Syntel Inc.: Value at a Value Price

Syntel Inc. (SYNT, Financial) provides information technology (IT) and knowledge process outsourcing (KPO) services. Syntel provides its services to the banking and financial services, health care and life sciences, insurance, manufacturing, retail, logistics and telecom industries. Within those industries, Syntel assists their clients with modernizing their systems and processes as well as fulfilling the never-ending desire to remain on the cutting edge of the technological wave.Â

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 not be cost-effective 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 companies 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 different industries would likely have ready-made solutions for a problem that a client may be facing because the consultant probably solved a similar issue for a different client. This is where 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.

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 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 companies have them locked in with the same switching costs.

Non-cyclical advantages

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 onto existing ones because it makes more economic sense to the client.

Risks

High clientele concentration

As of the third quarter, 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 clientsof Syntel, so they seem to have a decent relationship.

High margins

The company rides on massive 20% margins. This bothers me personally 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 begin undercutting each other to steal their clients. I believe switching costs will insulate this.

Outsourcing and H1B Visas

President-elect Donald Trump’s stance on immigration as well as 'sending jobs to China' is another issue. In Syntel's case, it is India. Seventy-eight percent 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 works under permits or visas. The elimination of H1B will be difficult to justify because, according to the National Foundation for American Policy, 51% of all billion-dollar startups 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 before getting to India, including China, Germany, Japan and others. 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. The workforce at 13.9% is also quite small, meaning the risk is insignificant.

Capital allocation

Bharat Desai and Neerja Sethi, 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, 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 am wrong - 'Syntel India' is the subsidiary of the company that receives payment 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 SoftwareTechnology 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 topay a 17.7% dividend distribution tax and then bring it over to the U.S.; Uncle Sam collects his share as well.

So the poor capital allocation may be due to the reluctance of management to pay Indian dividend distribution taxes and U.S. repatriation taxes. Although the cash is held by U.S. and Indian banks, it is domiciled in India. So even if it is technically held 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 government bodies are unattractive to business in the sense that the government could choose to flex its muscle on a whim by changing laws without considering how it will effect 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 am all ears.

Why buy now?

The stock is down 56% yeat to date and 60% from its peak this year. The decline is attributableto 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 - the second and third quarters were weak, to say the least, and the company has guided to a ~7% revenue decline and a 43% earnings decline for the fourth quarter.

The recent loss was due to the tax repatriation expense that the company incurred to repatriate cash from India last quarter in order 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 that. Every corporation longs to be on the cutting edge of technology and efficiency, and this will not change over the long term. 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. 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, are engineering and computer science professionals. From feeding to travel to hotels to salaries -- the costs are variable; the variability makes cost adjustments feasible. If Syntel lost a large client, for example, the team servicing the large client would eventually be laid off; there is little continuing fixed costs. Also, the attrition rate was 25.4% in the third quarter, which is high but quite normal within the industry, making it easier to adjust the headcount by reducing or freezing hiring. So the large swing in fourth quarter 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 to average 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. Among them are 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

Desai and Sethi 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. It is negative because they control 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 is that post this mayhem, with the stock trading at $20 per share, Desai 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 $200 million in free cash flow, they would essentially only have to pay for 30% of the equity, which at $20 per share 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 both Desai and Sethi. 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 price-earnings of the following companies:

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:

• Top-line volatility is not necessarily indicative of a longer-term issue, although it could be.
• I expect revenues and net income to stabilize over the next few quarters, especially with easy comps in the third quarter of 2017, which the company reports in November but should guide in August 2017.
• The high variable cost structure and high attrition rates make it easy for management to adjust costs when necessary.
• If I end up completely wrong - If revenue and earnings do not revert and EPS falls and remains 50% lower than its fiscal year 2015 peak, Syntel's valuation will be comparable to its competitors; so we have little downside in the worst-case scenario.
• 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 do not plan on holding it above $40, no matter what.

References

(1) Purchase Price is my weighted average purchase price of both my purchases on Dec. 20, 2016 and Dec. 28, 2016.

Disclosure: 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 Dec. 31, 2016, 46.1% cash.

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