Stock Review: Mahindra SATYAM

 

The ghost of the financial fraud is long buried, or so it seems. For Satyam Computer Services, renewed demand and settlement of lawsuits provide a big push. Credibility apart, this has put the company in reboot mode

 

   SATYAM Computer Services is witnessing renewed investor interest. After sluggishness over the past four quarters, the stock rebounded last week on news that the company has settled yet another lawsuit in the US courts. The development is expected to provide more credibility to the current management, which took over in the middle of 2009 following fraudulent practices of Satyam's previous management.

   We had recommended the stock at Rs 80 in October 2010 after the company, which now uses Mahindra Satyam as its brand identity, restated previous financial numbers. In the subsequent period, the stock has underperformed our expectations, mostly trading range-bound below 70. With reducing exposure to lawsuits and improving demand traction across geographies, we believe that the worst is over for the company. It is expected to return to normal business growth and profitability in the next 6-8 quarters.

BUSINESS AND GROWTH PROSPECTS:

Satyam offers IT services and solutions, infrastructure management, and business process outsourcing to global clients. It grossed nearly 3,770 crore in revenue in April-December 2010 by selling its deliverables to customers across verticals, including banking and finance, manufacturing, healthcare, and telecom. In mid-2009, Tech Mahindra through a special purpose entity took over the management control of Satyam after its earlier board confessed to financial manipulation. Since then, the new management has struggled to bring the company back on the growth track.

   The company has so far been able to report a gradual improvement in its operating profitability. This will improve further since the proportion of uncertain cash outflows towards meeting prior period obligations and settling legal claims are expected to go down. The company reported a 2.5% growth in business volumes measured in terms of billed man hours in October-December. Though this is lower than 3-6% growth shown by its bigger peers, what could offer some relief is the fact that Satyam's billing rates are stable. This reflects that the company is no more facing pressure to retain clients. Moreover, it has begun to grow its client base, adding seven customers in the past quarter. The company has picked up momentum in Australia, Europe and West Asia, which are expected to drive its growth in the near term.

LEGAL TANGLE:

Satyam has settled most of the lawsuits after the new management took over. In the past two months, it has gone for out-of-court settlement, which would result in outflow of around 570 crore. At the last count, the company had cash of 2,900 crore, which would be utilised to pay for these settlements. Therefore, such legal issues will not stretch its balance sheet. Settlement of legal issues would also help reinstate the credentials of the management, thereby improving saleability of its services.

VALUATIONS:

The company's earnings in January-March 2011 would be a crucial indicator of its future prospects. The company is expected to report operating margin in higher single digits. Given strong outsourcing demand and possibility of higher billing rates, the company is likely to report a 10-12% profitability and a similar revenue growth by FY12. Considering this, the stock trades at a forward P/E of over 15 at the current level of 75. Investors with a horizon of at least two years may stay invested.

Key factors

Positives

• Settlement of a majority of lawsuits brings more clarity to future cash outflows

• With settlement of SEC's lawsuit, shares may be re-listed in the US after due process, which can improve visibility

• Traction in demand from Europe, West Asia, and Australia

• A steady improvement in operating margin

Negatives

• Uncertainty over tax-related issues and pending private lawsuits may result in higher cash outflow in the near term

• Difficult employee resource management due to intense competition

• Wage hikes to retain key human resources may increase expenses