ICICI Securities Limitedcontent.icicidirect.com/mailimages/ICICIdirect_Mahindra...Mahindra group acquired Satyam in April 2009 after the erstwhile founders reported financial irregularities

September 28, 2011

ICICIdirect.com | Equity Research

Initiating Coverage

ICICI Securities Limited

Rating Matrix Rating : Hold

Target : | 75

Target Period : 12 months

Potential Upside : 6%

Performance Highlights (| Crore) FY10 FY11 FY12E FY13ENet Sales 5481.0 5145.0 5974.4 6651.6EBITDA 256.7 455.1 817.7 1010.7Net Profit -124.6 -147.3 794.8 862.6EPS (|) -1.1 -1.3 6.8 7.3

Valuation FY10 FY11 FY12E FY13E

PE (x) -62.3 -56.8 10.5 9.7EV to EBITDA(x) 25.7 14.5 8.1 6.5Price to book (x) 1.8 1.8 1.5 1.3Target PE -65.8 -60.0 11.1 10.2Target EV/EBITDA 27.5 15.5 8.6 7.0Target P/BV 1.9 1.9 1.6 1.4

Stock Metrics Bloomberg/Reuters Code SCS IN/SATY BOSensex 16727Average Volumes (yearly) 2979531Market cap (| crore) | 8353 Cr.Debt (Mar-11) | 32 Cr.Cash (Jun-11) | 1800 Cr.EV | 6585 Cr.52 week H/L (|) 114 / 54Equity capital 235.30Face value 2.00DII Holding (%) 3.7FII Holding (%) 13.0

Comparable Return Matrix (%) Returns (%) 1M 3M 6M 12MMahindra Satyam 12.9 (15.2) 6.6 (25.9) Tech Mahindra (0.1) (12.5) (16.7) 21.2 HCL Tech 8.9 (19.5) (16.2) (5.7) Patni Comp 9.1 (12.4) (37.8) (34.4)

Price Movement

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020406080100120140

Nifty Satyam(RHS)

Analyst’s name

Abhishek Shindadkar [email protected]

Aishwariya KPL [email protected]

Reincarnated!!! Yet uncertain macro weighs… Mahindra Satyam, once the fourth largest Indian IT services company, is recovering well and is in the third year/final leg of its three-year restructuring journey. Having salvaged the erstwhile Satyam Computers, the existing management has stabilised and invested in the business for the last two years, the outcome of which is encouraging. Q1FY12 sales have grown 4.3% QoQ led by 3.9% volume growth while operating (EBIT) margins improved by 9.5 percentage points (pp) since Q2FY11. With a majority of legal lawsuits settled, we believe the foundation of the rebuilding exercise has been laid with likely payoffs over the longer term. However, an uncertain macro merits attention as it could likely delay CY12 IT budget decisions, reminiscent of 2009 prospects of pricing pressure, elevated bench and modest volume growth. We initiate coverage on Mahindra Satyam with HOLD rating and price target of | 75.

Pending macro, ride the turnaround as restructuring draws to a close Subsequent to its acquisition of Mahindra Satyam, the new management had laid out its three-year transformation strategy of restoring customer and employee confidence in the first two years and growth in the third year. Q3FY11, Q4FY11 and Q1FY12 quarterly earnings suggest a likely conclusion of the rebuilding exercise. With foundations laid and a shift of management focus to profitable growth, we believe the time is ripe to ride the turnaround. However, the uncertain macro makes us cautious as its pertinent deterioration could weigh on IT sector valuations and remains the decisive factor in our HOLD rating.

Valuations Mahindra Satyam was impacted by a variety of issues led by financial irregularities of erstwhile promoters. However, the last two years have seen the management succeed at stabilising operations and invest for the future. At current levels, the stock is trading at 10.6x and 10x our FY12E and FY13E diluted EPS estimate of | 6.8 and | 7.3, respectively. From a Mcap/sales and EV/EBITDA perspective, Mahindra Satyam is trading at 1.4x and 8.1x on FY12E and 1.25x and 6.5x on FY13E basis, respectively. Though PE valuations appear reasonable post the recent 15-20% price correction, on a PEG basis it continues to trade at 1.1x on FY13E estimates, a premium relative to peer group average of 0.9x. This implies fair valuations at current levels. Further, pertinent deterioration in the macroeconomic environment could curtail CY12 client budgets and weigh on IT sector valuations. Consequently, we have valued the stock at | 75 i.e. at 10.2x our FY13E EPS estimate of | 7.3. We are initiating coverage on the stock with a HOLD rating. Exhibit 1: Financial performance (| Crore) FY09 FY10 FY11E FY12E FY13ENet Sales (| crore) 8812.6 5481.0 5145.0 5974.4 6651.6EBITDA (| crore) -200.6 256.7 455.1 817.7 1010.7Net profit (| crore) -8176.6 -124.6 -147.3 794.8 862.6EPS (|) -121.5 -1.1 -1.3 6.8 7.3PE (x) -0.6 -62.1 -56.6 10.5 9.7EV to EBITDA(x) -32.7 25.5 14.4 8.0 6.5Price to book (x) 2.7 1.8 1.8 1.5 1.3RoNW (%) NM NM NM 14.7 13.7RoCE (%) NM 5.5 9.8 15.1 16.1

Source: Company, ICICIdirect.com Research

Mahindra Satyam (SATCOM) | 71


ICICIdirect.com | Equity Research Page 2

Company background Incorporated in 1987 by the two Raju brothers, Satyam Computers was the fourth largest Indian IT company, with ~53,000 employees and revenues in excess of $2 billion, providing services to 2000 global companies. The company’s historical focus has been manufacturing and package implementation services, thanks to its relationship with SAP. The Mahindra group acquired Satyam in April 2009 after the erstwhile founders reported financial irregularities in January 2009.

Business description

Mahindra Satyam primarily offers application development & maintenance (ADM), infrastructure management services, enterprise business application & engineering services to ~220 clients (annual revenue run rate of >$250k, with the total client base in excess of 350). The company offers its services across manufacturing, banking & financial services, healthcare & life-science, energy & utilities, insurance & telecom in areas such as product life-cycle management, treasury & risk management, core banking, asset management, regulatory compliance and risk management services. Exhibits 6-9 highlight the company’s offerings across vertical and service lines.

Revenues & EBIT margins have stabilised

Subsequent to its takeover of Mahindra Satyam and having faced several headwinds during the initial 12-18 months, the new management has laid the foundations for rebuilding the company in the first two years of the three-year resurrection strategy as reflected in the past three quarterly earnings. Note, Mahindra Satyam would not have likely participated in >$50 million total contract value (TCV) deals in the first half of FY11. Further, in Q1FY12, the company reported EBITDA and EBIT margins of 14.6% and 12%, respectively, vs. 5.9% and 2.5% in Q2FY11. For full year FY11, the company reported EBITDA and EBIT margins of 8.8% and 5.3%, respectively, vs. 4.7% and 0.5% in FY10. Finally, the client roster has stabilised at ~220 with the company adding >50 logos since restructuring started. Exhibit 2: Revenues have stabilised as reflected from past three quarterly earnings

5481.0

1248.0 1242.4 1279.3 1375.3

5145.0

1433.9

0

2000

4000

6000

FY10 Q1FY11 Q2FY11 Q3FY11 Q4FY11 FY11 Q1FY12

| cr

ore

Revenues


Share holding pattern (Q1FY12)

Shareholder Holding (%)Promoters 42.7Institutional Investors 16.7Other Investors 1.9General Public 29.3

FII & DII holding trend (%)

42.7

42.7

42.7

42.7

42.7

13.7

13.2

11.1

12.6

16.7

0

8

16

24

32

40

48

Q1FY11 Q2FY11 Q3FY11 Q4FY11 Q1FY12

(%)

Promoters FII & DII

`



Exhibit 3: EBIT margins rise 230 bps to 12% vs. 9.7% in Q4FY11

62 30.6 172270.413443.829.1

5.0

2.53.4

5.3

12.09.7

0.5

0

60

120

180

240

FY10 Q1FY11 Q2FY11 Q3FY11 Q4FY11 FY11 Q1FY12

| cr

ore

0

4

8

12

16

%

EBIT EBIT Margin


Exhibit 4: Revenue by geography as of Q1FY12

Rest of world26%

Europe24%

North America50%


Exhibit 5: Revenue by verticals as of Q1FY12

Others11%

Healthcare & Life Sciences

7%

Retail, T&L12%

BFSI 17% TME

20%

Manufacturing 33%

Source: Company, ICICIdirect.com Research, TME - Technology, Media & Entertainment

Mahindra Satyam


4 Error! Reference source not found.

Exhibit 6: Revenue by vertical & service lines

Verticals Segments Offerings Areas Customers

Engineering Services Manufacturing

Avionic Solutions Concept

Enterprise Business Solutions Design

Application Development and Maintenance Aftermarket Service

Business Process Outsourcing Product Lifecycle Management

RFID Solutions

Outsourcing and Electronic Data Interchange Solutions Product Development 8 of the top 10 original equipment manufacturers (OEMs)

Integrated Engineering Solutions Supply Chain Management 4 of the top 10 suppliers in the automotive industry

Manufacturing

Sales and Marketing

After Sales Service

Support Functions

Business Transformation

Manufacturing Operations Management

Plant Asset Management

Global Spend Analytics

Real-Time Order Processing

Pricing Management

Environment Health and Safety

Innovation Management

Product Development Farm Equipment

Supply Chain Management Construction/Mining Equipment

Manufacturing Forestry Equipment

Sales and Marketing Quarry & Aggregates

After Sales Service Paving & Compaction

Industrial Equipment

Manufacturing Aerospace and Defence 1 out of the Global Top 2 commercial aircraft manufacturers

Automotive

Chemicals 3 of the top 5 global chemical companies


Mahindra Satyam





Cloud Computing Cards 8 of Top 10 wholesale banking majors

Product and Application Testing Lending 4 of Top 10 retail banking majors

SAP SolutionsTreasury and Risk Management

3 of Top 5 credit card majorsElectronic Bill Payments

Online Banking

Lock Box Processing

Cheque Processing

Payments Processing

Cash Management

Core Banking

Product and Application Testing Market Data Research 3 of Top 5 insurance majors

Oracle Solutions Trading Systems Group 8 of Top 10 asset management majors

SAP Solutions Reference Data Systems

Business Intelligence and Performance Management Asset Management

Hedge Funds

Regulatory Compliance

Risk Management Services

Constituent Relationship Management

University Administration

Student Self-Help

eLearning

Grants Management

Technology solutions

Infrastructure solutions

Domain Solutions

Enterprise Business Solutions

SAP Solutions

IT infrastructure for Generation

Banking and Financial Services

Banking

Financial Services

Education

Energy and Utilities

Energy (Oil and Gas Industry)

Data services Exploration & Production, Oil Field

Midstream, Refining and Marketing

Trading and Risk Management

Environment Health and Safety

Enterprise Asset Management

Utilities

Smart Grid

IT infrastructure for Transmission

IT infrastructure for Distribution

IT infrastructure for Retail


Mahindra Satyam





2 of the top 5 global pharma majors

2 of the top 10 biotech majors

3 of the top 10 medical device majors

Application Development and Maintenance

BPO Services

Application Development and Maintenance

Enterprise Data Warehousing

CRM solutions

Analytics

Integration Services

Cloud Computing

SAP Solutions

Product and Application Testing Product development

SAP Solutions Benefit validation

Marketing & Distribution

Underwriting

Claims

TV Content Procurement Digital Rights Management

Print Content Distribution Media Process Outsourcing

Web Content Archival Animation

Mobile Content Retrieval Consulting

Insurance Property & Casualty (General Insurance

Media and Entertainment

Corporate IT

Health Insurance Vertical Underwriting

Rating

Claims & Benefits

Sales and Marketing

Manufacturing

Supply Chain Management

Product Lifecycle Management

Sales & Marketing

Healthcare and Life Sciences

Healthcare Infrastructure Management Services

Analytics

BPO

Electronic Health Record Services

Hospital Information System

Telemedicine Solutions

Life Sciences Vertical Research and Development


Mahindra Satyam





Governments

NGOs

IGOs

Central Banks

Development Banks

Higher Education

Retail Technology Architecture Consulting Merchandising

Consumer Process Goods Six Sigma ConsultingSupply Chain Management

Packaged Implementation Services Store Operations

Infrastructure Management Services Marketing

Business Process Outsourcing Product Development

Business Intelligence Manufacturing

Supply Chain Management

Sales & Marketing

Semiconductor Equipment Manufacturers

Software Development SEMI Standards

IDMs Maintenance &Support Fab Automation

Fabs Testing Productivity

Foundries Application Development and Support Semiconductor Manufacturing

BPO Services Operations Management

Infrastructure Services

Embedded Solutions

Engineering Solutions

Communication Design, development and testing Mobile devices

Computing System Software and Migration Services Network elements

Consumer electronics Set-top boxes

Technology Infrastructure

20 of the Fortune 500 companies

Semiconductor

Public Services Application Development and Maintenance

Retail and Consumer Process Goods


Mahindra Satyam (SATCOM)


Management profile Vineet Nayyar is the Chairman of Mahindra Satyam and the Vice Chairman of Tech Mahindra. His earlier assignments include stints as Chairman & Managing Director of Gas Authority of India, Managing Director of HCL Corporation & Vice Chairman of HCL Technologies. He was also the founder & CEO of HCL Perot systems. Vineet holds a master’s degree in Development Economics from Williams College, Massachusetts. He held senior roles in the Indian Government including Director, Department Of Economic Affairs and served the World Bank for more than 10 years. CP Gurnani, Chief Executive Officer, held senior positions in various companies including HCL Hewlett-Packard Ltd, Perot Systems (India) Limited and HCL Corporation Ltd, including Chief Operating Officer and a co-founder of Perot Systems (India) Limited. CP holds a Chemical Engineering degree from National Institute of Technology, Rourkela. Vasant Krishnan, Chief Financial Officer, is a member of Institute of Chartered Accountants of India (ICAI), an associate member of the Institute of Company Secretaries of India (ICSI) and holds a diploma in Business Finance from the Institute of Chartered Financial Analysts of India (ICFAI). Prior to Satyam, he has held various positions in the Mahindra Group. He was the COO of South Asian Real Estate, a private equity fund and the CFO of the Adani Group (Realty). Rakesh Soni, Chief Operating Officer, is an alumnus of IIT Kanpur. In his career of over three decades, he was EVP - Perot Systems TSI and has held senior positions in Abu Dhabi Computer Centre, Tata Consultancy Services and Engineers India Ltd. AS Murthy, Chief Technology officer, is an electrical engineer from National Institute of Technology, Warangal and also holds a Masters' degree in School of Automation from the Indian Institute of Science (Bangalore). Murthy is a Satyam veteran having worked for >15 years. During his tenure, he has held various positions including Head of Global Delivery, Head of the Leadership Development, Head of Human Resources and Head of the insurance vertical. He was the CEO from February-June 2009. Hari Thalapalli, Chief Marketing Officer and Chief People Officer, is an old hand having served for 11 years at Satyam and >20 years in the IT industry. He is among the top HR professionals in the country. Vijayanad Vadrevu, Senior Vice President, Strategic Initiatives, has 20 years of IT services experience in sales, practise building, pre-sales, global delivery and customer advocacy functions across various verticals. He holds a Masters in Computer Engineering from IIT Kharagpur.



Investment Rationale Two years (of the three year restructuring strategy) have concluded Subsequent to its acquisition of Mahindra Satyam, the new management had laid out its three year transformation strategy of restoring customer and employee confidence in the first two years and growth in the third year. The first year (FY10) could best be described as ‘act of survival’ wherein governance, financial disclosure, business confidence and employee morale was at its trough. That said, during the second year (FY11) the management invested in the core business to arrest revenue decline and employee attrition. Concurrently, the company increased its efforts to improve customer and employee confidence. Q4FY11 and Q1FY12 quarterly earnings suggest that the management has been successful in stabilising operations and laying a foundation for growth with likely tangible results over the longer term pending any macroeconomic headwinds.

Ride the turnaround with likely payoffs over longer term

Q1FY12 revenues grew 4.3% QoQ in US dollar terms led by growth in the telecom, media, entertainment and retail vertical. Revenue growth was aided by 3.9% volume growth. Noticeably, Q4FY11 and Q3FY11 revenues grew 7.5% and 3% sequentially led by 3.5% and 2.5% volume growth. Revenue growth across quarters was accompanied by deal wins and signing of 50+ new logos.

Rationalisation of employee pyramid may yield operating margin expansion

Analysing the current employee pyramid suggests that employees with 0-3 years of work experience constitute ~20-25% of total employee base, 3-6 years - 34%, 6-10 years - 25% and the remaining with >10 years of experience as of Q4FY11. This could be largely attributed to minimal fresher hiring during the two year rebuilding process as Indian IT companies generally have ~45-55% of their employees in the 0-3 year band. This helps elucidate the employee costs disparity between Mahindra Satyam (~70% of FY11 revenues) vs. other Tier-I IT companies (~53-65% of revenues). Rationalisation of the employee pyramid coupled with fresher hiring (15,000 over the next three year) could yield meaningful EBITDA and EBIT margin expansion in FY12E/FY13E from 9.7% level in Q4FY11.

Exhibit 10: Employee pyramid skewed towards laterals as on Q4FY11

Source: Company, ICICIdirect.com Research,

The past two years have seen the management stabilise

and invest in the business. The results of this are

encouraging

The employee pyramid continues to be skewed towards

laterals. Increased fresher hiring could help flatten the

employee pyramid and yield EBITDA/EBIT margin

expansion. The number of employees under 0-3 years

stood at 24% as of Q1FY12

10+ years – 21%

6 - 10 years – 25%

3 - 6 years – 34%

0 - 3 years – 20%



Operating metric has room for improvement

Below, we analyse the operating metric data at Mahindra Satyam. Note that our analysis is limited to data availability as the company started publishing operating metric data only since Q4FY11. Mahindra Satyam operates at one of the highest onsite-to-offshore ratio of 56%:44% vs. industry average of 38%:62%. Though high onsite helps revenue growth performance, it impacts the operating margin as onsite costs are higher relative to offshore. Noticeably, a shift to offshore should help operating margin expansion. Separately, the company has managed to trim Q1FY12 last 12 month (LTM) attrition to 17% vs. 22% in Q4FY11 and 24% in Q3FY11 helped in part by historical HR initiatives – institutionalised by existing chief people’s officer – such as inculcating ownership behaviour among all its business associates by building effective communication, employee empowerment and Esops.

Exhibit 11: Operating metric highlights Offshore Onsite Attrition Utilisation Fixed Time &material Top1 Top 5 Top 10

HCLTech 72.9 27.1 17.0 78.6 42.0 58.0 NA 16.2 25.2Infosys Ltd 75.8 24.2 17.0 68.1 40.3 59.7 4.6 16.4 26.2TCS 51.0 44.0 14.4 76.2 49.4 50.6 7.4 21.4 29.6Tech Mahindra 64.0 43.0 NA 74.0 NA NA 41.0 70.0 79.0Wipro Ltd 48.3 51.7 22.7 77.0 NA NA 2.6 11.0 19.7

Average 62.4 38.0 17.8 74.8 43.9 56.1Mahindra Satyam 56.0 44.0 17.0 74.0 46.0 54.0 10.0 26.0 39.0Attrition is LTM basisUtilisation is on including trainee basis


Exhibit 12: Attrition levels in-line with industry average

14.414.8

17

15.8

20.9

23.2

1716.5

22

17

24.6

22.9

10

15

20

25

30

Q4FY11 Q1FY12

%

TCS Infosys Wipro HCL Tech Satyam Patni


Shift to owned facilities & subcontracting may add 1.5% to net margin in three years

During FY11, Mahindra Satyam surrendered 32 rented properties (~1520 spaces) across various locations. Leased facilities, classified as operating, are being replaced with owned facilities at Infocity SEZ, Hyderabad, which was completed in FY11 and created 4,304 spaces. Under construction facilities at the Hyderabad and Chennai SEZ, which are scheduled to be complete in FY12E, should create incremental 5,974 spaces. Further, subcontracting cost increased 1.33x during FY11 vs. FY10. Shift to owned

Q1FY12 LTM attrition declined to 17% vs. 22% in Q4FY11

Subcontracting and shift to owned facilities could aid net

margin expansion



facilities along with subcontracting could yield operating margin expansion and likely add 1.5% to net margin in three years.

Exhibit 13: Subcontracting costs have risen 1.33x YoY in FY11 vs. FY10

98.5

229.2

0

80

160

240

FY10 FY11|

Cro

res

0

4

8

12

16

20

24

%

Subcontacting costs As a % of Operating & Admin expenses


Exhibit 14: Leases decline 38% YoY in FY11 vs. FY10

199.5

122.7

0

50

100

150

200

FY10 FY11

| C

rore

s

0

4

8

12

16

20

%

Lease rentals As a % of Operating & Admin expenses


Merger resolution likely to reach Board in October

Though the debate on procedure and timing on merger continues, we believe the merger resolution could likely reach the Board of Directors (Board) in October. Our discussion with the management suggests winding down of the ADR programme and merger process can continue concurrently. The topical merger process entails Board and shareholder approval for both listed entities along with high court approval from both Maharashtra and Andhra Pradesh (headquarter location of Tech Mahindra and Mahindra Satyam, respectively). Assuming target PE multiple of 10x on our FY13 estimates of | 65.9 and | 7.3 for Tech Mahindra and Mahindra Satyam, respectively, yields potential swap ratio of 9:1 (one share of Tech Mahindra for nine shares of Mahindra Satyam). Exhibit 15 highlights the swap ratio sensitivity to different target multiples for both companies.

Discussion with the management suggests winding down

of ADR programme and merger process can continue

concurrently



Exhibit 15: Sensitivity analysis for swap ratio

9.0 7 9 10 11 13

7 9.0 11.6 12.9 14.2 16.8

9 7.0 9.0 10.0 11.0 13.0

10 6.3 8.1 9.0 9.9 11.7

11 5.7 7.4 8.2 9.0 10.7

13 4.9 6.2 6.9 7.6 9.0

Target PE,x for Tech Mahindra

Targ

et P

E,x

for

Mah

indr

a Sa

tyam


Top 10 client distribution broad based across verticals

We analysed Mahindra Satyam’s top 10 client distribution across verticals. Revenue generation from a diverse set of clients across verticals minimises revenue and earnings growth volatility during an uncertain macro environment. Exhibit 16: Top 10 client distribution across verticals

1

3

1 1

2

1 1

0

1

2

3

4

Auto

BFSI

Ener

gy a

ndut

litie

s

Aero

spac

e

Phar

ma

Tech

nolo

gy

Cong

lom

erat

e

Top 10 clients distribution across verticals


Synergies with parent likely to benefit manufacturing vertical

The external IT services spend from the manufacturing sector is expected to be ~$108 billion in 2011 and is expected to grow at a CAGR of ~3% between 2009 and 2013E. Note that manufacturing has been Mahindra Satyam’s expertise since inception. Currently, there are more than 130+ clients in this area (25 of the fortune 500 companies) and contributes ~31% of the total revenues. Sub-vertical wise discrete manufacturing contributes ~33%, automotive (29%), process manufacturing (22%) and aerospace & defence (16%). Mahindra Satyam, complimented by Mahindra & Mahindra (M&M) group’s strong engineering capabilities, continues to witness a demand pick-up in supply chain optimisation, plant modernisation initiatives, product life cycle management and regulatory compliance & sustainability.



Exhibit 17: Manufacturing verticals trends for Tier-I IT companies

-16.6-9.5

-0.4 -2.5

16.28.5

20.38.2

3.6

12.3 15.1

27.030.7

24.8

-26.3

38.1

-8.9

20.0

-40

-20

0

20

40

Q1FY10 Q2FY10 Q3FY10 Q4FY10 Q1FY11 Q2FY11 Q3FY11 Q4FY11 Q1FY12

TCS Infosys


Enterprise applications continue to be key differentiator Historically, Satyam had a strong application software practice built around the manufacturing vertical given its association with SAP. The company continues to see positive demand trends in application rationalisation, software-as-a-service (SaaS) implementation, packaged application implementation and enterprise mobility services. Noticeably, the 10,800+ resources are competent across platforms and distributed across verticals with focus on manufacturing. With 1700+ employees hired in Q3 and Q4 and 60 new logs wins in FY11, we believe, customers still perceive the company’s enterprise application positioning.

Verticalisation of delivery function Historically, Satyam Computers had its sales force aligned to verticals while the delivery was aligned to services offerings, a practice common to a majority of Indian IT vendors. Though beneficial on multiple counts, the existing structure did not leverage the domain expertise of employees. Further, frequent rotation of resources would impede generation of domain knowledge, which could be shared for future projects through knowledge management. Reorganising the delivery function along verticals by the new management should help create customer-centric and vertical focused solutions, thus improving customer satisfaction.

Defence requirement alone may lead to $600-million IT opportunity As India finalises its purchase of 126+ fighter jets for $10.6 billion, its biggest since 1990, a large IT outsourcing opportunity draws near for Indian IT vendors. Remember, the Indian offset policy mandates that services worth 30% of the contract value should be sourced domestically. The ratio rises to 50% for purchases over $70 million. Though a majority of these would go towards component manufacturers, 20% of offset value would go towards sourcing IT engineering solutions. This implies an engineering solutions’ IT outsourcing opportunity of ~$600 million. Having built an engineering solutions practice with 4000+ associates over 15 years and a long-term relationship with five out-of-the eight leading aircraft OEMs, we believe Mahindra Satyam is better positioned to participate in the incremental demand. Exhibit 18: Engineering solutions portfolio Globalised R&D Art to Part Solutions Outsourcing Consultancy New Product Development Manufacturing Support and Global Sourcing System Integration Product Sustenance Plant and Process Engineering Life Cycle Management


Verticalisation of delivery function could help improve

customer satisfaction

Manufacturing vertical capabilities coupled with the

parent’s (M&M) exposure to defence, makes Mahindra

Satyam better positioned to participate in incremental

demand



Risks and concerns Winding down of ADR programme in US may have supply overhang

During Q1FY12 earnings, the company announced the winding down of its American depository shares (ADS, receipt issued by depository Citibank, NA) programme. Recall, the company’s ADS’ were delisted from New York Stock Exchange (NYSE) effective October 2010 but continued to trade on the over-the-counter market. The company expects to complete the programme in approximately seven months from September 2011. As of June 2011, ADS constitute 9.4% of the total O/S shares or 11.1 crore shares. Availability of limited options for ADS holders could create supply overhang in the local shares at higher levels. Further, we believe, winding down of the ADS programme could have a sentimental impact given Mahindra Satyam earns 50% of its revenues from the US.

Aberdeen lawsuit could likely mirror class-action settlement

In November 2009, a trustee of two trusts, representing claims of 20 investors who had invested in the company’s ADS, brought forward an individual action alleging losses in excess of $68 million. Though both parties are contesting the claims, recent class action lawsuit settlements may help size the losses. Recall, Mahindra Satyam settled a similar lawsuit in FY11 by paying | 641.1 crore ($141 million) including | 569 crore ($125 million) as settlement charges and | 72 crore ($16 million) as litigation expense. Recent discussions with the management suggest potential resolution to the issue include 1) mirror prior settlement terms, 2) continue dialogue till settlement, 3) wait and watch. Note that the company has not made any provisions against these claims.

SEC settled, claims from Indian Tax Authorities could be a drag

The company has already settled its dispute with SEC and made the final payment of | 46.7 crore in April 2011 and has filed an application seeking a binding advance ruling under the Income Tax Act 1961 regarding taxability of the said income. However, apprehensions related to Income tax claims continue to prevail. Recently, the company received draft notices of incremental demand for | 1037.7 crore and | 1075.7 crore for assessment years 2002-03 and 2007-08, respectively. Except for these incremental claims, the company has provided bank guarantee of | 617 crore for unfavourable ruling in its petition against the income tax department (Exhibit 19). An adverse ruling in case of incremental demands from income tax could lead to additional bank guarantees that could impact the cash balance of the company.

Exhibit 19: Details of claims from Indian Tax Authorities

Statute Nature of Dues Forum where dispute is Pending Amount (| cr) Period to which amount relatesIncome Tax Act,1961 Income Tax Income Tax Appellate Tribunal 256.2 2007-08Income Tax Act,1961 Income Tax Income Tax Appellate Tribunal 81.2 2006-07Income Tax Act,1961 Income Tax Commissioner of Income Tax Appeals 144.1 2004-06Income Tax Act,1961 Income Tax Income Tax Appellate Tribunal 134.9 2002-04Income Tax Act,1961 Income Tax Commissioner of Income Tax Appeals 0.8 2001-02Revenue & Taxation code, US New York State Income Tax New York State Taxation and Finance 9.3 2005-07Revenue & Taxation code, US California State Income Tax Franchise Tax Board, California 5.4 2003-05Revenue & Taxation code, US Pennsylvania State Income Tax Commonwealth of Pennsylvania - Dept. of Revenue 0.3 1998-2005Andhra Pradesh VAT Act, '05/CST Act, '56 Sales tax (including penalty) High Court of Andhra Pradesh 5.2 2007-2009Finance Act,1994 Service Tax (including penalty) Central Excise and Service Tax Appellate Tribunal 20.2 2004-05 to 2008-09




Accounts receivables rise but unbilled declines

Analysing the balance sheet metric suggests an increase in account receivables. Other debts considered good increased 28% YoY (faster than revenue growth) to | 1,078 crore in FY11 vs. | 841.5 crore in FY10. Doubtful debts outstanding for a period exceeding six months have also increased 2% YoY to | 491.6 crore in FY11 vs. | 484.3 crore in FY10. Q1FY12 days sales outstanding (DSO) of 102 days continue to remain at elevated levels relative to Tier-I average of 70 days but have declined from 107 days in Q3FY11. Finally, unbilled revenues declined 31% YoY in FY11 to | 313.9 crore vs. | 454.3 crore in FY10. Exhibit 20: Accounts receivables have risen YoY in FY11

1,078

492

842

484

100

500

900

Other debts -considered good Debts outstanding for a period exceeding sixmonths but considered doubtful

| Cr

ore

March 31,2011 March 31,2010


Exhibit 21: Unbilled revenues have declined YoY in FY11

Particulars (| crore) March 31,2011 March 31,2010Unbilled Revenue 314 454


Amount pending investigation suspense account

As of March 31, 2011, the company’s balance sheet carried an understated liability of | 1230.4 crore. This relates to the funds arranged by Ramalinga Raju while he was still the Chairman. Further, 37 companies, predominantly promoter firms, have staked repayment claims along with compensation at the rate of 18% per annum from the date of advance till date of repayment. Though the Enforcement Directorate has advised the company not to return the money, any ruling against Mahindra Satyam could have a negative impact on the cash balance of the company.

Significant currency volatility may impact operating margin recovery

Mahindra Satyam has announced average wage hikes of 12-20% offshore and 2-4% onsite effective Q3FY12 that could impact its operating margins (EBIT) by ~250-300 bps. Significant currency volatility from current levels could have a material impact on the operating margin recovery.

Political uncertainty in Andhra Pradesh may impact normal operations

Political uncertainty in Andhra Pradesh, current headquarters of the company, could adversely impact Mahindra Satyam’s operations.



Adverse ruling in FEMA violation may impact cash balances

The Enforcement Directorate issued a show-cause notice dated April 28, 2011 for contravention of the provision of the Foreign Exchange Management Act, 1999 and the Foreign Exchange Management Regulations, 2000. This relates to the realisation and repatriation of export proceeds of foreign exchange equivalent to | 50.6 crore for invoices raised during July 1997 to December 31, 2002. The company was granted 30 days to respond and we are anticipating further updates on the same.



Financials Modelling 16.1% & 11.3% revenue growth for FY12E and FY13E

We are modelling FY12E and FY13E revenues will grow 16.1% and 11.3% YoY to | 5,974 crore and | 6,651 crore, respectively. The growth would be driven by strength in enterprise application and package implementation aided by mining of existing customers. From a quarterly perspective, we are modelling revenue growth of 3.3% in Q2FY12, 2.5% in Q3 and 1.5% in Q4. Exhibit 22: Revenue growth forecasts

1375

.3

1433

.9

1481

.2

1518

.2

1541

.0

1579

.5

1626

.9

1688

.8

1756

.3

1000

1200

1400

1600

1800

Q4FY

11

Q1FY

12

Q2FY

12E

Q3FY

12E

Q4FY

12E

Q1FY

12

Q2FY

12E

Q3FY

12E

Q4FY

12E

| cr

ore

(1.2)

0.8

2.8

4.8

6.8

8.8

%

Revenue growth


Employee cost rationalisation, declining LTM attrition, rupee depreciation may aid EBITDA margin expansion in FY12E, FY13E

We expect the company’s EBITDA margin to increase by 490 bps and 150 bps in FY12E and FY13E, respectively, led primarily by cost rationalisation, utilisation improvement and decline in LTM attrition. Similarly, the EBIT margin could increase by 560 bps and 150 bps in FY12E and FY13E, respectively. However, on a quarterly basis, we expect the EBITDA margin to stay flat in Q2FY12 (15% vs. 14.6% in Q1FY12) and decline by 280 bps in Q3FY11 due to 12-20% offshore and 2.5% onsite wage hikes effective October 2011. Exhibit 23: EBITDA growth forecast trend

178.

3

210.

0

222.

2

185.

2

200.

3

236.

9

231.

0

261.

8

281.

0

150

200

250

300

Q4FY

11

Q1FY

12

Q2FY

12E

Q3FY

12E

Q4FY

12E

Q1FY

12

Q2FY

12E

Q3FY

12E

Q4FY

12E

| Cr

ores

10.0

14.0

18.0

%

EBITDA margins




Improving return ratios

We estimate Mahindra Satyam would continue to generate moderate return ratios between FY12E and FY13E driven by improving profitability. The RoE is expected to improve to 14.7% and 13.7% in FY12E and FY13E, respectively, vs. negative return in FY11. Similarly, RoCE is projected to increase to 15.1% and 16.1% in FY12E and FY13E vs. 9.8% in FY11.

Valuations Apart from the recession, Mahindra Satyam was impacted by a variety of issues including financial irregularities and the subsequent rebuilding exercise. However, in-line with its stated objective, the last two years have seen the management succeed at stabilising operations and client roster, improve customer and employee confidence, trim attrition and invest for the future. This is adequately reflected in the last three quarterly earnings. At current levels, the stock is trading at 10.6x and 10x our FY12E and FY13E diluted EPS estimate of | 6.8 and | 7.3, respectively. From a Mcap/sales and EV/EBITDA perspective, Mahindra Satyam is trading at 1.4x and 8.1x on FY12E and 1.25x and 6.5x on FY13E basis, respectively. Though PE valuations appear reasonable post the recent 15-20% price correction, on a PEG basis it continues to trade at 1.1x on FY13E estimates, a premium relative to peer group average of 0.9x. This implies fair valuations at current levels. Further, pertinent deterioration in the macroeconomic environment could curtail CY12 client budgets and weigh on IT sector valuations. Consequently, we have valued the stock at | 75 i.e. at 10.2x our FY13E EPS estimate of | 7.3. We are initiating coverage on the stock with a HOLD rating. Exhibit 24: One year forward PE(x) chart

0

30

60

90

120

Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11

price 15 12 9 6 3


Though earnings would not likely show near term

weakness, our HOLD rating stems from the uncertain

macro, which could impact FY13 estimates and valuations



Exhibit 25: Peer valuation Name Price (|)

FY11 FY12E FY13E FY11 FY12E FY13E FY11 FY12E FY13E FY12E FY13E FY11 FY12E FY13ETCS 1044 44.4 52.2 60.0 23.2 19.8 17.2 17.0 14.7 13.1 1.1 1.1 5.4 4.5 4.0Infosys 2454 119.4 137.3 159.9 20.5 17.9 15.3 12.7 11.3 9.6 1.2 0.9 4.8 4.1 3.5Wipro 348 21.6 24.0 27.6 16.1 14.5 12.6 11.9 10.0 8.7 1.3 0.8 3.4 3.0 2.6HCL TECH 393 24.2 31.5 36.6 16.2 12.5 10.7 10.2 8.2 6.9 0.4 0.7 1.8 1.5 1.2Tech Mahindra 610 49.4 61.8 65.9 12.3 9.9 9.3 9.8 9.3 8.4 0.4 1.4 1.2 0.9 0.7

Patni 295 46.4 26.4 30.1 6.4 11.2 9.8 2.9 3.6 3.2 NM 0.7 1.2 1.1 1.0

Mphasis 330 39.31 37.7 41.4 8.4 8.7 8.0 7.2 8.9 7.9 NM 0.8 1.9 1.8 1.6Average 49.3 53.0 60.2 14.7 13.5 11.8 10.3 9.4 8.3 0.9 0.9 2.8 2.4 2.1

Mahindra Satyam 71 -1.3 6.8 7.3 NM 10.5 9.7 14.5 8.1 6.5 NM 1.1 0.8 0.8 0.7

Mcap/Rev (x)Diluted EPS (|) P/E (x) EV/EBIDTA (x) PEG (x)


Exhibit 26: Scenario analysis

Key Parameters Bear case Base case Best case

Legal Claims

Aberdeen Settlement Settlement amount in excess of class action settlement in-line less

i.e. (+) | 641.1 Crores | 641.1 Crores (-) | 641.1 Crores

Tax disputes

Existing claims for which |617 crore bank guarantee given loses dispute with tax authorities One time settlement wins the case

Addiitonal claims worth | 2113.42 crores either additional bank guarantee or payment under protest no payment but additional bank neither

guarantee required

Global Economic Outlook

Impact on economic uncertainity on CY12 IT budgets Decline >5% YoY Declines by 0-2% Flat

Revenue Growth 5-8% 11.30% 14-16%

EPS Growth 3-4% 8.7% 12.1-12.8%

EPS 7.0 7.3 7.6

Valuation Multiple (PE,x) 7 10.2 12

Target Price (|) 49 75 91


Exhibit 27: Trading at 1.1x PEG, premium relative to peer group average of 0.9x

1.10.9

0.80.7

1.4

0.70.8

1.1

0.0

0.5

1.0

1.5

2.0

TCS Infosys Wipro HCL TECH TechMahindra

Patni Mphasis MahindraSatyam

x




Tables and ratios Exhibit 28: Profit & loss account

(|crore) FY09 FY10 FY11 FY12E FY13ETotal Revenues 8,812.6 5,481.0 5,145.0 5,974.4 6,651.6 Growth (%) - (37.8) (6.1) 16.1 11.3 Total Operating Expenditure 9,013.2 5,224.3 4,689.9 5,156.6 5,640.8 EBITDA (200.6) 256.7 455.1 817.7 1,010.7 Growth (%) - (228.0) 77.3 79.7 23.6 Depreciation 839.4 227.6 184.7 167.7 179.1 Interest 62.1 32.9 9.7 9.4 0.5 Other Income 63.1 105.6 294.2 325.9 265.0 PBT before Exceptional Items (1,772.8) (101.7) 554.9 966.5 1,096.2 Less: Exceptional Items 6,242.8 - 641.1 - - PBT (8,015.6) (101.7) (86.2) 966.5 1,096.2 Growth (%) - (98.7) (15.2) (1,221.2) 13.4 Total Tax 159.0 22.2 57.8 171.8 233.6 PAT before MI (8,174.6) (123.9) (144.0) 794.8 862.6 Minority Interest 2.0 0.7 3.3 - - PAT (8,176.6) (124.6) (147.3) 794.8 862.6 Growth (%) - NM NM NM 8.5 EPS (121.5) (1.1) (1.3) 6.8 7.3 EPS (Growth %) - NM NM NM 8.5


Exhibit 29: Balance sheet

(|crore) FY09 FY10 FY11 FY12E FY13EEquity Capital 135 235 235 235 235 Share application money - - - - - Reserve and Surplus 1,610 4,395 4,386 5,181 6,043 Total Shareholders funds 1,745 4,630 4,621 5,416 6,279 Total Debt 814 42 32 12 - Deferred Tax Liability 5 4 7 7 7 Minority Interest 20 20 23 23 23 Amount Pending Investigation Suspense Account 1,230 1,230 1,230 1,230 1,230Source of Funds 3,813 5,927 5,913 6,688 7,539 Net Fixed Assets 1,239 987 950 1,107 1,290 Investments - 627 435 435 435 Deferred Tax Assets 7 7 8 8 8 Inventory 1 - 59 59 59 Cash 501 2,177 2,754 2,601 3,587 Debtors 1,552 923 1,159 1,662 1,479 Loans and Advances 466 385 378 378 378 Total Current Assets 5,436 6,729 7,625 8,233 8,893 Provisions 1,478 1,540 1,558 1,549 1,540 Total Current Liabilities 2,868 2,422 3,104 3,095 3,086 Net Current Assets 2,568 4,307 4,521 5,138 5,806 Deferred Tax Assets 7 7 8 8 8 Application of Funds 3,813 5,927 5,913 6,688 7,539




Exhibit 30: Cash flow statement

FY09 FY10 FY11 FY12E FY13EProfit after Tax (8,015.6) (101.7) (86.2) 966.5 1,096.2 Depreciation 907.2 227.6 184.7 167.7 179.1 (inc)/dec in Current Assets - (1,293.4) (896.0) (608.4) (659.2) (inc)/dec in current Liabilities - (507.4) 664.5 - - CF from operations 302.0 86.4 (61.2) (124.7) 1,094.8 Other Investments (163.5) (2,125.3) 547.2 325.9 265.0 (Purchase)/Sale of Fixed Assets (590.2) (95.1) (247.5) (325.0) (361.8) CF from investing Activities (753.7) (2,220.4) 240.1 0.9 (96.8) Inc / (Dec) in Equity Capital 51.3 2,908.5 - - - Inc / (Dec) in sec.loan Funds 588.0 (766.7) (10.7) (20.0) (11.5) Dividend & Divendend tax (275.7) - - - - Interest Paid on Loans (57.8) (38.2) (9.7) (9.4) (0.5) CF from Financial Activities 305.8 2,103.6 (20.4) (29.4) (12.0) Cash generating during the year (145.9) (30.4) 158.5 (153.2) 986.0

Amounts Pending Investigation Suspense Account (Net) 210.4 - - - - Opening Balance Adjustments (809.7) - - - - Cash on Account of New Subsidiaries 20.6 - - - - Effect of Exchange Rates (5.0) (26.1) 9.1 - - Opening cash balance 1,194.0 464.4 337.8 2,753.8 2,600.6 Closing cash 464.4 407.9 505.4 2,600.6 3,586.6


Exhibit 31: Key ratios

FY09 FY10 FY11 FY12E FY13EPer Share Data (|)EPS (121.5) (1.1) (1.3) 6.8 7.3 Cash EPS (108.9) 0.9 0.3 8.2 8.9 BV 25.9 39.4 39.3 46.0 53.4 Operating profit per share (3.0) 2.2 3.9 6.9 8.6 Operating Ratios (%)EBITDA/Total Revenues (2.3) 4.7 8.8 13.7 15.2 PBT/Total Revenues (91.0) (1.9) (1.7) 16.2 16.5 PAT/ Total Revenues (92.8) (2.3) (2.9) 13.3 13.0 Return Ratios (%)RoNW NM NM NM 14.7 13.7 RoCE NM 5.5 9.8 15.1 16.1 RoIC NM NM NM 13.4 12.9

FY09 FY10 FY11E FY12E FY13EValuation Ratios (x times)P/E (0.6) (62.3) (56.8) 10.5 9.7 EV / EBITDA (32.8) 25.7 14.5 8.1 6.5 Price to Book Value 2.7 1.8 1.8 1.5 1.3 EV/Total Revenues 0.7 1.2 1.3 1.1 1.0 MCap/Total Revenues 0.9 1.5 1.6 1.4 1.3 Total Revenues/ Equity 5.1 1.2 1.1 1.1 1.1 Turnover Ratios (x times)Inventory Turnover - - - - - Debtors Turnover Ratio - 4.4 4.9 4.2 4.2 Creditors Turnover Ratio - - - - -Fixed Asset Turnover ratio - 4.9 5.3 5.8 5.5 Solvency Ratios (x times)Debt / Equity 0.5 0.0 0.0 0.0 - Current Ratio 1.9 2.8 2.5 2.7 2.9 Quick Ratio 1.9 2.8 2.5 2.7 2.9 Debt / EBITDA (4.1) 0.2 0.1 0.0 -




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ICICI Securities Limitedcontent.icicidirect.com/mailimages/ICICIdirect_Mahindra...Mahindra group acquired Satyam in April 2009 after the erstwhile founders reported financial irregularities