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 repeated 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.

Valuation
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.

conclusion
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.

6 Comments

  1. Aniket Khera says:

    Hello Rohit,

    Thanks for the very helpful analysis on Patni. This is my first post to your blog, though I have been following it for about 6 months now. Well, about last October/November, I developed an interest in Patni primarily due to the cash on the books and the repeat business. In all, it was a great value buy then due to the cash on the books. Another minor catalyst could be the phasing out of Narendra Patni from executive duties (though from recent interviews, it seems that he will surely have a strong hold on the overall direction of the company). However, I do agree that they have overdone the executive management payout! Mr. Patni junior (Anirudh Patni) now earns more than $350K/year, which is excessive even with the Wharton MBA that he has!

    I just wanted to touch upon the part on “repeat business”. I have been working in the IT industry for the past 10 years. Though developing and maintaining software is a commodity (it is, without a doubt), the aspect of repeat business is somewhat of a conundrum. When bidding for a tender, all vendors are essentially the same providing the same services (aka, the ability to recruit and a place to sit for the recruited). However, when an account is established (1-2 years, or scale in terms of engineers), switching costs are *huge*. This is where the IT business, though exhibiting commodity like characteristics, is different from say cement or steel. The client is really much better off retaining a mediocre team/vendor than to try and switch. The client has to create alternate capacity elsewhere which is very expensive and disruptive, and unless there is a very very compelling reason, the client’s CFO will object to this course of action. Most of the bigger outsourcers realize this, and have started getting a second vendor for mitigating this very risk from the get go. Let’s say that they have to outsource ~100 engineers worth of work, they will divvy it up 60-40 where 60% goes to vendor 1 and 40% goes to vendor 2. The vendors will then compete for any additions, and if vendor 1 is sub-standard, the outsourcer will scale up vendor 2 and gradually scale down vendor 1 with minimal disruption.

    Well, I have a holding in Patni and plan to hold on to it for another year/couple of years of so. I want to see what Mr. Jeya Kumar is made up of.

    Thanks,
    Aniket Khera

  2. admin says:

    Hi aniket
    thanks for comment and good to know that you are following the blog.

    I agree with you comment on repeat business. I have been in the same industry for the last 10 odd years and have seen an identical dynamics in terms of customer lockin and relationship.

    It is not a given that a company will get repeat business, but the stickiness of the business is pretty high. Most indian companies – actually their employees – do a pretty good job at client site in keeping the client happy. they work long hours, for most part do a decent job and are customer oriented.

    In addition, one thing which indian IT vendor have got right is their focus on customer and the high level of importance they give to keeping the customer happy – sometimes at the expense of employee

    i am current looking at patni as more of an undervalued play and not sure how much the impact the new CEO will have till the promoters continue to call the shots.

    regards
    rohit

  3. Nice Analysis, wanted to learn more about Value Investing, like something you have done. If any guidance you can provide, it will be helpful.

  4. admin says:

    Hi tanmay
    you can start learning about value investing by reading some books on it
    A good place to start would be these books
    – intelligent investor by benjamin graham
    – warren buffet way by hagstrom
    – letter to shareholders – warren buffett

    regards
    rohit

  5. Aniket Khera says:

    Hello Tanmay,

    In addition, read lots and lots of annual reports and watch as little CNBC as possible 🙂

    Thanks,
    Aniket

  6. admin says:

    yes aniket ..that too 🙂

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