June 22, 2009

Analysis - Patni computers - II

I initiated the analysis of Patni computers in my last post. The rest of the analysis follows

Competitive analysis
The IT services industry is a very competitive industry driven by scale, customer relationships and management quality.

I think there is a low level of differentiation in the industry (contrary to what each company claims in its annual report) and most of the companies provide a similar product.

There is a decent amount of lockin at the customer level. Most companies including patni have a high % of repeat business and are able to leverage these relationships and customer lockin to sell additional services. However there is a substantial amount of competition now and it is no longer a given that a company will always maintain the same level of engagement at a client.

Patni has had a high concentration of revenue from its top customers. This has however been reducing in the last few years which is a good thing.

Finally management quality is an important factor in the IT industry, which I evaluate in the next section

Management quality checklist

- Management compensation: The founders and executive directors are entitled to a pension equal to 50% of last pay after 62 yrs of age. I cannot fathom the logic of this compensation. The current value of this obligation is almost 35 Crs and increasing. This is around 1% of the company’s market cap. Although not a large amount by itself, I cannot see any precedent for this kind of compensation in any other company in the industry. The compensation for the top management including the founders is almost 8% of net profit. This level of compensation is quite high and above the industry average. In addition this represents a 50% increase in 2008, when the performance does not justify such an increase.
- Capital allocation record: average record. The ROE has been high and the management has not blown too much cash on accquisitions, but as other IT companies, the company is holding too much cash. In addition the dividend payouts are not commensurate with the profit levels.
- Shareholder communication – good and in line with other IT services companies
- Accounting practise – The disclosure levels are good, in line with other IT company. However the company has around 185 Crs of hedge related liability on the balancesheet. I have not been able to find the details, but I can also see a 144 crs hedge reserve. This looks like a writeoff of the hedging losses without passing it through P&L. This is aggressive accounting. On the other hand the company has also adopted AS30 (forex related accounting) in advance which is a positive. In addition the company has a translation adjustment of almost 110 Mn usd (500 Crs) in the GAAP statement. I have to evaluate how much of this loss will reverse due to forex changes and how much will have a pass through into the P&L statement depending on the nature of the derivative contracts.
- Conflict of interest and related party transactions – Nothing stands out in terms of related party transactions. As stated earlier, the compensation is quite high and the same is confirmed in this section too.
- Performance track record – average. The management has shown average performance in terms of the topline and bottom line growth. On absolute basis the performance is good, but average in comparison to the industry.

The key to valuing an IT services company is to estimate its underlying earnings power. The net profit numbers for most companies has been fluctuating a lot due to forex changes. In addition, the current tax levels are too low due to imminent expiration of the tax holidays.

Patni had a forex gain of almost 103 Crs in 2007 and a loss of 83 Crs in the current year. The tax as a % of PBT has dropped from 16% of PBT in 2007 to around 5% in 2008. Clearly a 5% tax rate is not sustainable.

As a final adjustment to the valuation, one must also adjust the impact of the stock options (or RSU now). I have made the following assumptions in arriving at my final numbers (these can ofcourse be debated)

Tax as % of PBT = 25%
Future earning power = 7.5% of sales (7.5 % net margin) excluding the impact of forex. Current net margins are around 12-14%.
Cost of outstanding options = 152 Crs
Dilution due to options = 1.17 cr additional shares

If we consider the above assumptions, a PE of 14 (which is not aggressive for a company with 8-10% growth and ROE of 15%+) and cash on books of around 1300 Crs, the intrinsic value is 6000-6300 Crs.

Scenario analysis
The above valuation assumes a very modest topline growth (around 10% per annum) and a negative growth for net profits (due to falling net margins and higher taxation).

The company could get a better valuation if it is able to hold its net margins and reduce the forex losses. I think the performance risk for the company are low as the current market enviorment is as bad as it can get – drop in demand, forex losses etc.

Patni is a decent undervalued idea. However due to the various management issues outlined earlier and average performance in the past, I will not look at the company as a long term holding. It would be good idea to hold the company as long as the undervaluation exists and then exit once the gap closes.

Disclaimer – I have a holding in the stock.


Abhi said...


As usual, congrats for a great analysis. I have a couple of questions here. Firstly, how does Patni stand against NIIT Tech in terms of discount to intrinsic value. I feel that NIIT Tech is more undervalued than this one. If this is the case, why not be with NIIT when there are management issues with Patni? Why take undue risk when another company in the same sector is available which is more undervalued!!

By the way, have you looked at other IT companies like Nucleus, Sonata, and Zensar? I have worked with Zensar in the past and from my friends there, I have known that it is doing quite well even in this downturn.


Rohit Chauhan said...

Hi abhi
you are right, niit tech has a higher discount than patni. In terms of management quality, i dont see much difference between the two companies (i have only annual reports to base my analysis). patni however has an advantage of scale and a longer operating history ..so the business risk with patni is lesser than NIIT. In addition, investing in two ideas is also a way of diversifying the risk for me.

i have not looked at sonata, nucleus etc closely ..but had looked at some last year and dropped them for some or other reason (cant recall the reason now). will have a look at them again


Rathin Shah said...

"If we consider the above assumptions, a PE of 14 (which is not aggressive for a company with 8-10% growth and ROE of 15%+) and cash on books of around 1300 Crs, the intrinsic value is 6000-6300 Crs."

-Hi Rohit,

I really awe your thinking power in the analysis done. Great!
Just wanted to understand how do u come up with the PE number with x% growth and y% of ROE. In fact the current PE is ~9 (ttm). could u throw some light here (some calculations deriving PE of 14?. I am also trying it from my end...

Thanks for the analysis. and sorry if this is a stupid question from my end...


Rohit Chauhan said...

Hi rathin
you have a very valid question. i have covered your question in an earlier post . you can find it here - http://valueinvestorindia.blogspot.com/2008/01/valuation-how-to-evaluate-pe-ratio.html

let me know if you have more questions on it