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.

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.

I will be publishing the analysis in multiple parts.

About
Patni is an IT services company similar to Infosys, WIPRO and other companies in the same industry. The company derieves a major portion of its revenue from the US. The main industry segments in which the company operates are Financial services, insurance, manufacturing and media.

The key feature of the business model is offshoring. Indian IT services company provide a cost advantage to the customer by executing the work in low cost locations such as India.

Financials
The company has been doing fairly well financially for the last couple of years. It has been able to maintain its ROE in excess of 15% over the past 5 years. The calculated ROE is depressed due to high cash on books (running almost 1400 Crs now). The company had a good topline growth till 2005, which slowed down in 2007 and 2008. However it has still been able to pull off a double digit growth for 2008.
The net margins has dropped from around 20% to around 13% levels due to forex losses. The net margins are not as high as the Tier I companies such as infosys, but still at healthy levels.
The net profit growth has been fairly erratic in the last few years due to the forex changes. However the profit has doubled in the last 5 years inspite of the major changes in the market such as recession, flucutations in the Rupee-dollar rates and increases in the salary etc.

Positives
The company has a fairly healthy cash flow and the same is visible via the strong level of cash on the balance sheet. The company has had a moderate growth in the topline and bottomline numbers.
The company is also growing faster in the non US markets and thus reducing the dependence and contribution of the US markets.
The company recently completed a buyback of almost 10% of its equity at around 210 Rs per share. Thus the company has been able to buyback its shares at a fairly discounted price and thus add value to the exisiting shareholders. This buyback is however partly offset by almost 1 Cr ESOP outstanding for employees which would increase the dilution.

Negatives
The are several negatives with the company. The company performance has been average and has not been of the level of the tier I vendors. As a result the company will not get the valuations of its more successful competitors. The company has had a decent performance, but on a comparitive basis it is poorer than the tier I vendors.

The other negatives is the stock options plan of the company. The earlier stock option plan was almost 5% of the equity. However in 2008, the plan was converted to a RSO (restricted stock options) plan with a strike price of almost Rs 2 / share. The irritating part is that the proposal was approved without the management specifying if the ESOP numbers will roll into the RSO plan. If that happen,I am looking at a reduction of almost 150 Crs (6-7 Rs/ share) in the value of the stock. This may not be huge, but it is irritating to see the company change the plan at the expense of the shareholders.

Risks
The company shares the usual risks faced by the other IT companies such as recession, protectionism in developed markets, cost escalation and competitive pressures from other IT vendors – both indian and foreign.

Next post : competitive analysis, Management quality, valuation and conclusion

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