The Hindu Business Line : Satyam Computers: Hold

Despite a strong first quarter and an upward revision in guidance, sluggish growth in revenues from the top five clients and sequential drop in per-share earnings make this stock a hold.

(LEFT TO RIGHT): MR B. RAMALINGA RAJU, Chairman; Mr Ram Mynampati, President; and Mr V. Srinivas, CFO. — K. Gajendran

Shareholders can consider retaining their exposure in Satyam Computers. At the current market price, the stock trades at a price-earnings multiple of 17.4 times the projected FY-07 earnings.

Despite a strong first quarter, an upward revision in financial guidance in a robust demand environment and reasonable valuations relative to its peers, fresh exposure can be avoided.

This can be attributed to the relatively sluggish growth in revenues from the top five clients, sequential drop in per-share earnings in the second quarter on account of salary increases and the possibility of large deals affecting margins in the initial phase. Besides, Satyam was one of the few frontline software stocks that saw a significant re-rating over the past year, before the May market meltdown.

The upsides...

Demand environment: As the demand environment for offshoring continues to be robust and discretionary spends are moving up, Satyam will be one of the beneficiaries, like its other frontline peers. As one of the strongest players in the enterprise solutions business, it is geared to capitalise on sustained growth in this segment. That apart, its strategic push into new growth areas of engineering services and infrastructure management, are encouraging.

Large deal trigger: The company, which recently bagged multi-year deals from GM and Nissan, is well-placed to participate aggressively in the global trend of unbundling of large-sized deals. Satyam was among the first companies to set up a separate large deal strategy by inducting a senior executive from Computer Sciences Corporation last year. And it plans to pursue this, despite the possible margin-diluting impact of large deals.

Good quarter/guidance revision: Satyam has delivered a strong first quarter-ended June 30, 2006, aided, no doubt, by the depreciating rupee. It has exceeded the first quarter guidance by a long chalk. However, its operating margin has come down by about one percentage point to 24.6 per cent in the latest quarter. The company has also revised its guidance upwards for the full year FY-07, with a 3.1 per cent increase in revenues at Rs 6,290 crore and 7.9 per cent jump in per share earnings at Rs 39.5 at the upper end from the original guidance announced in March.

Client pipeline/margins: The steady rise in the number of clients in the $5 million (to 51 from 46 in the previous quarter) and $10 million bracket (to 33 from 27) is an encouraging trend. This suggests that the business momentum remains strong. For a company that has extremely competitive costs in offshoring among frontline companies, the wild card can turn out to be the billing rates. If the demand environment remains favourable, Satyam may be well-positioned to push for billing rate hikes among its existing clients. The only dark cloud in this scenario will be the sustained competitive pressure from its multinational and domestic peers.

...And what will be watched

Client composition: For the second straight quarter, the contribution from the top five clients has been sluggish. Though this is partly due to negative contribution from the top client, sluggishness on this front is likely to affect business growth in the coming quarters, as repeat business typically plays a significant role in volume growth among frontline companies. Clearly, the growth of clients, outside the top ten, has been the key driver of revenues for Satyam. This is also evident from new business accounting for 12.3 per cent of revenues, up from 8.6 per cent on a sequential basis.

Wage inflation/attrition: Relative to its frontline peers, Satyam is putting through a higher wage hike of 18 per cent offshore and 5-6 per cent onsite, which is coming into effect in July-September quarter. Reflecting this wage hike partially, Satyam has projected a decline in its per share earnings for the second quarter.

Despite having multiple levers to manage margins such as onsite-offshore mix, new service offerings and utilisation, the wage hike may be one of the key variables accounting for a one percentage point decline in operating profit margins projected for FY-07.

The attrition rate of Satyam, at 19 per cent plus, remains a cause for concern. In the light of this wage hike and the company's plans to induct more freshers in its overall employee base, its attrition rate will be a critical variable to watch over the next few quarters.

Footprint in Europe: Compared to its frontline peers, Satyam's contribution from Europe is significantly lower. It clocked 17.6 per cent of revenues from Europe in the latest quarter, down from 18.6 per cent, on a sequential basis.

The company's ability to broadbase its footprint in Europe will play a key role in improving volume growth and also impact its margins favourably.

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