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By Bronte Capital (Reporter)
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Syntel – a plea for help

Thursday, February 16, 2017 16:30
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I don’t often use the blog to find people who can just “tell me the story” but I am becoming increasingly puzzled by Syntel (SYNT:NASDAQ), an Indian outsourcing company and a competitor of Infosys and similar companies.

This is a company I have had continuously analytically wrong – but made (very small) profits. I would rather be lucky than smart (and in this case I have been lucky) but with you dear readers I hope to be lucky and smart.

I found Syntel on a systematic search for companies that were so incomprehensibly profitable that fraud was a reasonable suspicion.

Syntel was one of about thirty that came up. (Incidentally that same search generated some longs when we worked out why the businesses were so profitable…)

Anyway Syntel was full of red flags which made us investigate further for fraud. (We found no evidence of fraud in the end – but we did look.)

Here are our red flags.

  • Syntel has a fatter margin than most Indian outsourcing companies. On a quick search of Thomson Reuters the margin is about 5 percentage points fatter than most of the competitors. We could find no convincing explanation.
  • The fat margin meant the company was extraordinarily profitable. Which is well and good – except that they never paid a dividend and never bought back any shares.
  • The past profits – almost in their entirety – sat in cash and short term securities – undistributed in India. When this happens in China it is a very strong red-flag.
  • The company was run by a husband and wife team. The board seemed very incestuous – controlled by the said team.
  • A search of LinkedIn showed an enormous number of key staff who had left to competitors – sometimes for seeming demotions.
The Indian outsourcing industry has had accounting frauds before (see the major fraud at Satyam) and so I had marked Syntel as something to research and maybe do a big research piece on.
I was not the only person who thought the cash balances (which got to over a billion dollars) were weird. Here is an extract from a Seeking Alpha article referencing a conference call:

“Great, thanks. I wanted to come back to cash, unfortunately it’s really the only question I have. We’ve heard for years, cash has been a board discussion and it’s evaluated every quarter. Can you share what reluctance has been from a board level to put the cash to work from an M&A perspective? And then given, there’s been sluggish growth for a couple of years, has the board’s attitude towards M&A change at all or is it still just as cautious as it has been in the past?” 

Result? Complete shutdown from management - not surprising. Further, there is no chance of activist involvement here given founder Bharat Desai’s stranglehold on ownership (owning two thirds of the common shares outstanding). This was of course something I knew going in, but it is something for investors to consider that are weighing their position in the company.

When management have a billion dollars sitting around that they do not use and will not explain the use of then we wonder whether something really fishy is going on. 
This company just seemed too profitable. And when something is seems too good to be true it often is too good to be true.
Failed research
At Bronte we are a fairly paranoid about companies that seem to profitable. We see 2+2=4 and think we ought to investigate for major fraud.
We spent about a week on it and got nowhere. We simply could not find anything beyond these red-flags. 
However I could not convince myself of the excessive profitability either – so I kept a small – and I mean tiny – position short – just to force me to monitor results in the hope I would finally really work it out.
Alas this disappeared into the (fairly extensive) list of things that I wanted to spend a couple of months researching – maybe to put out an extensive (and negative) research report.
And then it was forgotten.
Comprehensively wrong
There are those moments when you realise you are comprehensively wrong. Syntel gave us one of those moments. 
They paid a dividend.

Not an ordinary dividend – a billion dollars – $15 per share in dividend which is a lot given the current stock price is $20. All of those stored up cash and securities were liquidated and sent as cash to the shareholders.

Whatever: we thought the company might be faking its margins – but it is was not. And we know for sure it wasn’t because they sent a billion dollars of cash out to shareholders. It is easy to fake accounts (they are numbers filed electronically with the SEC). It is to our knowledge impossible to fake the distribution of cash to shareholders. 
And so we were comprehensively wrong. We turned around and bought back our short (remarkably at a small profit).
What to do when you are comprehensively wrong…
I have learned from experience that when I am comprehensively wrong about a short it is often very profitable to turn around and go long the same stock. Usually I short funky companies and they are funky for a reason – they are designed to bamboozle onlookers.
But sometimes funky companies are funky because they have worked out something truly new – some better mousetrap – and they just seem weird. 
Those companies make good speculative longs. 
So we bought a tiny position in Syntel and decided (so far with little luck) to investigate it as a long. 
One of the things we decided was that because the cash was real (see the dividend) then the underlying business really was as it seemed. And we read the past dozen or so conference calls and decided the management were mostly matter-of-fact. They would tell you when the business was turning better or worse. And they were probably right. 
Given management statements and past results the stock was – we guessed – trading at about 9 times earnings of $2.40 or so for 2017. Given shareholder friendly management (see that dividend) and what seems a superior business (see that margin) that did not seem unreasonable.

Today’s results
Syntel today announced results that were not (very) inconsistent with guidance but they simultaneously guided down pretty sharply and the stock was off 17 percent. The small (dumb luck) profits we made on the short we have mostly given back. 
That said the results are not objectively bad. Cash is building up on the balance sheet again (and we know that is real). Margins are still superior for the business. All-in-all it still looks on the accounts like a better-than-decent business.
And I am still none-the-wiser about what makes this business tick, why its margin is so much superior to the competition and why the management have this odd capital allocation strategy where they do nothing for years whilst cash builds up and then pay massive dividends.
I am looking for readers – preferably customers of or competitors to Syntel – to explain what is really going on.
Because – to be frank – I just don’t understand.


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