Investment Activity Should Pick Up With Gross Fixed Capital Formation Accounting Essay

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Indian Economy

India's GDP is projected to grow at a rate of 9.4% in 2010 (IMF). It was earlier projected to grow at 8.8%. However, with robust corporate profits and favorable financing conditions fuel investment the growth rate was raised. The projected rate for 2011 is 8.5%.

Growth in the services sector, which accounts for nearly 57 per cent of the GDP, is expected to moderate marginally from 8.7 per cent in 2009-10 to 8.4 per cent in 2010-11 due to decline in growth of government expenditure relative to the last year. Industrial growth is expected to maintain its performance of 2009-10 as demand, both exports and domestic, continues to rise. In the event of a normal monsoon, agriculture is expected to grow at a rate higher than its trend.

Investment activity should pick up with gross fixed capital formation expected to grow at 12.5 per cent in 2010-11 Industrial activity is expected to remain buoyant in the next fiscal year. Capital goods are expected to benefit from an upturn in investment demand, while the consumer goods industry is likely to receive a boost.

Year-on-year inflation should start to slow down in spite of demand pressures, given the exceptionally high base of this year. Overall, WPI inflation is expected to be around 6.5-7.0 per cent.

As growth gains further traction and inflation remains elevated, the RBI would start raising interest rates in FY11. Moreover, the large government borrowing would exert an upward pressure on yields. It is expected to be around 8.3-8.5%.

The current exchange rate is Rs 46.53 per dollar. Going forward, the Rupee is expected to strengthen further due to economic uncertainty in US and other developed markets and robust performance of the Indian economy during the crisis.

The roll-back in tax concessions and the sustained recovery in industry performance is expected to result in a significant improvement in tax collections during FY11. In addition, the combined expected revenues from the disinvestment in public sector enterprises, and revenues from the auction of 3-G are expected to further inflate the gross revenues. Hence the fiscal deficit is expected to be around 5.6% of GDP.

On the other hand, the unemployment rate in India is around 10.7%, which is 57.3% higher than 2009.

However, the outlook for India can alter depending on the changes in the outlook for the global economy. On the domestic front, any unanticipated sharp rise in inflation is likely to result in relatively speedy tightening of the monetary policy, which in turn, would raise market interest rates, thereby posing a downside risk to economic growth.

India IT Sector

The Indian IT sector is expected to experience single-digit revenue growth for the first time in a decade in FY2010. The sector revenues to grow by 4% in FY2010E, as compared with sales CAGR of 35% over FY2000-FY2009E owing to a decline in the global macro economic growth and the resulting decline in IT spending. From these lows, the IT sector is expected to recover and post double-digit revenue growth-revenue CAGR of 14% over FY2010E-FY2012E. Also, with the 30% sales CAGR witnessed by the Indian IT sector during this decade, the sector also enjoyed high operating margins owing to industry-specific characteristics of low manufacturing costs.

Factors Fostering Growth

Amongst verticals, the demand in BFSI, Retail and Telecom sectors is increasing. As service lines, BPO and IMS are the key growth drivers and show a marginal increase in demand.

Growth is expected largely from existing clients though moves to target new clients and new verticals are positive from a long-term perspective.

Also vendor consolidation was deployed during the downturn which helped clients in bulk savings. This turned out to be positive for the Indian IT companies.

The focus would shift to countries such as India, China, the Middle East and Russia which have the potential to offer better growth opportunities for the global IT services industry and are forecasted to have IT spending CAGR over 2007-2011 in these countries to be significantly higher (9%-17%) than that in the US and Europe.

Focus will be shifting to untapped verticals such as government projects, infrastructure services, and healthcare.

The Indian IT sector has benefited from tax holidays provided by the STPI and SEZ.


The US and Europe together contribute to 86% of the revenue for most Indian IT companies. With the decline in both the US and EU GDP in 2009, there can be a direct impact on the growth of the Indian IT sector in FY2010E

Indian Rupee (INR), which was fairly stable through the first half of this decade, has been volatile since 2007. This has exposed Indian IT firms to both the translational and transactional impact of currency volatility.

An average wage inflation of 15% YOY has contributed significantly in reducing the offshore leverage advantage.

The average attrition rate in the Indian IT services industry is around 12%-13% per year and much higher in the BPO industry at around 40%-50%, according to Nasscom.

The Indian IT industry has benefited from lower tax rates as a result of the STPI tax holiday which is set to end in March 2011. This would have a direct impact on the sector's profitability from FY2012E.

Continental Europe continues to show increased openness to off-shoring but has issues on labor regulations related to the replacement of overseas jobs by offshore employees

M&A integration opportunities have been less than earlier anticipated

Company Research

Mahindra Satyam

HOLD 31 July 2010

Price Target

Rs 86.4 Rs 95

Sensex 16690

Stock Details







Face Value (Rs)


No of shares o/s (mn)


Market Cap (Rs bn)


Daily Average Vol (No of shares)

.25 mn

Shareholding Pattern (%)









Source: Company data

New management efforts likely to bear fruit, expect positive surprises in June disclosure.

Satyam is benefiting from a recovery in IT spending environment, new management team that is setting systems in place and strong interest from senior personnel in Mahindra group. Business in Satyam has stabilized and is gradually beginning to move up with new contract closures. Backed by strong cost management and utilization improvement, Satyam is expected to see sharp uptick in profitability leading to EPS of Rs 8/Rs 11 in FY11E/FY12E. The disclosure of accounts in Oct-10 end is expected to be a positive surprise for most analysts/investors and be the key catalyst for next upward share price move.

Business is beginning to move up in our view after a period of decline and uncertainty.

While the company has lost a few large customers due to the accounting scandal, the uptick in offshore spending and limited options in the large-cap space (TCS, Infosys, Wipro, Cognizant and HCL Tech) is helping Satyam to arrest business decline and win new deals. The current revenue has reached the US$ 1.3 billion mark and is further expected to rise with new upcoming deals uptick from Jun-10 quarter. It is expected to have a 5%/29% revenue growth in FY11/FY12 with FY12 on a low base.

Margins/ROIC in line with peers over medium term:

The new management has taken several steps to cut costs including cancellation of leases, reduction in sales and gradual employee realignment. While current margins would be in single-digits, Satyam's margins in the medium term would scale up close to peer group - EBITDA margins of ~20% in the next 18-24 months. Further, asset disposals would lead to return ratios in line with peer group by FY12 in our view. For legal liabilities, our model has a US$200 m write-off - US$ 70 m for Upaid and remaining for class action suits in US. The government expects the US market regulator Securities Exchange Commission (SEC) not to impose any penalty for frauds committed by the previous management.

Risks Involved

The key risk to this thesis comes from a delay in Satyam turn-around. While the new management team has taken a number of right steps in our view, the turning around a big company can take longer than anticipated especially given the size of crisis that Satyam faced. However the limited set of quality players in Indian IT sector and sharp IT spend revival is helping Satyam mitigate this risk. Secondly, Tech Mahindra's patchy performance over the last few quarters has raised questions about ability of management to turn-around Satyam. The senior management in Mahindra have been more closely associated with Satyam and there is considerable focus on turning around Satyam.

Right employee mix - Another big challenge, post near-completion of employee rationalisation

Despite near-completion of employee rationalisation, the right talent mix to cater to the growth in demand would be the next big challenge for Satyam during FY11 vis-à-vis peers. This is based on factors such as high attrition in Satyam, likely deterioration in training infrastructure and increasing lateral attrition in the industry. The utilization rate is expected to be 49.5% in FY10, which is likely to increase to 65.9% in FY11E albeit still lower than industry peers operating at 70-80% at present. In FY12, with expected pick-up in revenue growth (while number of employees largely remaining flat YoY) and likely improvement in training infrastructure, the utilization rate is expected to increase to ~73.5% for Satyam that, which would be normal for similar-size companies.

Merger with Tech Mahindra

The merger with Tech Mahindra is expected to be completed by 2015-16. This would strengthen the company's management bandwidth by adding the management from the Mahindra group. This would provide the two companies with more stability and a higher share in the market. This would also sharpen the focus in respective areas and generate traction for the business. The merger would start from Oct 15 when the financial details would be disclosed.

FIFA World Cup '10 Project, rebuilding the brand

Satyam's role during the FIFA World Cup 2010 was quite visible and it is now looking forward to tap that market further. Not long ago, the brand was almost written off. But with brand associations such as FIFA, the company hopes to resurrect its brand image. No surprise then that the company is striking a deal with football's international governing body FIFA, to be the IT services provider for the 2014 Fifa World Cup as well..

New Products and Clients

The company has been quite proactive in launching new products. Recently it launched a new service delivery model called "Delivery Xpress" based on Oracle. It has recently launched a new development centre of BASF IT Services at its office in Chennai. In June this year, Mahindra Satyam BPO had entered into a partnership with Direct Channel Holding Ltd., one of Africa's leading contact centre and BPO companies. It also commenced an SEZ in Hyderabad this year. Moreover, it is now diversifying into other markets such as Africa and Latin America.

Re-statement of accounts to improve Satyam's deal pipeline

The deal pipeline is likely to improve post re-statement of Satyam's financial statements (due in Oct'10) that would give more comfort to clients and increase the company's eligibility in new-deal RFPs; therefore, higher growth for Satyam is expected in FY12 vs FY11.

EBITDA margin beyond 18-20%, a challenge

The challenges relating to revenues, managing utilisation rates and employee cost would continue over the medium term for Satyam. Achieving margins beyond 18-20% requires regaining lost market share, tight control on SG&A investments, high pricing power with customers, material change in employee pyramid & delivery model, higher off-shoring etc, for which, we believe, Satyam has lower flexibility over the next 1-3years. Hence, the full benefit of economies of scale is still distant for Satyam and the FY12 EBITDA margin estimate of 18.2% for Satyam is reasonable, particularly post significant reorganisation by TechM management.

Predictability for items below EBITDA lower

The re-statement of Satyam's earlier financial statements may lead to losses, which can be carried forward, and offset against taxable income from FY11. A nil tax rate has been assumed for FY10E, ~8% for FY11E and ~25% for FY12E. The PAT estimates for Satyam exclude other income (including forex). The forex gain/loss is likely to add volatility to estimated PAT. Hence, Satyam can be valued using EV/E rather than P/E, given lower earnings predictability for items below EBITDA level. A fair value estimate for Satyam (based on EV/E method) factors-in net cash including treasury returns on idle net cash.

Notably, the balance sheet for Satyam has not been estimated as, post re-statement of Satyam's accounts (due in Oct'10), the balance sheet would differ significantly from any estimates. Also, while disseminating information on Q3FY09 and expounding on January '09 & February '09 results, Satyam management stated the unreliability of information and any estimates therein with its caveat that final and/or audited results may be materially higher or lower than projected. Further, while valuing the company on EV/E, certain assumptions have been made with respect to cash & debt in Satyam's books.

Valuation - Target price offers unfavourable risk-reward

EV/E is a better multiple for valuing Satyam, given lower predictability on items below EBITDA and likely restatement of Satyam's previous years' accounts, going forward. Reinitiated coverage on Satyam is with HOLD and target price of Rs95/share. Based on target EV/E of 7.4xFY12E, recurring EBITDA which is at 40-45% discount to Infosys and 10-15% discount to HCL Tech, is fair, given lack of sufficient information to value Satyam as well as the uphill task to turn it around. The current valuation of Satyam already factors-in 15-20% EBITDA margin in FY11E-12E versus likely single-digit EBITDA margin in FY10. Hence, further valuation re-rating for Satyam is dependent on EBITDA margin upside beyond 20%, which is an uphill task for the management and unlikely till FY12. The estimate of 18.2% EBITDA margin in FY12 is based on utilisation rate of 73.5% (standalone), which would be at industry standard for companies with similar-size as Satyam.

Company Description

Mahindra Satyam (NYSE: SAY) is a leading global business and information technology services company that leverages deep industry and functional expertise, leading technology practices, and an advanced, global delivery model to help clients transform their highest-value business processes and improve their business performance.

The company's professionals excel in enterprise solutions, supply chain management, client relationship management, business intelligence, business process quality, engineering and product lifecycle management, and infrastructure services, among other key capabilities.

Mahindra Satyam is part of the $7.1 billion Mahindra Group, a global industrial federation of companies and one of the top 10 industrial firms based in India. The Group's interests span financial services, automotive products, trade, retail and logistics, information technology and infrastructure development

Key risks

Key risks to these recommendations are the re-statement of Satyam's accounts and the resulting higher-than-estimated revenue run rate, net cash/bank balances and lower-than-estimated employees (implying positive surprise for Satyam). On the other hand, lower-than-estimated revenue run rate, net cash and bank balances and higher-than-estimated employees can lead to a material negative surprise.

Another fact is that re-stated net cash and bank balance will impact our target price estimate for Satyam.

The post re-statement of Satyam's accounts and more clarity on its liabilities (including off-balance sheet), the TechM management will considermerging TechM and Satyam. Our estimates, at the current market price of TechM and Satyam, value the Mahindra Group's stake in TechM (excluding TechM's stake in Satyam) at ~US$550mn and in Satyam at ~US$450mn. With lack of clarity on Satyam's re-stated financial statements and resulting change in Satyam's valuations, ambiguity exists on the merger ratio and, hence, lack of investor interest, at least till the re-statement of Satyam's accounts. The brand identity will also be considered while merging any company with the other.