Wednesday, August 7, 2013

What Makes This Small Outsourcing Firm a Buy?

Syntel (NASDAQ: SYNT) is one of the leading providers of IT and knowledge- process-outsourcing (KPO) services. The company has been reporting steady growth despite operating in an extremely competitive environment. It has recently released its quarterly results in which it has again beaten both top- and bottom-line estimates by crossing the $200 million quarterly sales benchmark. This is the third time in a row that Syntel has delivered better earnings than market expectations.
Positive earnings beat
In its results announced two weeks ago, Syntel reported a 13% year-over-year and 7% sequential increase in revenue to $202.5 million, which beat analysts’ estimates by $4.6 million. Its net income also
increased by 9.5% year-over-year and 2.3% sequentially to $47.5 million. This translated into EPS of $1.14, which was $0.09 above estimate. Applications outsourcing has been the core business of the firm from where it gets 76% of its total revenue. The third-consecutive revenue beat has translated into even higher expectations for the current quarter and the full year. The quarterly EPS estimates have gone up from $1.12 to $1.15 while the annual EPS target has moved up by $0.08 to $4.48.
Following the earnings release, the outlook for the company is more positive than it was before.
Revenue sources
The company has operations in the two corners of the world, the United States and India, which makes it truly a global operator poised for future growth. Although the company currently earns 92.3% of its revenue from North America and 7% from Europe, it is eying expansion in the Asia Pacific region.
Its operations in offshore-IT services are looking particularly promising due to its relatively higher margins.The company generates its revenue from a variety of industries ranging from financial services -- from where it gets more than half of its revenue -- to retail. 
A significant portion of its sales, nearly a quarter, comes from its biggest customer American Express, while almost all of its 25 largest clients are from the list of Fortune-500 companies. 
Expansion plans
Syntel will spend up to $65 million as capital expenditure this year. The company is currently eyeing expansion by setting up global delivery centers (GDCs) in Tamil Nadu, India and Manila, Philippines. Its top management believes that the Philippines would offer greater opportunities in healthcare KPO than India. Besides entering new locations, Syntel is also expanding its existing GDCs. By the end of June, Syntel had more than 22,800 employees and through expansion, it plans to increase its workforce to a total of 100,000 people.
Attractive valuation
Syntel’s market cap is slightly less than $3.0 billion, which makes it considerably smaller than other India-based IT outsourcing firms such as Infosys Technologies (ADR) (NYSE: INFYand Wipro (ADR) (NYSE: WIT). As mentioned earlier, market’s expectations from Syntel have been rising, but its PEG ratio, based on five-year growth expectations, is just 0.9 as opposed to a 10-year average of 1.0. This indicates that market’s expectations are still lower and therefore the company could very well beat the next quarter’s earnings estimates as well.
Moreover, Syntel's stock is reasonably priced and is trading at lower multiples of its trailing-12 months and current full-year profit estimates as compared to the shares of Infosys and Wipro. The company has also been more profitable than Infosys and Wipro by earning higher operating margins. It was also able to generate a better return on equity than its rivals.
Market Cap
$2.96 B
$28.40 B
$20.77 B
P/E current
P/E Fwd
Op margin

Strong guidance from rivals
The business environment is also improving, which was evident in the strong guidance given by Syntel’s bigger rivals.
Infosys is the second-biggest Indian IT outsourcing firm and like Syntel, it also gets a significant portion of its revenue, more than two-thirds, from North America. Its stock has delivered a decent performance this year and is just behind the S&P 500. But what makes Infosys attractive is its impressive return on equity of nearly 27%, a 10-year history of EPS growth and zero long-term debt levels.
However, Infosys has been under margin pressure amid severe competition but the drop in the value of the Indian rupee would ease up some pressure.
But the company delivered better-than-expected quarterly results on July 12 and has reaffirmed its FY-2014 guidance. Infosys’ investment in Lodestone, cloud computing and big data is also paying off by giving a boost to the company’s top line. With Narayana Murthy at the top, the leadership crisis appears to be over. The company is now looking attractive for long-term investors.
Similarly, on Monday, Wipro issued strong guidance for the September quarter, a rarity in Wipro’s case. It now expects a 2% to 3.9% sequential increase in revenue as opposed to market expectations calling for a 1% to 3% increase. In its recent earnings release, its EPS of $0.11 came inline with market expectations and was unchanged from the year-ago quarter; but revenue dropped by 13.4% to $1.6 billion, missing Wall Street’s expectations by $170 million.
Wipro’s shares have struggled this year, but the stock is still more expensive than its rivals, which is evident in its higher price-to-earnings ratio. Despite showing margin improvements in the current quarter, it still earns a lower operating margin than Infosys or Syntel. The company also generates a lower return on equity (shown in the table above). Therefore, I wouldn’t recommend Wipro at the moment.
Syntel has solid fundamentals, revenue and income growth and a good track record of beating market’s expectations. Its stock has delivered an impressive performance this year and is up by 34.4%, easily outperforming Infosys (up 18.9%), Wipro (down 2.6%) and the S&P 500 (up 20.4%). Its international presence, diversity of revenue streams and focus towards serving the mega-cap companies highlights strengths in Syntel’s business model.
The company’s significant exposure to the financial-services sector could also result in a considerable increase in revenue in the near term as financial institutions are expected to increase their IT spending under new requirements coming from the Dodd-Frank Act and Basel III.
Therefore, despite its rally, Syntel is still trading at a reasonable price and could be a healthy addition to our portfolio. 

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Disclosure: I, Sarfaraz A. Khan, have no position in any stocks mentioned and no plans to initiate any within the next 72 hours of this publication. I have no business relationship with any company mentioned in this article.
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