Bought some more Syntel

I just increased my Syntel position by 25%. Syntel makes up 15% of the portfolio and my cost basis is now $19.4, or an unrealized loss of approximately 15%. I initially wanted to wait until $15 to buy more, but the general market continues to rise which makes Syntel even more attractive. The portfolio now holds 41.5% cash. 

Syntel Earnings Update

Syntel reported earnings two weeks ago. A few things to note:

  • Revenues came in at $225.9m, down 6.5% from the comparable quarter last year.
  • Net Income came in at $38.4m, down 27.6% from the comparable quarter last year.
  • Total debt down $52.5m or 10.6%.
  • Guidance of $1.57 – 1.77.

Screen Shot 2017-05-15 at 9.03.33 AM

This quarter was quite disappointing. Top-line volatility for the quarter came from the Banking and Financial sector dropping off 12.75%. The culprit within was American Express — Revenues from Amex fell 23.68%. If one were to exclude the Amex account, revenues would be down 1%. That’s no excuse, but I’m just putting it into perspective. I think management needs to execute and go out there and win more business. There is clearly still growth in the industry, as shown by the competition, so there isn’t much of an excuse for flat or negative revenue top-line growth. Manufacturing makes up only about 5% of the revenues, so volatility within the sector does not have much of an impact on the company.

I thought it was a fairly weak quarter, but Mr. Desai’s long-term track record of growing the company and penny-pinching gives me hope. Valuation is also still reasonable relative to the market, so I’m holding on for now but will trim my position at my break even price of $20.32 to 10% of the portfolio.

Syntel Inc: Outsourcing at a Value Price

Real Time price: SYNT 16,51 +0,07 +0,43%

Purchase Price1: $20.24 (12/28/2016) Market Capitalization: $1.68 Billion
Price Target: $30.36 Enterprise Value: $2.02 Billion
Upside: 50% EV/EBITDA: 6.7

 

Syntel Inc. provides Information Technology and Knowledge Process Outsourcing (KPO) services. Syntel provides its services to the Banking and Financial Services, Healthcare and Life Sciences, Insurance, Manufacturing, Retail, and Logistics, and Telecom industries. Within those industries, Syntel assists their clients with modernizing their systems, processes, as well as fulfilling their never-ending desire to remain on the cutting edge of the technological wave. The company separates its services into the following categories:

  • Managed Services provides software development, IT infrastructure, cloud, and automation services.
  • Digital One provides consulting and implementation services, data warehousing, business intelligence, web and mobile application development, and data analytics services.
  • Knowledge Process Outsourcing (KPO) provides outsourced solutions for knowledge and business processes. The KPO category is the outsourcing of services an in-house IT department would otherwise do. So in essence, the client can outsource one-off large-scale or even multiple small projects that would be cost ineffective to hire and perform internally, at a lower cost than it would be if it were done in-house.

Why do Corporations outsource?

As a Consulting firm, exposure to various industries and clients within the same industry builds intellectual capital over time. What this means is that Syntel and other consulting firms accumulate knowledge that the individual clients would not be aware of or be able to implement or replicate on a comparative basis. A company that provides services to various companies within the same or to different industries would likely have ready-made solutions for a problem that a client may be facing because the Consulting firm probably solved a similar issue for a different client. This is where a cost advantage comes in — they do not have to reinvent the wheel every time. So it makes it cheaper to outsource rather than hiring an in-house team.

SYNTEL’S ADVANTAGES

Switching Cost Advantages

Switching costs make it less attractive to switch service providers. When a company initially provides a service, it makes it cheaper and much more efficient to use the same company the next time because they already understand the processes of the company and will likely get going faster than a new firm would. So less human capital hours translate to lower costs. Though this would not be that much of an advantage in this case because of the size of Syntel’s largest clients, American Express would likely have higher bargaining power given their importance to Syntel, but it would be for the smaller clients. It works on both sides – revenues become stable because switching is expensive, but then it also makes it difficult to win new clients because other consulting firms have them locked in with the same switching costs.

Non-Cyclical Advantages

Ok – Saying ‘non-cyclical’ is quite a stretch, but this advantage is simple: The outsourcing industry is defensive in the sense that corporations seek efficiency regardless of where the business cycle is. So a Syntel client will not choose to take their IT services in-house simply because a recession is on the horizon. They are more likely to outsource because it not only increases the variable portion of their costs, it also decreases overall costs. So even though new projects slow in recessions, the outsourcing industry can hold on to existing ones because it makes more economic sense to the client.

RISKS

High Clientele concentration

As of Q3, 47.2% of Syntel’s revenues came from American Express (21.1%), State Street (13.6%), and FedEx (12.5%). The company derived approximately 49% of its revenues from the financial services industry. All three companies have been long-term clients of Syntel, so they seem to have a decent relationship.

High Margins

The company rides on massive 20% margins, and it bothers me because, when the industry is in its rapid growth phase, sourcing clients is feasible and the price of the service does not matter much as long as it is economical to the customer. When the industry matures, however, as this has, we start seeing margin compression because the participants start undercutting each other to steal their clients. I believe switching costs will insulate this.

Outsourcing and H1B Visas

President-Elect Trump’s Stance on immigration as well as ‘sending jobs to China’ is also another issue. In Syntel’s case, it is India. 78% of the billable workforce is based in India, so gross margins will likely be hit, although not much, when the dollar bull market eventually comes to an end. Approximately 13.9% of the Company’s worldwide workforce work under permits/visas. The elimination of H1B will be difficult to justify because according to the National Foundation for American Policy, 51% of all Billion dollar start-ups had at least one immigrant founder. Trump also flip-flopped a bit on the issue during the debates.

America’s trade imbalance with India is about 7% of the imbalance with China. So there are lists of countries that will be the focus of fixing the imbalance which includes, China, Germany, Japan, etc. and others before we get to India. It also helps that Trump’s criticism was geared towards the Manufacturing sector and unfair trade advantages that were created, and maintained by the Chinese government. So our bases are covered given that Syntel is in IT and India. 13.9% is also the totel number of employees on Visas world wide and not just in the U.S.; the risk is insignificant, IMO.

 

Capital Allocation

Bharat Desai and Neerja Sethi, who are both a couple, and the co-founders of Syntel jointly control 69% of the company; whatever they say goes. Sometimes, we have great companies where the founders view the company as ‘their creation’ and thus, and choose to neglect minority investors. Syntel’s valuation has trodden the low-end of the IT sector (even before the recent mishap) despite the company’s impressive 13.3% organic top line CAGR since 2001.

Perhaps, the actual reason for the this could be because – someone, please correct me if I’m wrong – ‘Syntel India’ is the subsidiary of the company that receives payments for the company’s services for tax purposes. One evidence of this is that although 90% of the company’s revenues come from North America, the money seems to end up with its Indian subsidiary. This is likely because of the tax breaks the company receives in India. The subsidiaries within India are registered as special entities called Software Technology Parks (STP), Special Economic Zones (SEZ), or Export Oriented Units (EOU), where the Indian government awards certain tax breaks for specified periods of time to corporations. If the company wants to take the money out of India, they have to pay a 17.7% dividend distribution tax and then bringing it over to the U.S., Uncle Sam collects his share as well.

So the poor capital allocation may be because of the reluctance of management to pay Indian dividend distribution taxes and U.S. repatriation taxes. Although the cash is held by US and Indian based banks, it is domiciled in India. So even if it is held technically in the U.S., the parent company would have to pay taxes on it to spend it. A Trump presidency with lower tax rates might make direct payments to the U.S. subsidiary more attractive which could also potentially improve capital allocation.

One last point is India’s recent elimination of 86% of cash in circulation – impromptu moves such as those from Governmental bodies are unattractive to business in the sense that the government could choose to flex its muscle at a whim by changing laws without regards to how it will affect the economy. So if the math makes sense, the U.S. could become a more attractive place to store cash. That is my theory. If anyone has a better theory or explanation for why the cash is domiciled in India, I’m all ears.

Why Buy Now?

The stock is down 56% YTD and 60% from its peak this year. The decline is attributable to two main events:

  1. Special Dividend – The company paid a $15 special dividend. The dividend was 37% of the price the day before it was announced (stock rallied on the day it was announced), and about 75% of the current price.
  2. Lower Earnings and Revenue Forecasts – Q2 and Q3 were weak, to say the least, and the company has guided to a ~7% revenue decline and a 43% earnings decline for Q4. Part of the reason for the sharp drop in earnings came as a result of the absence of investment income going forward after the payment of the special dividend.

The recent quarter loss came about because of the tax repatriation expense that the company incurred to repatriate cash from India last quarter which was used to pay the special dividend. Net income would have been positive absent of this.

The Long-term forecast & Low-cost Structure

Money spent on technology will likely run higher next year and the year after than it is today. Every corporation loathes to be on the cutting edge of technology and efficiency, and this will not change over the long-run. Syntel will always be around to fill this need. Syntel’s revenues are unpredictable because it is based on client needs, which will fluctuate over time, so I do not believe that downturns such as these are indicative of any long-term issues. Outsourcing will also be much more favorable than in-house because of its cost dynamics.

The largest costs consulting firms face are costs tied to employees which, in this case, is engineering and computer science professionals. From feeding to travel to hotels to salaries — the costs are variable, and the variability makes cost adjustments feasible. If Syntel lost a large client, for example, the team servicing the large client would eventually get laid off, there is little continuing fixed costs. Also, the attrition rate was 25.4% in Q3 which is high, but quite normal within the industry, which makes it easier to adjust the headcount by reducing or freezing hiring. So the large swing in Q4 earnings is something I believe the company can and will adapt to over time, most likely within the next few quarters. The only relatively significant fixed costs the company incurs is the SG&A which, since 1998 averaged 17.2%, but has come down significantly and has averaged 13% over the last five years. The company has operated at this level of sales in the past and should be able to do so again with similar margins, given the aforementioned variable cost structure.

Uncertainty

The company had cited various excuses for the declining and negative revenue growth such as the inability to close deals due to regulatory and election uncertainty. The election is now a certainty, and the outlook is now clear based on what President-Elect Trump has and is still proposing. So this could also serve as a catalyst for revenue stabilization and EPS reversion.

Insider Ownership

Bharat and Neerja own a combined interest of 69% of the company which is both a positive and negative thing. It is positive because their interests are aligned with shareholders, and negative because they hold control of the business and can do whatever they want with it. They have a history of not making bad decisions with the cash, though.

The good news, though, is that post this mayhem with the stock trading at $20/sh, Bharat increased his stake in the company from 37.1% to 40.4%. So I believe there is a decent chance that he may choose to take the company private. With just over $400 million in debt and $200m FCF. They would essentially only have to pay for 30% of the equity, which at $20/sh is $515 million. They would be spending $915 million to take the company private while the company generates $200 million in cash flow per annum, which would be a phenomenal deal for him and Neerja. Acquiring financing for this transaction should not be too difficult.

VALUATION

My favorite valuation method is backing into the worst case scenario and comparing how bad things would have to get for the company to be less attractive than its competitors. The competitor comparison is the normalized PE of the following companies:

Competitor Comparison

We would need to see Syntel’s normalized earnings fall, and remain 50% lower for its competitors to become as attractive. Some of the competitors have characteristics ranging from organic to acquisitive growth, and they all have different metrics with varying factors driving their valuations. Despite all this, Syntel still has an edge in terms of price-to-value.

 

Conclusion

This is one of those – ‘everyone thinks the situation is terrible,’ and it certainly is, but the price also reflects that. The case for Syntel is simple:

  1. Top line volatility is not necessarily indicative of a longer term issue, although it could be.
  2. I expect revenues and net income to stabilize over the next few quarters, especially with easy comps in Q3’17, which the company reports in November, but should guide in August 2017.
  3. The high variable cost structure and high attrition rates make it easy for management to adjust costs when necessary.
  4. If I end up completely wrong – If revenue and earnings do not revert and EPS falls and remains 50% lower than its FY 2015 peak, Syntel’s valuation will be comparable to its competitors, so we have little downside in the worst case scenario.
  5. Although I think the stock is worth about $45, I will sell the stock if it runs to $30 with no news or if I find something else trading at a superior discount to intrinsic value. I don’t plan on holding it above $40 no matter what.
I purchased more shares late last week. Syntel is 40.77% of my portfolio at a cost basis of $20.24. The portfolio holds, as of 12/31/2016, 46.1% cash.

References

1Purchase Price is my weighted average purchase price of both my purchases on 12/20/2016 and 12/28/2016

Happy New Year!