Tuesday, November 1, 2011

Satyam ADR

I believe that the ADSs of Mahindra Satyam are misunderstood and mispriced. Early next year, the ADSs will be canceled and converted to India-traded shares (which trade at a 5% premium at current exchange rates). Another catalyst is Satyam’s impending takeover by Tech Mahindra. Satyam has scored contract wins and partnerships with major firms such as EMC (EMC), Oracle (ORCL) and Mastercard (MA). Earnings are growing quickly and ROE is now over 30%. This is no longer a turnaround story with fleas. This is an opportunity to buy one of India’s leading businesses before it is rerated as a growth story. Satyam trades at just 1.6X FY2011 sales vs. 4-6X FY2011 for other Indian IT companies. This would be a perfect pitch, if not for the potential tax liability (more on this near the conclusion of my writeup).

You probably last heard about Satyam Computer Services in January 2009 when the Chairman and founder admitted to falsifying the company’s financial statements. Satyam lost several important clients and the stock declined by over 80%. Tech Mahindra, the software unit of Indian manufacturing conglomerate Mahindra & Mahindra, then installed its own management at the company in April 2009 after winning a government-led auction. The ADSs were delisted from the NYSE in October 2010 because Satyam could not file with the SEC on time, adding further downward pressure on the stock.
Recovering From the Fraud
During the financial year ended March 31, 2010, Satyam, under new management, took several steps including the appointment of a new Audit Committee, the revision of the Code of Ethical Conduct and the nomination of a Corporate Ombudsman. The internal audit function was also strengthened by appointing Deloitte, Haskins and Sells as the internal auditor.
In September of 2010, Satyam released restated audited financials. This was an important step in the recovery, as clients often consider a service provider’s financial resources when awarding contracts.
Business Description
Satyam is an information technology consultant to mid-size and large corporations. It helps clients become more efficient and more profitable. Competitors include Wipro and Infosys. I do not profess to be an expert on the IT business so here is a link describing Satyam’s various services.
I spoke with two employees of Infosys: one is an IT consultant; the other is a business analyst. They are paid rather well since their work involves a lot of technical knowledge about computer programming. Their managers are Americans who went to business school to learn management skills, but it is really the Indians who do all the real work. Cliches aside, the most important asset of this business is people. (Incidentally, this is an ideal business to own during inflationary periods because capital investment is minimal.) My Infosys contacts said that Satyam is full of talented employees.
Catalyst for the ADSs
Satyam’s ADSs represent two shares of common stock trading on the Bombay Stock Exchange, which last traded at 66.9 rupees. At current exchange rates, this means that the ADSs should trade at $2.94. The ADSs last traded at a 5% discount, which is much larger than usual.
The reason for the mispricing is that Satyam plans to delist its ADSs and convert them into common shares trading in Bombay. As a result, I believe that retail holders and perhaps some institutions are selling their positions. The idea of owning a stock trading in India may be too awkward. Moreover, even some large clearing firms such as Penson cannot facilitate the conversion as they do not have trading desks in India. ADS holders do have the option of receiving cash in lieu of Indian shares, but they need to pay a fee of 5 cents per ADS, or almost 2%.
The reason for the ADS Delisting is Disclosed here:
The Company’s equity shares underlying its American Depository Shares (ADSs) and the ADSs themselves have been registered with the US Securities and Exchange Commission (SEC) since 2001, when the Company began trading on the New York Stock Exchange (NYSE). The registration obligates the Company to file annual and other reports with the SEC. The Company has, however, been unable to file the required reports post September 2008, because the financial irregularities identified for earlier years were substantial in amount, perpetrated across multiple accounting periods affecting many areas and due to non-availability of required information/documentation relating to several unexplained transactions and amounts pertaining to the period affected by the financial irregularities. This has a resultant continuing impact on the Company’s ability to prepare the financial statements under U.S. GAAP and to achieve a form of audit opinion thereon that would comply with the SEC’s requirement that such opinions contain no audit qualifications including scope limitations arising from the Company’s inability to provide required information/documentation relating to the period affected by the financial irregularities as indicated above. Accordingly, the Company has now determined that it will not be able to become current in its SEC filing obligations.
This disclosure seems a little unsettling, but I think Satyam’s restated financials are fine. It is simply not worth the time to satisfy the SEC’s requirements as Satyam is soon going to be merged into Tech Mahindra.
The Merger Catalyst
Satyam shareholders will inevitably own shares of Tech Mahindra after the merger, so it is important to look at what the combined business will look like. This article provides an excellent description. More information on Tech Mahindra can be found here:
Tech Mahindra is an above average business, with 20% EBITDA margins. Unlike Satyam, however, its earnings and revenues do not grow. Moreover, the customer base is much more concentrated. There is the potential for the combined entity to cross-sell and thereby increase revenues.
Satyam Standalone Turnaround in Middle Innings
I spoke with someone who advises the board of Tech Mahindra, and he said that Satyam is a great turnaround story. Revenues are improving, margins are improving. Deals are being signed with EMC, Oracle and other big names. Despite its comparable quality to other Indian IT companies, Satyam trades at 1.6X FY2011 sales vs. 4-6X FY2011 for competitors. Here’s what some local sell-side analysts have to say.
Tax Liabilities Depress Stock Price
Alas, this fat pitch is not perfect. In late August, the Indian tax authorities sent Satyam a draft notice (not a final notice) that it owed $463 million for years 2002 and 2007. Satyam has argued that since taxable income was fictitiously inflated during these years, the actual tax liability should be much lower. Satyam’s legal team is preparing to appeal the case to the Andhra Pradesh High Court.
I expect the High Court to resolve this case in Satyam’s favor. First Satyam needs to prove that the former Chairman did in fact fictitiously inflate earnings. The income tax department’s view is that this has not yet been proven. Apparently they don’t read the paper. Ramalinga Raju has been sentenced to prison for several years, and the Andhra Pradesh High Court (the same court in which Satyam is arguing the tax case) previously denied bail for Raju, presumably because he is an evil man. Second, Satyam needs to argue that taxes cannot be levied on income that does not exist. This point I believe is self evident. To argue otherwise would be unjust and nonsensical. You can watch Vice President Vineet Nayar argue this point here.
Satyam has reserved about $87 million for tax liabilities related to a similar tax notice covering 2003-2009. It has no reserve set aside for the $463 million claim received this past August. In a worst-case scenario, which I find very unlikely, Satyam would still be able to earn its way out of this taxing problem.
Obviously Satyam’s earnings have been obscured by many non-recurring gains and losses (mostly losses) over the past few years. Here I will try to estimate the company’s normalized earnings as difficult as this task may be.
In the fiscal year ended March 31, 2011, Satyam earned 5.67 billion rupees, or $124.2 million. This is before charges for class action lawsuit settlements and other non-recurring charges related to the fraud. I would argue that the $124.2 million figure understates earnings going forward, as the company continues to win new clients, and QoQ earnings will probably continue to grow in the mid-teens percentage-wise. This compares with a low single-digit increase in Infosys’ QoQ earnings.
There is a clear upward trend in Satyam’s earnings. As you can see below, earnings grew 16% MoM from March to June of this year. There is no seasonality in this business that would explain the increase.
  • Quarter ended June 30, 2011: 2.7 billion rupees, or $59.2 million
  • Quarter ended March 31, 2011: 2.3 billion rupees, or $51.2 million
  • Quarter ended December 31, 2010: 1.3 billion rupees, or $29 million
Again, it is difficult to estimate Satyam’s normalized earnings, but I am confident that the company will earn at least $50 million per quarter going forward as the operating momentum continues.
Satyam’s capitalization consists of the following: (a) 564,222,092 common shares publicly trading at 66.9 rupees–equivalent to $829,406,475, (b) 501,843,740 non-encumbered shares–equivalent to $737,710,297 and (c) 110,604,486 ADSs trading at 2.77–or $306,374,426. Total market capitalization is $1.87 billion.
Based on my $50 million quarterly earnings assumption, Satyam is trading at less than 10X forward earnings. This compares with 13-14X for its Indian peers.
Satyam is a prime candidate for rerating. Now that impact of the scandal has diminished, new perceptions will emerge. This is a rare opportunity to buy a leading company at a cheap price (on an absolute and relative basis). It may soon be perceived as a secular growth story Or a great emerging markets story. There are at least three catalysts. You even get a 5% discount by buying the ADSs. If you believe as I do that the Indian tax authorities have no case, this is a fat pitch.

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