DSIJ Mindshare

Tech Mahindra + Mahindra Satyam: A Wealth-Creating Marriage

This is probably the beginning of the end of one of the most dramatic corporate events that unfolded in India with the confession of Ramalinga Raju, the former chairman of Satyam about the accounting fraud in the company (See box: Journey Till Date). The end started with the Board of Directors of Tech Mahindra (Tech M) and Mahindra Satyam (Satyam) approving the merger of both the companies along with their wholly-owned subsidiaries, Venturbay Consultants, C&S System Technologies, CanvasM Technologies and Mahindra Logisoft Business Solutions. The swap ratio approved by the board of both the companies is 2:17. This means that a shareholder would get two shares of Tech M (face value of Rs 10 each) for every 17 shares of Satyam (face value of Rs 2 each) held by him/her. The merger process is likely to take up to six to nine months to complete, and will be effective from April 1, 2011.

We asked C P Gurnani, CEO, Mahindra Satyam, as to what prompted such a move. According to him, “The decision of merging the two companies was taken after an extensive and careful consideration about what we need to do in the changing and competitive environment”. Gurnani further added, “There were many milestones, small and big, on the way such as restatement of accounts, our first acquisition, reinforcing the confidence of customers and associates that we achieved, and only then did we go in for the merger of the two entities”.

Moreover, the lacklustre financial performance of Tech Mahindra also seems to be one of the reasons for the announcement of the merger. at this moment. We did ask Gurnani as to whether the timing of this merger was meant to boost the performance of an otherwise laggard Tech M. On this, he commented, “Over the last three years, Mahindra Satyam’s business has revived and is on a growth path. Right now, there is enhanced visibility on legacy issues and the liabilities of Mahindra Satyam. Hence this was an appropriate time for the merger.”

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Where The Stocks Stand

The stock market gave a thumbs up to the news of the merger, and the share price of Tech M moved up by six per cent from the date of the announcement till April 4, 2012. Whereas, the shares of Satyam appreciated by four per cent. During the same period, other major IT companies saw their share prices either declining or have increased marginally. The broader market benchmarks also fell, with the Sensex seeing a one per cent fall and and the BSE IT index a neglible one.

Nevertheless, if we look at performance of the very same IT companies since April 13, 2009, when Tech Mahindra took over the reins of the scam-hit Satyam Computer Services in a government-managed acquisition, we find that the stocks of Tech M and Mahindra Satyam have been among the worst performers on the bourses. For example, HCL Tech and TCS saw their share prices go up by more than 3.5x, while the shares of these two companies (Tech M and Satyam) grew by less than 2x. The only solace that they can find is in the fact that they have managed to beat the Sensex.

Following this, the next obvious question that comes to our mind is whether Tech M will be able to catch up, or whether it has run out of steam.

In our story, we will try to analyse these issues and much more about where we expect the combined entity to stand. We will compare it with other listed players and try to gauge if there is a mismatch in the valuations and whether the stock still has a scope of outperforming the broader market and its peers.

The Mega Union

This corporate wedding will help create the fifth largest IT company of India, with revenues of around Rs 12000 crore (USD 2.5 billion) for FY12. However, this size will still be only a quarter of that of the largest software company in India, TCS, and a good 38 per cent lower than its nearest rival HCL Tech, which will post revenues of around 19000 crore
for FY12. Therefore, we believe that the company has to cover significant ground to emerge as the fourth largest IT company of India.

It is not just the absolute topline number that counts. How the numbers add up is, in fact, a more important point to consider. The more the numbers are diversified in terms of verticals, geography and clients, the better they are. This diversification helps in de-risking the business profile of the company by reducing its dependency on a single sector, country or company.[PAGE BREAK]

Given below is an evaluation of the combined entity on these crucial parameters, as we see them going forward. This also gives a fair idea of how it stands vis-a-vis its larger counterparts.

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A Vertical Split

If we look at revenues (Q3FY12) of Tech M before the merger, we find that they are highly concentrated in one sector, with the company deriving almost 96 per cent of its entire revenue from one vertical, i.e. telecom. Contrary to this, Mahindra Satyam has a well-diversified revenue model spread across various verticals. The largest revenue contributor (manufacturing) brings in 32 per cent of its total revenue. Although there will be some improvement in terms of the vertical diversification of revenues post the merger, it will be highly skewed towards the telecom sector, whose contribution will continue to be the highest at 47 per cent. If we compare this with the other major listed peers like HCL Tech, TCS and Infosys, the verticals that contribute the highest in those companies brings in 30 per cent, 43 per cent and 35 per cent respectively.

While this poses a problem of concentration risk in the nature of overdependence on a single sector, what might actually impact the growth of the company is the slower spending in telecom services. According to Gartner, a technology research firm, the worldwide IT spending is likely to grow by 3.7 per cent in 2012 and the telecom services spending is projected to show a growth of merely around 2.3 per cent. However, when we look at the absolute growth, telecom services account for 45 per cent of the entire IT spending worldwide, and hence, they would be the highest spenders. “The fact is that if you look at the NASSCOM projection along with McKinsey, we strongly believe that there is a good demand from this sector, and we will nurture that”, holds Gurnani.

Thus, we believe that this merger is definitely going to help the combined entity to diversify its risk and broadbase its revenue by industry.

Geographical Concentration

Geographically, while Tech M derives a significant portion of its revenues from Europe, Satyam’s business is highly focussed on the Americas. For Tech M, at the end of Q3FY12, Europe contributed 45 per cent of the revenue, USA gave it 33 per cent, while the rest of the world accounted for 22 per cent. If we look at Satyam’s revenue split by geography, USA contributes half of the revenue, while Europe and rest of the world make up a quarter each.

Post the merger, USA will continue to dominate the revenue in terms of geography, with 42 per cent of the merged entity’s income coming in from that part of the world. This is the area where the merged entity will be better placed than its peers though, as its dependence on a single geography will be lesser. For example TCS, Infosys and HCL Tech derive most of their revenues from America, which makes up more than 50 per cent of their total revenues. In fact, Infosys depends the most on USA, drawing close to two-thirds of its revenues from the region.

If we look at the current macro-economic situation worldwide, the Euro zone crisis is yet to be resolved and the uncertainty for both businesses and consumers persists in Western Europe, leading to lower IT spending. However, Gurnani says that the “European economies are in difficulty, but we are hardly present in the areas that are facing difficulty and our business exposure is very limited there”. Hence, the impact on the company is expected to be minimal. He further adds, “Our balanced portfolio is a blessing for us in the current situation”.

Thus, we believe that the balanced portfolio of the merged entity will help it to navigate the situation in a much better manner going forward.[PAGE BREAK]

Client Base

One of the clear benefits of the merger for Tech M will be the reduced dependence on a single client. Currently, Tech M derives 35 per cent of its revenue from BT, which is its single largest client in terms of revenue, while Mahindra Satyam derives 11 per cent of its revenues from its single largest client. Post the merger, BT will still contribute to 17 per cent of the total revenues. Such a percentage of revenue from a single client is high enough to make any company uncomfortable. More so in the light of the fact that the larger companies like Infosys and TCS derive only 4.1 per cent and 6.9 per cent of their revenues respectively from their single largest clients. Even if we look at the top 10 clients, they contribute to 47 per cent of the revenues for the merged entity, while the same figures for Infosys and TCS stand at 24.4 per cent and 27.7 per cent respectively.

We believe that such a high concentration in case of the merged entity is primarily due to the presence of BT. If this company is excluded, the figure looks more or less in line with the industry average. In this regard, we asked Gurnani how he assesses this risk. He opines, “Our relationship with BT has been at an arm’s length for a long period of time, and we do not expect any impact on the ongoing business and do not think that our commercial relationship will be jeopardised”. Therefore, we do not see much of a risk from the focus on a single client as of now. On the contrary, this merger will help the company to serve BT better, as the expertise and services of Satyam can be used for account mining.

Creating Synergies

All the operating matrices discussed yet are likely to change once the merger process is complete. In Gurnani’s words, “The synergies through this merger would resonate across all these aspects in tandem, and are relevant to ensure that our position and top quartile growth ambitions are met.”

We believe that this merger will bring more benefits to the combined entity in terms of the topline rather than any substantial decline in costs, as there is an overlap of just 20 per cent of the office locations in case of both the companies. The topline will definitely be improved by enabling the company to offer a “differentiated service offering, particularly around NMACS (Network, Mobility, Analytics, Cloud and Security).” “We do believe that is the basic driver for this merger, and we strongly believe that we will be able to differentiate, and hence, will be able to create an upside for the shareholders of both the companies, because we are more integrated and differentiated for our client”, adds Gurnani.

In addition to this, the company will also derive the benefits of scale on selling, general and administrative expenses as well as other overheads.[PAGE BREAK]

Risk Factors

This corporate marriage comes not just with its own set of benefits, but also with its own baggage in terms of risks. The contingent liabilities of Mahindra Satyam are one of them.

Though the company has paid off some of its liabilities, settled class action suits and cleared the SEC penalty, there are still some liabilities sitting on the books of the company. The highest among these is the Aberdeen case, which could cost the company around Rs 1856 crore in case the ruling goes against the company. Another major amount is related with the refund of advances claimed by 37 companies to the tune of Rs 1230 crore. These, along with the 18 per cent interest payable from the date the money was advanced till the date of repayment, could create a burden on the combined entity’s books. Though Gurnani avers, “Most of the legal cases are behind us, except for a few, which are being addressed appropriately. Necessary allocations have been made factoring in a worst case scenario. We do not believe that there will be any impact in our dealings with anybody as a result of this merger.”

If we assume that company has to pay all the liabilities in full, which is highly unlikely, the total amount works out to be Rs 38.20 per share of Mahindra Satyam. We believe that the total liabilities will be lesser than this, and our estimate is that they will be in the range of Rs 6-9 per share, which will be further reduced for the combined entity. Hence, if any risk eventually turns up, it will not substantially impact the company’s financials. Moreover, a part of Satyam’s cash is in restricted accounts towards the settlement of its legal disputes, and hence, the cash flow is also less likely to be impacted.

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Financials and Valuations

If we analyse Tech M’s financials for 9MFY12, we find that on a consolidated basis, the sales have increased at an anaemic rate of five per cent on a YoY basis, from Rs 3878 crore to Rs 4070 crore. This growth is slower as compared to the industry average, which stands at around 15-30 per cent. Even the profit at the operating level has shown de-growth of 13 per cent in the same period. On the other hand, Satyam has been performing well, its topline for 9MFY12 increasing by 25 per cent from Rs 3769 crore to Rs 4729 crore and its bottomline growing by 3.25x to Rs 773.81 crore.

On the valuations front, the combined entity’s total market cap as on April 2, 2012 stands at Rs 18700 crore against its total sales (trailing 12 months) of Rs 11437 crore. Therefore, the market cap to sales stands at 1.6x, which is far lesser than what the other listed players are trading at. For example, the market cap to sales for TCS and Infosys is at 5x, whereas for HCL Tech it is at 1.8x.

Although it seems that there is considerable scope for improvement in the valuations of the company, there are other parameters that need to be checked. Larger IT companies usually tend to grow faster and at higher margins, and hence, command higher valuations. All the companies mentioned above are much larger in terms of sales as compared to the merged entity. Even if we compare the net margins of these companies, they are better for the bigger companies. For example, the PAT margin is 24.33 per cent for Infosys and 22.15 per cent for TCS against the single digit margin for Satyam and 16.6 per cent for Tech M.

Moreover, a shadow of the legal disputes is definitely going to remain on the merged company till such time as the exact liability is not known. Going forward, we believe that once the synergistic benefits of the combined entity will start reflecting in the financials of the company, the valuations will catch up. It will take two-three quarters before the entire merging process is finished, and till then, we believe that it will trade at similar levels.

If we add up the expected profits of Tech M and Satyam for FY12, it works out to around Rs 1500 crore. Considering the new share count, the consolidated EPS comes in at Rs 68. If we remove Rs 7 per share for the risk of contingent liabilities and give it a discount of 15x as compared to an average of 20x enjoyed by other listed players, the value comes out to be around Rs 900 per share, which is 25 per cent above the current share price. Therefore, those investors who have a long term view (more than one year) can enter the counter now, as we believe the price will catch up only once the merger process is complete and the benefits of the merger start flowing in.

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A Marriage Made In Heaven

As the merger between Tech Mahindra and Satyam reaches its keenly awaited realisation, market watchers and investors are keen to know about the nitty-gritties of the same. C P Gurnani, CEO, Mahindra Satyam offers us an insider’s perspective on the alliance.

You have described the merger between the two entities as a marriage made in heaven. Please take us through the wedding.

We have taken this decision of merging the two companies after extensive and careful consideration about what we need to do in the changing and competitive environment. Now, when I look back, I feel proud that the team Mahindra Satyam was able to achieve this herculean task. What is happening now is like marriage after a period of co-habitation. The two companies know each other very well.

I am positive that the path we have taken will drive growth and innovation and create new opportunities for employees, shareholders, customers and the communities we serve globally.

What is the synergy that you are expecting to bring from this merger?

The merger will result in the creation of a new offshore services leader, with approximately USD 2.5 billion in revenues, 75000 employees and 350 active clients. Companies with a larger scale in our industry have a demonstrated track record of deeper penetration into the client wallet share, lower volatility in earnings and higher growth.

The combined entity will have a single ‘go-to-market’ strategy, with deep competencies across verticals and a balanced mix of revenues from NMACS (Networking, Mobility, Analytics, Cloud and Security). The combination will also benefit from operational synergies, economies of scale, sourcing benefits and the standardisation of business processes. The combined entity will offer the platform for improved organisational capability and the development of leaders across the larger group.

Can you take us through the current status on the litigations that are filed against Satyam? If the verdict goes against the company, how will it affect the company’s financial position?

Most of the legal cases are behind us, except for a few, which are being addressed appropriately. Necessary allocations have been made factoring in a worst case scenario. We do not believe that there will be any impact in our dealings with anybody as a result of this merger.

Do you think that the merger may increase the attrition levels?

On an average, both the companies are working on attrition levels of around 16 per cent. There is no reason why the merger should trigger attrition levels in either of the companies.

The associates of both the companies will benefit from the scale of benefits due to the substantially larger size of the business – i.e. the combined entity with around USD 2.5 billion in revenue and a workforce of around 75000 people.

Companies with larger scale in our industry have historically been growing at significantly higher growth rates. The associates of both the companies will be provided with the ability to work across multiple/varied projects. They will also get ample opportunities for assuming leadership roles across functions.

What are the synergies in terms of management bandwidth, financial, operational, geographic and sales that you will drive from this merger?

The synergies through this merger would resonate across all these aspects in tandem and as relevant, to ensure that our position and the top quartile growth ambitions are met.

What are the verticals or geographies that you are looking for growth with respect to any opportunity, and can you share any such specific opportunity?

We are looking at the ability to become a provider of ‘complete end-to-end solutions’ to key clients on account of a fuller product basket. The merged entity will be in a position to develop and deliver enhanced as well as new technologies that will create new benchmarks of excellence, and build up solutions that are differentiated, safe and meet the distinct needs of our customers in all market segments and geographic locations.

We will also be able to offer the most comprehensive customer support  programs.

What are the milestones (if any) that you have set for next couple of years for the merged entity?

The milestones for the next couple of years would definitely be growth, profitability, investor returns, brand, delivery, associate pride and a robust service portfolio.

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