Satyam+-+Edelweiss+-+29+12+08

India Equity Research | IT Company Update SATYAM COMPUTER SERVICES All roads lead to Rome INR 148 SELL December 29, 2008 Viju George +91-22-4040 7414 viju.george@edelcap.com Kunal Sangoi +91-22-6623 3370 kunal.sangoi@edelcap.com As investors and potential acquirers ponder feasible courses of action on Satyam, we lay out for the convenience of investors our view on the likelihood of the following options and impact thereof: (a) Board reconstituted but management remains (b) A big-ticket private equity major/financial investor buys out collective stake of a clutch of major investors (c) If an open offer is triggered, the deal or transaction may be even more unpalatable (d) A global MNC (such as IBM/Cap Gemini) as a strategic investor (e) Diminished stake of promoters is immaterial to situation at hand (f) Finally, what about investors view this? Upaid? How will potential financial/strategic Reuters : : SATY.BO SCS IN Board reconstituted but management remains This is purely cosmetic. In our view, investors will not be appeased with this course of action unless management is forced out (read: promoters and executive board members). After all, they could perceive the board (and some of the stalwarts in it) as ineffective but not dubious. It is now learnt that the management kept a tight lid on developments on the World Bank front and did not take the board into confidence on this. Hence, more than the board, we believe that management has come out worse from this episode. Thus, while the board is certain to get overhauled, the probability of management staying intact is low. A big-ticket private equity major/financial investor buys out collective stake of a clutch of major investors Again, this is unlikely to hold significance or yield much benefit unless the private equity major also imposes a change in the executive management. Why would a private equity major buy into a tarnished management? So, unless such a financial investor has the wherewithal to effect such a change, it is unclear how he can immediately take a stake in the company. Another possibility could be a temporary management reshuffle and appointment of an interim management team. However, much of this will depend on the ability of financial investors to find suitable replacement to Ramalinga Raju and his team. The sticking point may be in the offer price, which we have discussed further in this report. Bloomberg Market Data 52-week range (INR) Share in issue (mn) M cap (INR bn/USD mn) Avg. Daily Vol. BSE (‘000) : : : : 544 / 153 673.5 99.6/2,059.4 5,186.4 Share Holding Pattern (%) Promoters MFs, FIs & Banks FIIs Others : : : : 8.6 14.7 46.9 29.8 Relative Performance (%) Sensex 1 month 3 months 12 months 8.8 (29.3) (51.2) Stock (38.9) (58.0) (69.1) Stock over Sensex (47.7) (28.7) (17.9) Financials Year to March Revenues (INR mn) Growth (%) EBITDA (INR mn) Growth (%) Net profit (INR mn) Growth (%) Shares outstanding (mn) Diluted EPS (INR) EPS growth (%) Diluted P/E (x) EV/EBITDA (x) ROAE (%) FY07 64,851 35.3 15,377 31.9 14,047 23.0 667.2 20.8 22.1 7.1 4.0 27.9 FY08 84,735 30.7 18,348 19.3 16,879 20.2 670.5 24.7 18.7 6.0 3.1 26.0 FY09E 113,709 34.2 26,521 44.5 22,907 35.7 674.0 33.3 35.0 4.4 1.3 27.6 FY10E 122,868 8.1 28,382 7.0 24,115 5.3 600 475 40,000 30,000 20,000 10,000 0 (INR) 674.0 35.0 5.0 4.2 0.6 23.2 350 225 100 Dec-07 Jun-08 Dec-08 Edelweiss Securities Limited 1 Edelweiss Research is also available on Bloomberg EDEL , Thomson First Call, Reuters and Factset. ('000) Satyam If an open offer is triggered, the deal or transaction may be even more unpalatable An open offer for an additional 20% stake is triggered if the stake proposed to be acquired in the first instance is at least 15%. The open offer price as per the SEBI pricing formula is the higher of the 6-month average (INR 330 per share) and the two-week average (INR 176). At INR 330, it represents well over a 100% premium to the current market price. That is a tough sell for the existing investors to a financial investor. For this reason, we see the likelihood of a less than 15% stake sale accompanied by management change as the most probable option. A global MNC (such as IBM/Cap Gemini) as a strategic investor While this could be the most palatable option, it is also a difficult one. It is palatable because not only could an MNC exploit synergies and advantages of cost-arbitrage, but also it is best placed to replace the Satyam management and provide new leadership. However, the disadvantage of minimum open offer price of INR 330 may still hold. The name of Cap Gemini is doing the rounds. However, the balance sheet of Cap Gemini is somewhat constrained (net cash of USD 1.3 bn or EUR 0.9 bn) and its cash flow generating capacity low (free cash flows before acquisitions is just 4% of revenues). Also, Cap Gemini, in a significant acquisition, acquired Kanbay (an Indian offshore services firm) for EUR 954 mn in CY07 (cash outflows from the Kanbay acquisition in 2007 amounted to EUR 900 mn, while goodwill for the acquisition was EUR 830 mn). Would Cap Gemini really want to absorb one more, having already planted its stake in the offshore services territory ? Despite all this, even if Cap Gemini were still a willing suitor, it may able to assume a minority stake only in Satyam (~20-25% at the most) at the SEBI-prescribed floor price. The question really is whether that is a strong enough incentive in an environment like this. Thus, IBM, a name bandied about so often in the past, still seems the most likely horse needed to ride out Satyam and its management. Table 1: Most giant European system integrators lack the balance sheet liquidity and strength to fund decentsized acquisitions Logica 2007 3,073 29.4 133 4.3 (18.9) 168 5.5 26.5 274 108 (166) 1,597 1,059 CMG (mn £) 2006 2005 2,420 1,834 166 6.9 89 3.7 499 177 (322) 1,525 mn £ 121 6.6 83 4.5 118 245 127 819 Capgemini (mn €) 2007 2006 2005 8,703 7,700 6,954 11.9 493 334 214 5.7 4.3 3.1 35.7 440 293 141 5.1 3.8 2.0 46.1 1,059 1,160 1,145 648 442 416 (411) (718) (729) 3,851 3,697 2,750 3,836 mn € Atos Origin (mn €) 2007 2006 2005 5,855 5,397 5,459 3.6 271 247 399 4.6 4.6 7.3 (20.4) 63 (248) 246 1.1 (4.6) 4.5 (36.5) 444 589 506 348 453 534 (96) (136) 28 1,692 1,675 1,873 1,200 mn € TietoEnator (mn €) 2007 2006 2005 1,772 1,647 1,570 6.2 1 128 169 0.1 7.8 10.8 (91.7) (32) 247 138 (1.8) 15.0 8.8 (161.6) 172 200 106 73 139 100 (99) (61) (6) 474 622 489 555 mn € Revenue % CAGR (05-07) Operating income % of revenue % CAGR (05-07) Net income % of revenue % CAGR (05-07) Long-term debt Cash Net cash Networth Mkt cap (mn) Source: Company, Edelweiss research Diminished stake of promoters is immaterial to situation at hand Reports have emanated about a dilution of the promoters’ stake in Satyam (on account of selling by financial institutions of the shares pledged by them by promoters). This is immaterial in our view, since what is really at stake and an issue is not promoters’ holding or its dilution but control of the company by the current management. To the limited extent that dilution of promoter interest weakens the case of the current management to stay on, investors would be pleased. Edelweiss Securities Limited 2 Satyam Finally, what about Upaid? How will potential financial/strategic investors view this? All potential financial/strategic investors are likely to weigh consequences of the Upaid dispute with utmost deliberation (indeed, they would study all of Satyam’s liabilities and pending cases against it in full awareness). Upaid demands about USD 1 bn in damages, and if it is felt that the advantage in this suit lies with Upaid, that could be a big disincentive for an incoming investor in Satyam. An out-of-court settlement as a precursor to a transaction in Satyam with Upaid may be necessary, as nobody would want to be saddled with an albatross round the neck. A precedent for corporate governance arbitrage What this sorry episode has done is leave a huge hole in corporate governance at Satyam that is there to be almost instantly exploited. If shareholders manage to keel over the management, there is an immediate P/E lift. In this context, we recollect what Barings Private Equity Partners (Barings), an influential holder in BFL Software, did by merging Mphasis into BFL in 2001; it hired Jerry Rao and a host of heavy-weights from Citibank to head and manage MphasiS and also got rid of the management of BFL Software, who did not enjoy a great reputation with investors. They, then, merged BFL into MphasiS, making Jerry Rao and his team the managing entity. In doing so, Barings invested BFL with instant credibility and assured its investors. That one action and subsequent institution of a corporate governance framework sent the BFL scrip soaring 140% in three months’ time (during 2001). The P/E arbitrage for corporate governance was immediately exploited. Such exploitation in Satyam is perhaps possible by simply seeking to replace the management. There is sizable gain for shareholders when an influential entity or body of entities moves in that direction. Raiders are surely on the prowl. Conclusion: All roads lead to Rome Satyam management’s continuance seems to be untenable regardless of the new board composition. This possibility alone is likely to exploit the corporate governance arbitrage that we mentioned. The roads to this desired outcome, from the perspective of Satyam’s existing investors, are laced with hurdles that do not seem to have an easy or immediate solution (SEBI floor price in case of acquisition of stake exceeding 15%, Upaid and other liabilities, sharper customer contract due diligence in the wake of World Bank mess-up, management shake-up are some issues that we can identify at this stage). Whatever emerges is likely to be drawn-out. In the evolving scheme of considerations, we believe that a buy-back is relatively peripheral. Edelweiss Securities Limited 3 Satyam Company Description Satyam is the fourth-largest IT services company in India. It offers a range of IT services catering to verticals such as manufacturing, banking and financial services, insurance, telecom-infrastructure-media-entertainment-semiconductors (TIMES), and healthcare, among others. Satyam has the largest ERP practice amongst offshore vendors, with competencies in implementation of enterprise packages such as Oracle, SAP, PeopleSoft, and JD Edwards. Satyam’s presence spans 55 countries, across six continents. The company has 649 clients across the globe (including subsidiaries) and employs over 52,865 professionals, including its subsidiaries and joint ventures. Revenues for FY08 stood at INR 84.7 bn and profits at INR 16.9 bn, up 30% and 20% respectively from that in FY07. Investment Theme Satyam has, over the past 8-12 quarters, successfully de-risked its revenues and achieved success in growing relationships with other than the top 15-20 accounts. Recent initiatives at Satyam include growing practices such as engineering and infrastructure segments, which have huge untapped potential. The company has recognised the need to focus on large deals and formed a strategic deals group (SDG) to pursue and filter large deal opportunities. We believe that Satyam’s strong revenue momentum and lower BFSI exposure, compared with peers, puts it in a relatively good position in the event of weakness in this space. Key Risks Key risks to our investment theme include: (a) Slowdown in the US IT spending; (b) supply side constraints such as salary hikes and attrition; and (c) appreciation of the rupee against the dollar. Edelweiss Securities Limited 4 Satyam Financial Statements Income statement Year to March Revenues Cost of revenues Gross profit Total SG&A expenses EBITDA Depreciation & Amortization EBIT Interest expense Other income Profit before tax Tax Core profit Profit after tax Minority int. and others - paid/(recd.) Net profit after minority interest Shares outstanding (mn) EPS (INR) basic Diluted shares (mn) EPS (INR) diluted CEPS (INR) Dividend per share Dividend (%) Dividend pay out (%) Common size metrics - as % of revenues Year to March Cost of revenues Gross margin SG&A expenses EBITDA margin EBIT margin Net profit margins Growth metrics (%) Year to March Revenues EBITDA EBIT PBT Net profit EPS FY06 36.1 34.3 36.3 61.8 59.3 55.5 FY07 35.3 31.9 35.0 14.8 22.2 22.1 FY08 30.7 19.3 20.3 23.2 20.2 18.7 FY09E 34.2 44.5 44.2 35.2 35.7 35.0 FY10E 8.1 7.0 6.5 7.5 5.3 5.0 FY06 58.5 41.5 17.2 24.3 21.5 24.0 FY07 59.5 40.5 16.8 23.7 21.4 21.7 FY08 62.1 37.9 16.3 21.7 19.7 19.9 FY09E 60.2 39.8 16.5 23.3 21.2 20.1 FY10E 59.3 40.7 17.6 23.1 20.9 19.6 FY06 47,926 28,044 19,882 8,220 11,662 1,373 10,289 55 3,333 13,565 2,075 11,490 11,490 73 11,417 644 17.7 670 17.1 19.9 3.5 349.4 19.9 FY07 64,851 38,579 26,272 10,894 15,377 1,484 13,893 159 1,833 15,566 1,520 14,046 14,046 (1) 14,047 667 21.1 675 20.8 23.3 6.9 343.8 32.7 FY08 84,735 52,595 32,140 13,792 18,348 1,636 16,712 201 2,671 19,182 2,304 16,879 16,879 16,879 671 25.2 683 24.7 27.6 4.0 197.6 15.7 FY09E 113,709 68,475 45,234 18,713 26,521 2,417 24,105 190 2,027 25,942 3,033 22,909 22,909 2 22,907 674 34.0 687 33.3 37.6 4.0 197.9 11.6 (INR mn) FY10E 122,868 72,830 50,038 21,656 28,382 2,703 25,679 0 2,200 27,879 3,764 24,115 24,115 24,115 674 35.8 689 35.0 39.8 6.0 297.6 16.6 Edelweiss Securities Limited 5 Satyam Balance sheet Year to March Equity share capital Share premium account Reserves Total shareholders funds Borrowings Sources of funds Goodwill and other intangible asset Gross fixed assets Less: Accumulated depreciation Net fixed assets Capital WIP Investments Deferred tax asset Cash & bank balances Debtors Loans and advances Total current assets Sundry creditors Provisions Total current liabilities Working capital Application of funds Book value per share (BV) (INR) Free cash flow Year to March Net profit Depreciation Others Gross cash flow Less:Changes In working capital Operating cash flow Less: Capex Free cash flow FY06 11,417 1,373 (2,712) 10,078 2,605 7,473 2,446 5,027 FY07 14,047 1,484 (1,558) 13,974 4,078 9,896 3,827 6,069 FY08 16,879 1,636 (1,271) 17,244 4,159 13,085 3,572 9,513 FY09E 22,907 2,417 698 26,022 (489) 26,510 1,278 25,232 FY06 1,577 10,286 31,309 43,172 1,027 44,241 938 12,234 8,402 3,832 803 2 46 31,117 11,684 2,949 45,750 4,370 2,760 7,130 38,621 44,241 67 FY07 1,868 13,212 42,446 57,526 1,479 59,005 938 14,117 9,848 4,269 3,017 437 39,914 17,432 2,945 60,292 5,745 4,201 9,947 50,345 59,005 86 FY08 1,359 13,577 57,456 72,392 2,167 74,559 938 18,664 11,417 7,247 4,610 872 45,024 23,703 6,644 75,372 8,977 5,502 14,480 60,893 74,559 108 FY09E 1,348 15,079 77,242 93,668 351 94,021 938 24,102 13,834 10,268 450 750 176 66,059 25,546 6,011 97,616 10,177 6,000 16,177 81,439 94,021 139 (INR mn) FY10E 1,348 16,580 96,663 114,591 350 114,943 938 29,439 16,537 12,902 451 750 176 83,142 27,603 6,358 117,103 11,377 6,000 17,377 99,726 114,943 170 FY10E 24,115 2,703 0 26,818 1,204 25,615 5,339 20,276 Edelweiss Securities Limited 6 Satyam Cash flow statement Year to March Cash flow from operations Cash for working capital Operating cashflow (A) Net purchase of fixed assets Net purchase of investments Others Investments cashflow (B) Dividends Proceeds from issue of equity Proceeds from LTB/STB Financing cash flow (C) Exchange rate differences (D) Change in cash (A+B+C) + (D) Ratios Year to March ROAE (%) ROACE (%) Debtors (days) Payable (days) Cash conversion cycle Current ratio Fixed assets turnover (x) Total asset turnover(x) Equity turnover(x) Valuation parameters Year to March Diluted EPS (INR) Y-o-Y growth (%) CEPS (INR) Diluted P/E (x) Price/BV(x) EV/Revenues (x) EV/EBITDA (x) EV/EBITDA (x)+1 yr forward Dividend yield % FY06 17.1 55.5 19.9 8.7 2.2 1.3 5.5 4.2 2.4 FY07 20.8 22.1 23.3 7.1 1.7 0.9 3.8 3.2 4.6 FY08 24.7 18.7 27.6 6.0 1.4 0.6 3.0 2.0 2.7 FY09E 33.3 35.0 37.6 4.4 1.1 0.3 1.2 1.2 2.7 4.0 FY10E 35.0 5.0 39.8 4.2 0.9 0.1 0.6 FY06 30.0 13.4 74 26 48 6.4 14.2 0.3 1.3 FY07 27.9 13.5 82 28 53 6.1 16.0 0.3 1.3 FY08 26.0 12.5 89 32 57 5.2 14.7 0.3 1.3 FY09E 27.6 14.4 79 31 48 6.0 13.0 0.3 1.4 FY10E 23.2 12.4 79 32 47 6.7 10.6 0.3 1.2 FY06 10,078 (2,605) 7,473 (2,446) 301 (451) (1,838) 1,399 838 343 12 7,378 FY07 13,974 (4,078) 9,896 (3,827) (15,129) 2,130 (17,088) (2,611) 3,016 452 702 92 (6,398) FY08 17,244 (4,159) 13,085 (3,572) 631 (5,387) (2,738) (115) 681 (2,368) (421) 4,909 FY09E 26,022 489 26,510 (1,278) (750) (2,028) (3,121) 1,490 (1,816) (3,636) 20,846 17,083 (INR mn) FY10E 26,818 (1,204) 25,615 (5,339) (5,339) (4,694) 1,501 (1) (3,193) Edelweiss Securities Limited 7 Edelweiss Securities Limited, 14th Floor, Express Towers, Nariman Point, Mumbai – 400 021, Board: (91-22) 2286 4400, Email: research@edelcap.com Naresh Kothari Vikas Khemani Shriram Iyer Co-Head Co-Head Head Institutional Equities Institutional Equities naresh.kothari@edelcap.com vikas.khemani@edelcap.com shriram.iyer@edelcap.com +91 22 2286 4246 +91 22 2286 4206 +91 22 2286 4256 Research Coverage group(s) of stocks by primary analyst(s): Information Technology Geometric, HCL Tech, Hexaware, Infosys, Infotech, Mastek, Mphasis, Patni, Rolta, Sasken, Satyam, TCS, Take Solutions and Wipro Satyam Recent Research 550 460 370 280 190 100 Buy Buy Buy Buy Buy Sell Date 22-Dec-08 16-Dec-08 Company Accenture Satyam Computers Title Is the IDC overhyped? Company Update Proposed acquisitions plumb new lows in corporate governance; Event Update Price (INR) Recos USD 32 227 Sell (INR) 10-Dec-08 Apr-08 May-08 Dec-07 Feb-08 Mar-08 Jan-08 Nov-08 Dec-08 Aug-08 Sep-08 Oct-08 Jun-08 Jul-08 Infosys The leaders will pull away Technologies in a zero-sum game; Visit Note 1,174 Accum. 26-Nov-08 Infosys Rising premium reflects 1,187 Technologies expectations of resilience; Company Update Accum. Distribution of Ratings / Market Cap Edelweiss Research Coverage Universe Buy Rating Distribution* 94 Accumulate Reduce 59 14 Sell 8 Total 187 Rating Interpretation Rating Buy Accumulate Reduce Sell Expected to appreciate more than 20% over a 12-month period appreciate up to 20% over a 12-month period depreciate up to 10% over a 12-month period depreciate more than 10% over a 12-month period * 10 stocks under review / 1 rating withheld > 50bn Market Cap (INR) 75 Between 10bn and 50 bn 65 < 10bn 47 This document has been prepared by Edelweiss Securities Limited (Edelweiss). Edelweiss, its holding company and associate companies are a full service, integrated investment banking, portfolio management and brokerage group. Our research analysts and sales persons provide important input into our investment banking activities. This document does not constitute an offer or solicitation for the purchase or sale of any financial instrument or as an official confirmation of any transaction. 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