I found Syntel (SYNT, Financial) by running a simple screen specifying that the company should have less than 0.4 Debt/Equity, more than 10% insider ownership, over 10% EPS growth over the last five years, and an ROA of above 15%. Further I specified that it should have an RSI (Relative Strength Index) of oversold (40).
The first four fundamental elements give me companies that are not threatened by a heavy debt load, where management has significant skins in the game, has grown at a reasonable clip for quite some time and is well run. Further I was looking for companies that have recently experienced a significant selloff for one reason or another, which is why the last element was added.
As you might expect, the list is a fairly short one, where some were micro-caps with limited liquidity, some were pharmaceutical-related and too difficult for me to understand. One was gold-related, which I shy away from due to difficulties in valuation – I have no idea what a gold stock is worth, because I don’t know how to value gold. The rest of the stocks were either unprofitable or had valuations that seemed way too high in spite of any recent selloff.
Syntel however was –Â in Goldilocks’ terms –Â just right. So I figured it might be a good place to start digging for some value. And it was.
So what kind of company are we dealing with?
Syntel is a U.S.-based supplier of IT outsourcing for banking and insurance, healthcare, Retail and Manufacturing Global 2000 companies. This means that they develop and maintain the IT-systems these companies need, in order to keep their businesses running as smoothly as possible. This is done by delivering on-site services from their U.S.-based headquarters, and development and maintenance from their Indian-based operations, which is where the lion’s share of the work is done.
Syntel’s business model is based around its ability to deliver IT infrastructure faster, cheaper and more smoothly, by way of a cheap but well-trained labor force in their Indian facilities, complemented by the operations in the U.S. headquarters. The most important part of this business is the human capital, which Syntel recognizes, and it is my impression that it goes to great lengths to recruit, train and retain its workforce and, as a result, had a rather low industry personnel turnover of 15,6 % in 2014.
The industry they operate in has attractive fundamentals, and a growing market characterized by the increase in Indian IT-export, which is expected to rise to USD 175 billion in 2020. It is clear that this trend will benefit Syntel immensely.
The companies in the industry generally sport relatively wide margins, as the industry is characterized by a high degree of specialized knowledge, which translates to a differentiation on capabilities and not on scale, or efficiency, as we know it from the retail sector, for example where margins are slim. This is also the primary reason why it is absolutely key for Syntel to keep attracting and retaining highly skilled people.
The competition in this business is rather stark, symbolized by the two giants IBM (IBM, Financial) and Accenture (ACN, Financial). But where these two companies focus their attention on Fortune 500 companies, Syntel seem to have found a niche in the segment just below. This means they are not direct competitors, even though they are engaged in the same business. There are however many smaller fish in the market, who are directly comparable and compete in the same market. Among them are Igate (IGTE, Financial), and Genpact (G, Financial), but Syntel is the only company that has managed to consistently deliver growth. For this Mr. Market rewards it with the lowest valuation multiple among the directly and indirectly comparable firms.
It is not a reach, however, to call it a best-in-class performer, and Harvard Business Review recognized it for this by classifying it as an exceptional company in 2013.
The chairman of the board, Bharat Desai, is the co-founder of the company, which I like to see because it ties management and the business even closer together than purely financial incentives. The CEO has a long tenure with the company and has had management responsibility since 2002. Management is primarily of Indian descent, which is a plus from the perspective that much of their business is in India.
Is there value hidden here?
Applying Gurufocus’ reverse DCF calculator, we get an implied growth rate of 8,1%. This is, in my opinion, too low for a company that has grown EPS at almost 19% per year for the last five years. Furthermore, we are dealing with a company with talented, tenured senior management with a pristine track record, which has historically had high predictability in its earnings. Not to mention that they are a best-in-class performer in an attractive industry, with secular tailwinds, and plenty of room left to grow.
The reason we are presented with such an excellent long-term opportunity is the fact that, in the latest quarter, earnings fell off a cliff due to increased overhead. This is clearly a concern, but we are dealing with a management group with a track record of excellent execution who are highly motivated to get the company back on the right track, because of its high degree of insider ownership.
My money is on the fact that this is only a minor blip in the short term, presenting us with an excellent opportunity for the long term.
When playing around different growth rates, discount factors and terminal growth rates, it is clear that there is good value here and a solid margin of safety. Using my best judgment, I apply a conservative 16% growth rate for the next five years, with a discount rate of 8%[1]. Assuming that growth levels off after this, I set the terminal growth rate of 5%, and then add in the tangible book value which is mostly cash and equivalents, we get a fair value per share of USD 62,98, which translates to a margin of safety of 29%. This is the base case, and one can adjust the different parameters in either direction, but this is a classic case of Pabrai’s “Heads I win, tails I don’t lose much.” And that is a bet I am willing to take every day of the week.
[1] The discount rate can be viewed as the opportunity cost of holding the asset, i.e. the return that one could have gotten elsewhere with similar risk. The stock market as a whole returns 8% over the long term, historically speaking, so this seems like the best discount factor to use.
