 per cent from 48.38 per cent in the first. On a sequential basis, the new customer addition has slowed to 24 clients from 27. Over this period, the concentration of revenues from the US has actually gone up marginally, to 77.96 per cent from 76.92 per cent.

Divestment of stake in Sify: In a major move, there are plans to demarcate Satyam Computers in the IT services space and Sify (in which Satyam holds a 52.5 per cent equity stake) in the Internet arena. First, Satyam proposes to buyout the software services business of Sify with effect from January 1, 2002. The effective independent valuation is expected to be around $7 million (Rs 33 crore).

In a show of its strong commitment, the Satyam management has stated that apart from funds injected through the sale of the software business, it does not plan to invest any further funds into Sify. Given the mounting net losses of Sify, the critical test for Satyam will be its ability to divest its equity stake in Sify either in whole or in part as early as possible. It has also decided to restrict all further investments in its other loss-making subsidiary, Vision Compass Inc., to $500,000 (Rs 2.35 crore).

Ultimately, the biggest challenge for Satyam will be the deployment of the huge cash flows acquired through the ADS offer (of $161.90 million or Rs 760 crore, out of which $26 million (Rs 122 crore) was earmarked/utilised towards repayment of debt) and regular cash flow from operations. Having given the commitment that the funds will not be diverted towards Sify or its other subsidiaries, the future valuation of Satyam will be dictated by its ability to manage this huge fund flows in the IT services space either through acquisitions or enhanced capital expenditure in a productive fashion. Investors probably need to monitor this.

In this backdrop, investors with a medium-term perspective may take an exposure in the stock at current price levels. At a price earnings multiple of 10 times its projected 2001-02 per share earnings, the valuation discount of over 50 per cent to its frontline peers such as Infosys or Wipro seems exaggerated. However, in this volatile and uncertain external environment, the process of realignment may take time and, hence, a holding period of at least a year is recommended for good capital appreciation. Risk averse investors having exposure to Satyam may also stay invested.

Pic.: Satyam Computer's Chairman, Mr B Ramalinga Raju.