Syntel Inc. provides Information Technology and Knowledge Process Outsourcing (KPO) services. Syntel provides its services to the Banking and Financial Services, Healthcare and Life Sciences, Insurance, Manufacturing, Retail, and Logistics, and Telecom industries. Within those industries, Syntel assists their clients with modernizing their systems, processes, as well as fulfilling their never-ending desire to remain on the cutting edge of the technological wave. The company separates its services into the following categories:
- Managed Services provides software development, IT infrastructure, cloud, and automation services.
- Digital One provides consulting and implementation services, data warehousing, business intelligence, web and mobile application development, and data analytics services.
- Knowledge Process Outsourcing (KPO) provides outsourced solutions for knowledge and business processes. The KPO category is the outsourcing of services an in-house IT department would otherwise do. So in essence, the client can outsource one-off large-scale or even multiple small projects that would be cost ineffective to hire and perform internally, at a lower cost than it would be if it were done in-house.
|Purchase Price1: $20.24 (12/28/2016)||Market Capitalization: $1.68 Billion|
|Price Target: $30.36||Enterprise Value: $2.02 Billion|
|Upside: 50%||EV/EBITDA: 6.7|
Why do Corporations outsource?
As a Consulting firm, exposure to various industries and clients within the same industry builds intellectual capital over time. What this means is that Syntel and other consulting firms accumulate knowledge that the individual clients would not be aware of or be able to implement or replicate on a comparative basis. A company that provides services to various companies within the same or to different industries would likely have ready-made solutions for a problem that a client may be facing because the Consulting firm probably solved a similar issue for a different client. This is where a cost advantage comes in — they do not have to reinvent the wheel every time. So it makes it cheaper to outsource rather than hiring an in-house team.
Switching Cost Advantages
Switching costs make it less attractive to switch service providers. When a company initially provides a service, it makes it cheaper and much more efficient to use the same company the next time because they already understand the processes of the company and will likely get going faster than a new firm would. So less human capital hours translate to lower costs. Though this would not be that much of an advantage in this case because of the size of Syntel’s largest clients, American Express would likely have higher bargaining power given their importance to Syntel, but it would be for the smaller clients. It works on both sides – revenues become stable because switching is expensive, but then it also makes it difficult to win new clients because other consulting firms have them locked in with the same switching costs.
Ok – Saying ‘non-cyclical’ is quite a stretch, but this advantage is simple: The outsourcing industry is defensive in the sense that corporations seek efficiency regardless of where the business cycle is. So a Syntel client will not choose to take their IT services in-house simply because a recession is on the horizon. They are more likely to outsource because it not only increases the variable portion of their costs, it also decreases overall costs. So even though new projects slow in recessions, the outsourcing industry can hold on to existing ones because it makes more economic sense to the client.
High Clientele concentration
As of Q3, 47.2% of Syntel’s revenues came from American Express (21.1%), State Street (13.6%), and FedEx (12.5%). The company derived approximately 49% of its revenues from the financial services industry. All three companies have been long-term clients of Syntel, so they seem to have a decent relationship.
The company rides on massive 20% margins, and it bothers me because, when the industry is in its rapid growth phase, sourcing clients is feasible and the price of the service does not matter much as long as it is economical to the customer. When the industry matures, however, as this has, we start seeing margin compression because the participants start undercutting each other to steal their clients. I believe switching costs will insulate this.
Outsourcing and H1B Visas
President-Elect Trump’s Stance on immigration as well as ‘sending jobs to China’ is also another issue. In Syntel’s case, it is India. 78% of the billable workforce is based in India, so gross margins will likely be hit, although not much, when the dollar bull market eventually comes to an end. Approximately 13.9% of the Company’s worldwide workforce work under permits/visas. The elimination of H1B will be difficult to justify because according to the National Foundation for American Policy, 51% of all Billion dollar start-ups had at least one immigrant founder. Trump also flip-flopped a bit on the issue during the debates.
America’s trade imbalance with India is about 7% of the imbalance with China. So there are lists of countries that will be the focus of fixing the imbalance which includes, China, Germany, Japan, etc. and others before we get to India. It also helps that Trump’s criticism was geared towards the Manufacturing sector and unfair trade advantages that were created, and maintained by the Chinese government. So our bases are covered given that Syntel is in IT and India. 13.9% is also quite small; the risk is insignificant, IMO.
Bharat Desai and Neerja Sethi, who are both a couple, and the co-founders of Syntel jointly control 69% of the company; whatever they say goes. Sometimes, we have great companies where the founders view the company as ‘their creation’ and thus, and choose to neglect minority investors. Syntel’s valuation have trodden the low-end of the IT sector (even before the recent mishap) despite the company’s impressive 13.3% organic top line CAGR since 2001.
Perhaps, the actual reason for the this could be because – someone, please correct me if I’m wrong – ‘Syntel India’ is the subsidiary of the company that receives payments for the company’s services for tax purposes. One evidence of this is that although 90% of the company’s revenues come from North America, the money seems to end up with its Indian subsidiary. This is likely because of the tax breaks the company receives in India. The subsidiaries within India are registered as special entities called Software Technology Parks (STP), Special Economic Zones (SEZ), or Export Oriented Units (EOU), where the Indian government awards certain tax breaks for specified periods of time to corporations. If the company wants to take the money out of India, they have to pay a 17.7% dividend distribution tax and then bringing it over to the U.S., Uncle Sam collects his share as well.
So the poor capital allocation may be because of the reluctance of management to pay Indian dividend distribution taxes and U.S. repatriation taxes. Although the cash is held by US and Indian based banks, it is domiciled in India. So even if it is held technically in the U.S., the parent company would have to pay taxes on it to spend it. A Trump presidency with lower tax rates might make direct payments to the U.S. subsidiary more attractive which could also potentially improve capital allocation.
One last point is India’s recent elimination of 86% of cash in circulation – impromptu moves such as those from Governmental bodies are unattractive to business in the sense that the government could choose to flex its muscle at a