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Executive Summary
Satyam investors have witnessed a massive wipe-out of their wealth, with its
market cap nose-diving by 501% since Dec, 08. Typical of any financial scam ridden
company, Satyam stock got punished once its Chairman Mr. Ramalinga Raju jolted
the market with the news of billion dollars financial irregularities. The acquisition by
Tech-Mahindra infused confidence among investors community, reflected in the
300% stock appreciation since approval by India Law Board. The valuation report
conducted the fundamental analysis of Satyam and valued it at Rs. 214.49, with
75% of its value coming from terminal phase.
1
SAY has recovered since post-acquisition
The valuation report will re-evaluate Satyam’s enterprise value, taking into account
all new developments since Tech-Mahindra acquisition.
Valuation model
The 2 most popular valuation models are Relative valuation and Fundamental
analysis (a.k.a Discounted Cash flow model).
Without getting into much detail, relative valuation does a comparative valuation of
similar companies based on various metrics (P/E,PEG,EV/Sales). This approach
works best if the companies are relatively similar from growth, margins, cost of
capital and industry perspective. For example, one can compare TCS and Wipro
using P/E as both of them operate in IT outsourcing industry and get bulk of their
revenue from outside India. Although Satyam operates in the similar industry as
HCL, the idiosyncratic risks facing company today creates uncertainty about its
future growth prospects. To use relative valuation, one must control for all such risk
factors before slapping a multiple on Satyam. Not impossible, but it is fairly
challenging to control for such risk factors in determining P/E multiple of Satyam.
2
Revenues from Indian exports of software and back-office outsourcing services rose
by 16 percent in the 08-09 FY until mar09 to US$46.3 billion
3
(Source: Gartner)
(Source: Gartner)
Although several financial projections go into DCF valuation, the paper highlights
the salient parameters that have bigger impact on Satyam’s valuation. The research
paper will reference the most recently released audited Q3, 09 estimates of Tech-
Satyam that presents a much clearer picture of its financial situation.
Revenue projection
The US financial crisis has increased the cost sensitivity of large buyers, putting
India at a cost advantage compared to western BPO providers. India, among other
outsourcing destinations, enjoys several advantages such as language skills,
excellent government support and most importantly, moving up of IT vendors in
supply chain, providing higher value added services. BPO being the fastest growing
segment in IT outsourcing, Gartner forecasts the Indian share of global BPO
market to double by 2010.
Indian Application outsourcing (AO) exports already controls a healthy market share
of 38.15%. But the spiraling labor costs, higher cost of living, increased attrition and
margin pressures due to financial crisis will pose challenges to Indian IT market
4
(46.3+11.8)/456=12.6%
5
Doesn’t include companies with Corporate HQ outside India
6
Assuming domestic market has same AO (57%) and BPO (28%) distribution as in exports
market. Total Indian AO revenue=26.5+0.57*11.8=33. Global AO market
share=33/70.9=46.6% where 26.5 is AO export and 11.8 is domestic IT market
7
(12.7+0.28*11.8)/171 where 12.7 is BPO export, 11.8 is domestic market and 171 is total
market
players in strengthening its market share. On the positive note, the domestic IT
market is estimated to grow at a CAGR of 18.3% through 2012 to $22.87 billion,
propelling the growth for Indian IT service providers. Indian share of global AO
market is estimated to increase to at least 55% in next 4 years.
With Indian BPO market share growing to 18.7% and AO to 55% through 2012, the
total Indian IT revenue in 2012 will be (.187*2398+.55*97.99)=98.53. This results in
a 4 year CAGR of (98.53/56.310)^.25 -1=15%. NASSCOM estimates 2009-2010 IT
revenues to grow in the range of 4-7%. Based on the above estimates, the revenue
growth for next 4 years is -
In the terminal year, Satyam will exhibit characteristics of a mature and stable
growth company, growing at a rate not greater than Indian risk free rate11 of 3%.
Sensitivity analysis in the appendix addresses the valuation impact for different
growth rates.
EBIT margins
Lacking any other credible financials, recently disclosed audited Q3 2009 results are
used to estimate next 4 years EBIT margins. Q3 2009 income statement has high
legal expenses (attributed to lawsuits) and high bench costs (economy downturn
and financial irregularity) depressing the Dec Q3 EBIT margins to 12.99%. In Q3,
legal expenses constituted Rs 108 cr/4.7% of Q3 revenue (historically legal
expenses were 2.23% of revenue) and bench costs were Rs. 120 cr. At the time of
this valuation, global economy is seen to be ramping up and it is estimated that
bench costs should decrease with the recovery in sight. Additionally, it is believed
that legal costs will continue to depress company’s margins for next 2 years until
the legal liabilities are settled. The valuation analysis adjusts Q3 EBIT margins for
high bench costs (keeping the high legal expenses), estimating the next 2 year EBIT
margin of 18.2212%.
8
This is the AO market in 2012
9
This is the BPO market in 2012
10
46.3 is export market and 85% of domestic market of 11.8 results in 56.33 total IT-BPO
market
11
Indian 10 year yield is 7% and Indian Moody’s rating for local currency is Ba2,
corresponding to a spread of ~4%
12
See Appendix for calculation of next 2 years margin using Q3-09 financials
Company requires infusion of new capital to continue growing. The model uses
Capital turnover ratio, defined as Revenue/Invested capital14, to determine future
capital needs.
Last 5 year average of Capital turnover for SWITCH companies
To estimate Satyam’s Capital turnover during growth phase (through 2012), the
model uses average Capital turnover of SWITCH companies of 2.38. In low growth
phase, company’s turnover ratio will decrease to 115(average turnover of Sensex-
30), reflecting the maturity of the industry.
13
See Appendix for normalized margin calculations
14
Minus cash
15
See Appendix for Sensex-30 Capital turnover
Cost of capital
Cost of Debt
Satyam’s annualized cost of debt as of Q3, 09 (ending in Dec) was 16%. The
company took a loan of Rs.600cr to meet its working capital needs, carrying a
high rate of 13.5%. Cost of debt is determined by the risk free rate + risk
premium attributed to risk default. The risk default premium for Indian
companies generally has 2 components –
a. Country default – Unlike USA, India has a default rating of Ba2 according
to Moody’s. This carry a ~400bp spread over risk free rate.
b. Company default – This is company specific and identifies company’s
ability to service its debt, generally determined by Interest ratio coverage.
Cost of Equity
16
Retention ratio=Growth/Return on Capital.
17
See section on Total outstanding debt
18
See Appendix for Synthetic Credit Rating
19
Indian 10 Yr Yield is 7% and Indian country risk premium is 400bp corresponding to
Moody’s Ba2 rating
20
Corresponds to 200bp spread over Indian risk free
21
Corresponds to 100bp spread over Indian risk free
This is determined by company’s levered beta and the market risk premium.
Although historically, market risk premium ran around 4%, financial crisis has
drastically increased premium to around 7.5%. It is expected that market will
continue to exact high premium for next couple of years before reverting to
historical average of 4%.
The cost of equity in the growth phase is 10.16%, reducing to 8.1% in the
terminal year. (The contribution of country risk premium is ignored as Satyam
receives bulk of its revenue from developed economies, carrying zero country
risk premium)
WACC
Using above costs of debt and equity, weighted average cost of capital for
Satyam decreases from 9.73% in growth phase to 7.83% in the
stable phase. (See Appendix for WACC calculation)
This is the most important component in any valuation that generates value for the
company. It is the excess return over cost of capital that adds/detracts value from a
company – companies generating higher excess returns will have higher valuations
than others. Maintaining excess returns require company to have sustainable
competitive advantage. Companies like Microsoft, maintaining a monopoly, have
managed to enjoy higher excess returns for several years.
There is another school of thought, like Mckinsey, which believes that the company
will generate zero excess returns in stable growth – higher excess returns attracts
new entrants, increasing competition and thus depressing excess returns.
Although there have been several players in the outsourcing industry, it is believed
that each player holds some competitive advantage, supported by the fact that
SWITCH average ROI for the last 5 years has been 33.5022%.
22
This figure adjusts for any R&D expense, not treated as equity. Indian IT company’s
average WACC is ~9%.
These high ROIs may be justified by higher switching costs of IT outsourcing buyers
or by company’s competitive advantage in different verticals. (Tech Mahindra’s
focus on Telecommunication niche)
Matured technology companies such as Dell23 and HP24 enjoys an excess return of
around 6% in their most recent fiscal results. With the maturing of IT outsourcing
industry and increased competition, it is estimated that IT outsourcing companies
like Satyam will continue to enjoy excess return, though of the order of ~5-6%. As
discussed in cost of capital section, WACC in the stable growth is estimated to be
7.83%, resulting in ROC of 7.83+5=12.83%. The company will need to retain 23%
(G=b*ROC; G=3%, ROC=12.83%) of capital in the stable growth, as part of
capex. Investors, who hold a different opinion about excess returns, can visit the
sensitivity analysis section to find the variance analysis.
Debt/liabilities
Facing lawsuits due to financial irregularities, company has pending litigation that
can cost company from 3500-7000cr, according to legal experts. The class action
suit is with United States District Court for the Southern District of New York,
pending consideration of lead plaintiff, according to Q3-09 released company
financials. It is estimated that lawsuit charges should settle in 2-3 years, resulting in
a legal liability of Rs.4492.2625cr.
Other liabilities26:
23
Dell generated 4.17% excess return in FY ending Jan-09.
24
HP generated 6.02% excess return in FY ending Oct-08.
25
Expected value of liability=5000. Settlement in 2 years, so PV(5000,@5.5%)=4492.26
26
Source Q3-09 financials
Type of Amount27
liability (cr)
Caterpillar 192
Bridge 105.6
S&V 62.1
management
=359.7
(Source: Q3-09 financials)
Cost of Options/RSUs
Using Black Scholes, option value is 9828 and total cost of options/RSU
=98*19.09=Rs. 187.02cr
27
US$=Rs48 Eur=Rs69
28
Using vol=40%, K=2, t=5, rf=3%, Stock price=100 and div-yield=0.78%
29
TTM is through Mar-09, as Balance Sheet details are given until Mar-09. Mar rev is projected
to be same as Feb
30
Missing tax info for Jan and Mar, tax rate of FY-07/08 is used
Investments
Total Invested 31 3028.42 3725.54 4527.64 5450.5 6861.16 7885.65 8699.55 9265.67 9790.60
2808.00
Capital 4
FCFF 1386.51 859.66 1071.90 1270.2 677.29 1263.94 1628.95 2003.68 2083.18
1
Total cash 32
1521.40
LTD/OBD 5817.96
Market Leverage 33 7.81 4.4 2.7 1 3 4 4.5 5 5
14.61
(%)
Levered-Beta 0.94 0.94 0.87 0.83 0.8 0.9 0.95 0.98 1 1
Cost of debt (%) 16 5.5 5.5 5 5 4.5 4.25 4.13 4 4
After-tax cost of 13.76 4.73 4.26 3.45 3.45 3.11 2.93 2.85 2.76 2.76
Debt
Cost of Equity 10.16 10.16 9.68 9.44 7.2 7.65 7.88 7.99 8.1 8.1
(%)
Mkt. Risk 7 7 7 7 4.5 4.5 4.5 4.5 4.5 4.5
premium (%)
WACC (%) 10.68 9.73 9.44 9.28 7.16 7.51 7.68 7.76 7.83 7.83
ROIC (%) 53.06 44.17 42.59 40.52 31.65 27.75 25.66 24.29 12.83
EV 29682.94
Total Cash 34
1521.4
LTD/OBD 5817.96
Unfunded 89
pension
Cost of Options 187.02
Total Equity Val 25110.30
Outstanding 35
117
shares
Share value (Rs.) 214.49
Appendix
31
See Appendix for invested capital as of Mar-09
32
Including cash from second round of allotment to Tech Mahindra
33
Base year calculated by recursive function in Excel, using calculated market value and
current net debt
34
Includes cash inflow from second round of allocation of 19.8cr shares @58
35
Includes 19.8cr second round of allocation
Revenue 2294
Operating expense 1930
Depreciation 66
EBIT 298
EBIT margin 12.99%
(Source Q3-2009 financials)
Operating expenses
Revenue 2294
Operating expense 1930
Depreciation 66
Remove Bench cost (120)
EBIT 418
EBIT margin 18.22%
Revenue 2294
Operating expense 1930
Depreciation 66
Remove Bench cost (120)
Remove Legal cost37 (62.12)
EBIT 480.12
EBIT margin 20.93%
(Source Q3-2009 financials)
36
Legal cost will continue to be high for next 2 years, until legal claims are settled
37
Historically legal costs are 2% of revenue
Interest-coverage-ratio=1648.10/(4254.28*Interest-rate)
The above interest rate can be solved using excel against the default spreads
corresponding to respective S&P credit ratings.
Implied spread over Indian risk free rate based on S&P ratings= ~2.5%
Credit rating = A
Indian risk free rate=3% (400bp is country risk premium leading to 7% 10 Yr yield)
Because Satyam gets 95% of its revenue39 from outside India (primarily developed
economies), company’s risk drivers are least related to India-specific risk and hence,
shouldn’t be punished by slapping a 400bp country risk premium for just operating
out of India.
Current Assets:
Cash: 373
41
Latest financials from Reuters
Because 7542% of Satyam’s value is attributed to Terminal value, any valuation will
be incomplete without conducting sensitivity analysis43 on terminal parameters.
0 1 2 3 4
42
See section on DCF model
43
Sophisticated models will do sensitivity analysis in multidimensional space, changing more
than 1 parameter simultaneously. For such models, contact author@ pm1205@stern.nyu.edu