10-Q 1 k99360e10vq.txt QUARTERLY REPORT FOR PERIOD ENDED SEPTEMBER 30, 2005 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) [X] Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended September 30, 2005 or [ ] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from ____________ to _____________ Commission file number 0-22903 SYNTEL, INC. (Exact Name of Registrant as Specified in Its Charter) Michigan 38-2312018 (State or Other Jurisdiction of (IRS Employer Incorporation or Organization) Identification No.)
525 E. Big Beaver Road, Suite 300, Troy, Michigan 48083 (Address of Principal Executive Offices) (Zip Code)
(248) 619-2800 (Registrant's Telephone Number, Including Area Code) Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ----- ----- Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act.) Yes X No ----- ----- Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.) Yes No X ----- ----- Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Common Stock, no par value: 40,877,364 shares issued and outstanding as of October 31, 2005. 1 SYNTEL, INC. INDEX
Page ---- Part I Financial Information Item 1 Financial Statements Condensed Consolidated Statements of Income 3 Condensed Consolidated Balance Sheets 4 Condensed Consolidated Statements of Cash Flows 5 Notes to the Condensed Consolidated Financial Statements 6 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations 15 Item 3 Quantitative and Qualitative Disclosures about Market Risk 21 Item 4 Controls and Procedures 22 Part II Other Information 23 Signatures 24 Exhibit - 1997 Stock Option and Incentive Plan, (Amended & Restated) 26 Exhibit - Incentive Restricted Stock Grant Agreement Under the Syntel, Inc. 1997 Stock Option And Incentive Plan 39 Exhibit - Consent of Independent Registered Public Accounting Firm 43 Exhibit - Certificate of Chief Executive Officer 44 Exhibit - Certificate of Chief Financial Officer 45 Exhibit - Certification of Chief Executive Officer and Chief Financial Officer 46
2 SYNTEL, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF INCOME (IN THOUSANDS, EXCEPT SHARE DATA)
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------ ------------------- 2005 2004 2005 2004 ------- ------- -------- -------- Net Revenues $58,501 $46,602 $163,910 $137,537 Cost of revenues 35,298 27,014 97,756 79,333 ------- ------- -------- -------- GROSS PROFIT 23,203 19,588 66,154 58,204 Selling, general and administrative expenses 10,533 8,850 32,397 26,511 ------- ------- -------- -------- Income from operations 12,670 10,738 33,757 31,693 Other income, principally interest 810 753 2,654 2,106 ------- ------- -------- -------- Income before income taxes 13,480 11,491 36,411 33,799 Provision for (benefits from) income taxes 1,741 (402) 5,992 3,179 ------- ------- -------- -------- Net income $11,739 $11,893 $ 30,419 $ 30,620 ======= ======= ======== ======== Dividend per share $ 0.06 $ 0.06 $ 1.68 $ 0.18 EARNINGS PER SHARE: Basic $ 0.29 $ 0.30 $ 0.75 $ 0.76 Diluted $ 0.29 $ 0.29 $ 0.75 $ 0.76 WEIGHTED AVERAGE COMMON SHARES OUTSTANDING: Basic 40,576 40,236 40,487 40,205 Diluted 40,669 40,335 40,588 40,486
The accompanying notes are an integral part of the condensed consolidated financial statements. 3 SYNTEL, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS)
SEPTEMBER 30, DECEMBER 31, 2005 2004 ------------- ------------ ASSETS Current assets: Cash and cash equivalents $ 90,592 $109,142 Short term investments 27,865 58,899 Accounts receivable, net of allowances for doubtful accounts of $1,511 and $1,213 at September 30, 2005 and December 31, 2004, respectively 32,909 28,790 Revenue earned in excess of billings 9,045 4,390 Deferred income taxes and other current assets 9,836 5,891 -------- -------- Total current assets 170,247 207,112 Property and equipment 48,524 37,754 Less accumulated depreciation 24,499 21,290 -------- -------- Property and equipment, net 24,025 16,464 Goodwill 906 906 Deferred income taxes and other non current assets 755 2,486 -------- -------- TOTAL ASSETS $195,933 $226,968 ======== ======== LIABILITIES AND SHAREHOLDERS' EQUITY LIABILITIES Current liabilities: Accounts payable $ 5,776 $ 2,394 Accrued payroll and related costs 16,463 13,963 Income taxes payable 6,361 6,290 Accrued liabilities 5,935 6,015 Deferred revenue 3,628 5,231 Dividends payable 2,454 2,433 -------- -------- Total current liabilities 40,617 36,326 SHAREHOLDERS' EQUITY Total shareholders' equity 155,316 190,642 -------- -------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $195,933 $226,968 ======== ========
The accompanying notes are an integral part of the condensed consolidated financial statements. 4 SYNTEL, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
NINE MONTHS ENDED SEPTEMBER 30, ------------------- 2005 2004 -------- -------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 30,419 $ 30,620 Adjustments to reconcile net income to net cash provided by operating activities Depreciation and amortization 3,407 2,194 Bad debts provision 500 -- Realized gains on sales of available-for-sale securities (392) (996) Deferred income taxes 1366 1,612 Stock warrants sales incentive -- 77 Compensation expense related to restricted stock 1,273 524 Changes in assets and liabilities: Accounts receivable and revenue earned in excess of billings, net (10,003) (2,844) Other current assets (3,609) (1,507) Accrued payroll and other liabilities 6,423 2,785 Deferred revenues (1,586) 503 -------- -------- Net cash provided by operating activities 27,798 32,967 -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Property and equipment expenditures (11,049) (8,213) Purchase of short term investments: Investments in mutual funds (3,184) (43,890) Investments in term deposits with banks (4,416) (7,071) Proceeds from sales of short term investments: Proceeds from sales of mutual funds 16,557 28,173 Maturities of term deposits with banks 22,682 7,394 -------- -------- Net cash provided by / (used in) investing activities 20,590 (23,607) -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Net proceeds from issuance of common stock 2,527 2,933 Common stock repurchases (676) (1,479) Dividends paid (68,446) (7,252) -------- -------- Net cash used in financing activities (66,595) (5,798) -------- -------- Effect of foreign currency exchange rate changes on cash (343) (124) Net (decrease) / increase in cash and cash equivalents (18,550) 3,438 Cash and cash equivalents, beginning of period $109,142 $102,854 -------- -------- Cash and cash equivalents, end of period $ 90,592 $106,292 ======== ======== Non cash investing and financing activities: Dividend declared but unpaid $ 2,454 $ 2,433 Stock warrants -- 77 -------- -------- $ 2,454 $ 2,510 ======== ======== Cash paid for income taxes $ 6,234 $ 4,520 ======== ========
The accompanying notes are an integral part of the condensed consolidated financial statements. 5 SYNTEL, INC. AND SUBSIDIARIES NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION: The accompanying condensed consolidated financial statements of Syntel, Inc. (the "Company" or "Syntel") have been prepared by management, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments, consisting of normal recurring adjustments, necessary to present fairly the financial position of Syntel and its subsidiaries as of September 30, 2005, the results of their operations for the three months and nine months period ended September 30, 2005 and September 30, 2004, and cash flows for the nine months ended September 30, 2005 and September 30, 2004. The year end condensed balance sheet as of December 31, 2004 was derived from audited financial statements but does not include all disclosures required by accounting principles generally accepted in the United States. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company's annual report on Form 10-K for the year ended December 31, 2004. Operating results for the nine months ended September 30, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005. 2. PRINCIPLES OF CONSOLIDATION AND ORGANIZATION The consolidated financial statements include the accounts of Syntel, a Michigan corporation, its wholly owned subsidiaries, and a joint venture. All significant inter-company balances and transactions have been eliminated. The wholly owned subsidiaries of Syntel, Inc. are: - Syntel Limited ("Syntel India"), an Indian limited liability company formerly known as Syntel (India) Ltd.; - Syntel Singapore PTE., Ltd. ("Syntel Singapore"), a Singapore limited liability company; - Syntel Europe, Ltd. ("Syntel U.K."), a United Kingdom limited liability company; - Syntel Canada Inc. ("Syntel Canada"), an Ontario limited liability company; - Syntel Deutschland GmbH ("Syntel Germany"), a German limited liability company; - Syntel Hong Kong Ltd. ("Syntel Hong Kong"), a Hong Kong limited liability company; - Syntel (Australia) Pty. Limited ("Syntel Australia"), an Australian limited liability company; - Syntel Delaware LLC ("Syntel Delaware"), a Delaware limited liability company; - SkillBay LLC ("SkillBay"), a Michigan limited liability company; - Syntel (Mauritius) Limited ("Syntel Mauritius"), a Mauritius limited liability company; - Syntel Consulting Inc ("Syntel Consulting"), a Michigan corporation; and - Syntel Sterling BestShores (Mauritius) Limited ("SSBML"), a Mauritius limited liability company. - Syntel Worldwide (Mauritius) Limited ("Syntel Worldwide"), a Mauritius limited liability company. The formerly wholly owned subsidiary of Syntel Delaware LLC (as of December 31, 2004) that became a partially owned joint venture of Syntel Delaware LLC on February 1, 2005 is: - Syntel Solutions (Mauritius) Ltd. ("Syntel Solutions"), a Mauritius limited liability company. The wholly owned subsidiary of Syntel Solutions is: - Syntel Sourcing Pvt. Ltd. ("Syntel Sourcing"), an Indian limited liability company. The wholly owned subsidiaries of Syntel Mauritius are: - Syntel International Pvt. Ltd. ("Syntel International"), an Indian limited liability company; and - Syntel Global Pvt. Ltd. ("Syntel Global"), an Indian limited liability company. The wholly owned subsidiary of Syntel Sterling BestShores (Mauritius) Limited is: - Syntel Sterling BestShores Solutions Private Limited" ("SSBSPL"), an Indian limited liability company. 6 3. USE OF ESTIMATES The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Such estimates include, but are not limited to allowance for doubtful accounts, impairment of goodwill, contingencies and litigation, the recognition of revenues and profits based on the proportional performance method and potential tax liabilities. Actual results could differ from those estimates and assumptions used in the preparation of the accompanying financial statements. 4. REVENUE RECOGNITION The Company recognizes revenues from time and material contracts as the services are performed. Revenue from fixed-price applications management, maintenance and support engagements is recognized as earned which generally results in straight-line revenue recognition as services are performed continuously over the term of the engagement. Revenue on fixed-price, applications development and integration projects in the Company's application outsourcing and e-Business segments are measured using the proportional performance method of accounting. Performance is generally measured based upon the efforts incurred to date in relation to the total estimated efforts to the completion of the contract. The Company monitors estimates of total contract revenues and cost on a routine basis throughout the delivery period. The cumulative impact of any change in estimates of the contract revenues or costs is reflected in the period in which the changes become known. In the event that a loss is anticipated on a particular contract, provision is made for the estimated loss. The Company issues invoices related to fixed price contracts based on either the achievement of milestones during a project or other contractual terms. Differences between the timing of billings and the recognition of revenue based upon the proportional performance method of accounting are recorded as revenue earned in excess of billings or deferred revenue in the accompanying consolidated balance sheets. Revenues are reported net of sales incentives. Reimbursements of out-of-pocket expenses are included in revenue in accordance with Emerging Issues Task Force Consensus ("EITF") 01-14, "Income Statement Characterization of Reimbursement Received for 'Out of Pocket' Expenses Incurred". 5. CASH AND CASH EQUIVALENTS For the purpose of reporting Cash and Cash Equivalents, the Company considers all liquid investments purchased with an original maturity of three months or less to be cash equivalents. At September 30, 2005 and 2004, approximately $8.67 million and $24.5 million, respectively, represent corporate bonds and treasury notes held by Bank One, for which "AAA" rated letters of credit have been provided by the bank. The remaining amounts of cash and cash equivalents are invested in money market accounts with various banking and financial institutions. 6. STOCK WARRANTS SALES INCENTIVE In 2000, the Company agreed to grant to a significant customer performance warrants entitling the customer to purchase shares of Company stock. The issuance of the performance warrants is dependent upon the customer meeting performance milestones by purchasing specified minimum levels of services from the Company over a specified period. The Company has estimated that such performance milestones will not be met during the year. Accordingly, the Company has not accounted for these performance warrants. If and when the Company estimates that such performance milestones will be met, the sales incentive associated with the performance warrants will be recorded as a reduction of revenue. 7 7. COMPREHENSIVE INCOME Total Comprehensive Income for the three and nine months period ended September 30, 2005 and 2004 was as follows:
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------ ----------------- 2005 2004 2005 2004 ------- ------- ------- ------- (in thousands) (in thousands) Net income $11,739 $11,893 $30,419 $30,620 Other comprehensive income - Unrealized Gain (loss) 164 9 353 (38) - Foreign currency translation adjustments (439) (201) (1,098) (1,492) ------- ------- ------- ------- Total comprehensive income $11,464 $11,701 $29,674 $29,090 ======= ======= ======= =======
8. EARNINGS PER SHARE Basic and diluted earnings per share are computed in accordance with Statement of Financial Accounting Standards ("SFAS") No, 128 "Earnings Per Share". Basic earnings per share are calculated by dividing net income by the weighted average number of shares outstanding during the applicable period. The Company has stock options, which are considered to be potentially dilutive to the basic earnings per share. Diluted earnings per share is calculated using the treasury stock method for the dilutive effect of shares which have been granted pursuant to the stock option plan, by dividing the net income by the weighted average number of shares outstanding during the period adjusted for these potentially dilutive options, except when the results would be anti-dilutive. The potential tax benefits on exercise of stock options is considered as additional proceeds while computing dilutive earnings per share using the treasury stock method. The following table summarizes the movement in the Capital Structure from June 30, 2005
NO. OF SHARES PARTICULARS (IN THOUSANDS) ----------- -------------- Balance as on June 30, 2005 40,527 ADD: Shares issued on exercise of stock options & restricted stock 63 ------ Balance as on September 30, 2005 40,590 ------
The following table sets forth the computation of earnings per share.
THREE MONTHS ENDED SEPTEMBER 30, ----------------------------------------------------------------- 2005 2004 ------------------------------- ------------------------------- Weighted Average Earnings per Weighted Average Earnings per Shares Shares Shares Share ---------------- ------------ ---------------- ------------ (in thousands, except per share earnings) Basic earnings per share 40,576 $0.29 40,236 $ 0.30 Potential dilutive effect of stock options outstanding 93 -- 99 (0.01) ------ ----- ------ ------ DILUTED EARNINGS PER SHARE 40,669 $0.29 40,335 $ 0.29 ====== ===== ====== ======
8
NINE MONTHS ENDED SEPTEMBER 30, ----------------------------------------------------------------- 2005 2004 ------------------------------- ------------------------------- Weighted Average Earnings per Weighted Average Earnings per Shares Shares Shares Share ---------------- ------------ ---------------- ------------ (in thousands, except per share earnings) Basic earnings per share 40,487 $0.75 40,205 $0.76 Potential dilutive effect of stock options outstanding 101 -- 281 -- ------ ----- ------ ----- DILUTED EARNINGS PER SHARE 40,588 $0.75 40,486 $0.76 ====== ===== ====== =====
9. SEGMENT REPORTING The Company is organized geographically and by business segment. For management purposes, the Company is primarily organized on a worldwide basis into four business segments: - Applications Outsourcing - e-Business - TeamSourcing; and - Business Process Outsourcing (BPO) These segments are the basis on which the Company reports its primary segment information to management. Management allocates all corporate expenses among the segments. No balance sheet/identifiable assets data is presented since the Company does not segregate its assets by segment. Financial data for each segment for the three months and nine months period ended September 30, 2005 and 2004 is as follows:
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------ ------------------- 2005 2004 2005 2004 ------- ------- -------- -------- (in thousands) (in thousands) REVENUES: Applications Outsourcing $43,872 $36,706 $124,725 $104,898 e-Business 7,946 6,143 22,687 22,654 TeamSourcing 4,727 3,308 12,279 8,802 BPO 1,956 445 4,219 1,183 ------- ------- -------- -------- $58,501 $46,602 $163,910 $137,537 ------- ------- -------- -------- GROSS PROFIT: Applications Outsourcing $18,443 $16,013 $ 52,224 $ 45,720 e-Business 2,253 2,309 7,547 8,798 TeamSourcing 1,286 1,085 3,596 3,166 BPO 1,221 181 2,787 520 ------- ------- -------- -------- 23,203 19,588 66,154 58,204 Selling, general and administrative expenses 10,533 8,850 32,397 26,511 ------- ------- -------- -------- Income from operations $12,670 $10,738 $ 33,757 $ 31,693 ------- ------- -------- --------
9 During the three months ended September 30, 2005 and 2004, American Express Corp. contributed revenues in excess of 10% of total consolidated revenues. Revenue from this customer was $8.9 million during the three months ended September 30, 2005, contributing approximately 15.3% of total consolidated revenues, as compared to $7.9 million during the three months ended September 30, 2004, contributing approximately 17.0% of total consolidated revenues. During the nine months ended September 30, 2005 and 2004, American Express Corp. contributed revenues in excess of 10% of total consolidated revenues. Revenue from this customer was $24.3 million during the nine months ended September 30, 2005, contributing approximately 14.8% of total consolidated revenues, as compared to $21.9 million during the nine months ended September 30, 2004, contributing approximately 15.9% of total consolidated revenues. 10. GEOGRAPHIC INFORMATION Customers of the Company are primarily located in the United States. Net revenues and net income (loss) were attributed to each geographic location as follows:
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------- ------------------- 2005 2004 2005 2004 -------- -------- -------- -------- (in thousands) (in thousands) NET REVENUES North America, primarily United States $ 52,542 $ 42,090 $147,029 $123,086 India 29,880 24,050 84,313 64,755 UK 3,138 3,081 9,612 10,475 Far East, primarily Singapore, Mauritius 592 410 1,352 1,174 Germany 439 569 1,270 2,383 Inter-company revenue elimination (primarily India) (28,090) (23,598) (79,666) (64,336) -------- -------- -------- -------- TOTAL REVENUE $ 58,501 $ 46,602 $163,910 $137,537 ======== ======== ======== ======== NET INCOME/(LOSS) North America, primarily United States $ 4,188 $ 3,625 $ 9,142 $ 8,608 India 6,755 7,861 19,779 20,198 UK 506 371 1,516 1,436 Far East, primarily Singapore, Mauritius 84 108 124 184 Germany 206 (72) (142) 194 -------- -------- -------- -------- INCOME/(LOSS) AFTER INCOME TAXES $ 11,739 $ 11,893 $ 30,419 $ 30,620 ======== ======== ======== ========
10 11. INCOME TAXES The following table accounts for the differences between the federal statutory tax rate of 35% and the Company's overall effective tax rate :
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------ ----------------- 2005 2004 2005 2004 ------- ------- ------- ------- (in thousands) (in thousands) Income before income taxes $13,480 $11,491 $36,411 $33,799 Statutory provision 35.0% 35.0% 35.0% 35.0% State taxes, net of federal benefit 1.3% 0.9% 1.3% 1.0% Tax-free investment income 0.0% (0.4%) (0.2%) (0.5%) Foreign effective tax rates different from US statutory rate (16.6%) (23.8%) (17.1%) (19.5%) Tax Reserves (19.1%) (15.2%) (7.1%) (5.2%) Valuation Allowance 12.3% 0.0% 4.6% 0.0% Other, net 0.0% 0.0% 0.0% (1.4%) ------- ------- ------- ------- EFFECTIVE INCOME TAX RATE 12.9% (3.5%) 16.5% 9.4% ======= ======= ======= =======
The Company records provisions for income taxes based on enacted tax laws and rates in the various taxing jurisdictions in which it operates. In determining the tax provisions, the Company also provides for tax contingencies based on the Company's assessment of future regulatory reviews of filed tax returns. Such reserves, which are recorded in income taxes payable, are based on management's estimates and accordingly are subject to revision based on additional information. The provision no longer required for any particular tax year, is credited to the current period's income tax expenses. The provision for income tax contingencies no longer required for any particular tax year is credited to the current period's income tax expenses. During the three months ended September 30, 2005 and September 30, 2004, the effective income tax rate was 12.9% and (3.5)% respectively. During the nine months ended September 30, 2005 and 2004, the effective income tax rate was 16.5% and 9.4%, respectively. The tax rates for the three months and nine months ended September 30, 2005 is impacted by reversal of tax reserve of $2.6 million and provison for valuation allowance of $1.7 million. During the three and nine months ended September 30, 2004 the tax rate was impacted by reversal of tax reserve of $1.7 million, tax credit of $0.5 million in Syntel India and the research and development tax credit of $0.5 million in Syntel Inc. Syntel India has not provided for disputed Indian income tax liabilities amounting to $2.6 million for the financial years 1995-96 to 2001-02. Syntel India has obtained an opinion from one independent legal counsel (a former Chief Justice of the Supreme Court of India) for the financial year 1998-99 and two opinions from another independent legal counsel (also a former Chief Justice of the Supreme Court of India) for the financial years 1995-96, 1996-97, 1997-98, 1999-2000 and 2000-01 and for subsequent periods to date, which support Syntel India's stand in this matter. Syntel India had filed an appeal with the Commissioner of Income Tax (Appeals) for the financial year 1998-99 and received a favorable decision. A similar appeal filed by Syntel India with the Commissioner of Income Tax (Appeals) for the financial year 1999-2000 was however dismissed in March 2004. Syntel India has appealed this decision with the Income Tax Appellate Tribunal. Syntel India has since also received orders for appeals filed with the Commissioner of Income Tax (Appeals) against the demands raised in March 2004 by the Income Tax Officer for similar matters relating to the financial years 1995-96, 1996-97, 1997-98 and 2000-01 and received a favorable decision for 1995-96 and the contention of Syntel India was partially upheld for the other three years. Syntel India has gone into further appeal with the Income Tax Appellate Tribunal for the amounts not allowed by the Commissioner of Income Tax (Appeals). The Income Tax Department has appealed the favorable decisions for 1995-96 and 1998-99 and the partially favorable decisions for the other years with the Income Tax Appellate Tribunal. Further, Syntel India has not provided for disputed income tax liabilities aggregating to $0.06 million for financial years 1999-00 to 2001-02, against which Syntel India had filed or is in the process of filing appeals or petitions with the 11 Commissioner of Income Tax (Appeals). All the above tax exposures involve complex issues and may need an extended period to resolve the issues with the Indian income tax authorities. Management, after consultation with legal counsel, believes that the resolution of the above matters will not have a material adverse effect on the Company's financial position. UNDISTRIBUTED EARNINGS OF FOREIGN SUBSIDIARIES The Company intends to use accumulated and future earnings of foreign subsidiaries to expand operations outside the United States and accordingly undistributed earnings of foreign subsidiaries are considered to be indefinitely reinvested outside the United States and no provision for U. S. federal and state income tax or applicable dividend distribution tax has been provided thereon. However, the American Jobs Creation Act of 2004 enacted on October 22, 2004 ("the Jobs Act") provides a temporary incentive for U.S. corporations to repatriate accumulated income earned abroad by providing 85 percent dividends received, as a deduction, for certain dividends from controlled foreign corporations that occur prior to December 31, 2005. The Company is evaluating the potential effects of the Jobs Act and foreign laws that might affect any such repatriation. Subject to the completion of evaluation and the operating results of Company's controlled foreign corporations, the Company will be eligible to repatriate, subject to the appropriate withholding taxes thereon, some amount between $0 and $ 143 million, which if repatriated under the Jobs Act, would result into accrual of taxes between $ 0 to $25 million, which includes taxes payable on distribution of dividend under foreign laws. If the Company determines to repatriate all undistributed repatriable earnings of controlled foreign corporations as of September 30, 2005 (without considering the Jobs Act provisions), the Company would have accrued taxes of approximately $58.9 million. The Company's current outlook does not reflect the impact of tax and other charges or benefits, related to repatriation currently under evaluation, as mentioned above. 12 12. STOCK BASED COMPENSATION As permitted by SFAS No. 123, the Company has elected to measure stock based compensation cost using the intrinsic value method, in accordance with Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees" and has adopted the disclosure requirements of SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure, an amendment of FASB Statement No. 123". Had the fair value of each stock option granted been determined consistent with the methodology of SFAS No. 123, "Accounting for Stock Based Compensation", the pro forma impact on the Company's net income and earnings per share is as follows:
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------ ------------------ 2005 2004 2005 2004 ------- ------- ------- ------- (in thousands) (in thousands) NET INCOME Net income, as reported $11,739 $11,833 $30,419 $30,620 Stock based compensation expenses recognized in statement of income, net of tax 290 304 1,111 425 Stock based compensation expenses determined under the fair value method, net of tax (327) (290) (1,419) (1,352) ------- ------- ------- ------- PRO FORMA NET INCOME $11,702 $11,907 $30,111 $29,693 ------- ------- ------- ------- EARNINGS PER SHARE, PRO FORMA Basic earnings per share $ 0.29 $ 0.30 $ 0.74 $ 0.74 Diluted earnings per share $ 0.29 $ 0.30 $ 0.74 $ 0.73 EARNINGS PER SHARE AS REPORTED Basic earnings per share $ 0.29 $ 0.30 $ 0.75 $ 0.76 Diluted earnings per share $ 0.29 $ 0.29 $ 0.75 $ 0.76 WEIGHTED AVERAGE SHARES OUTSTANDING Basic 40,576 40,236 40,487 40,205 Diluted 40,669 40,335 40,588 40,486 Estimated fair value of option granted $ 3.21 $ 5.42 $ 3.21 $ 5.42
Under SFAS No. 123, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions for grants:
AS ON SEPTEMBER 30, ------------------- 2005 2004 ----- ----- Assumptions Risk free interest rate 4.19% 3.48% Expected life 5 5 Expected volatility 69.01% 72.76% Expected dividend yield 8.93% 1.45%
RESTRICTED STOCK: On different dates during the quarter ended June 30, 2004 the Company issued 319,300 shares of incentive restricted stock to its non-employee directors and some employees as well as to some employees of its subsidiaries. The stocks were granted to employees for their future services as a retention tool at a zero exercise price, with the restrictions on transferability lapsing with regard to 10%, 20%, 30%, and 40% of the shares issued on or after the first, second, third and fourth anniversary of the grant dates, respectively. On different dates during the nine months ended September 30, 2005 the Company issued additional 51,500 shares of 13 incentive restricted stock to its employees as well as to some employees of its subsidiaries. The stocks were granted to employees for their future services as a retention tool at a zero exercise price, with the restrictions on transferability lapsing with regard to incremental 25% of the shares issued on or after the first, second, third and fourth anniversary of the grant dates, respectively. Based upon the market value on the grant dates, the Company recorded $5.83 million during the quarter ended June 30, 2004 and $0.84 million during the nine months ended September 30, 2005 of unearned compensation included as a separate component of shareholders equity to be expensed over the four year's service period on a straight line basis. During the year ended December 31, 2004, the Company reversed $0.40 million of unearned compensation towards forfeiture of restricted stock on account of termination of employees and expensed $0.83 million as compensation cost on account of these stock grants. During the three and nine months ended September 30, 2005, the Company reversed $0.25 million and $1.03 million, respectively, of unearned compensation towards forfeiture of restricted stock on account of termination of employees and expensed $0.32 million and $0.81 million, respectively, as compensation cost on account of these stock grants. The recipients are also eligible for dividends declared on their restricted stock. The dividends paid or accrued on shares of unvested restricted stock are charged to compensation cost. For the year ended December 31, 2004, the Company recorded $0.05 million as compensation cost for dividends paid or accrued on shares of unvested restricted stock. For the three and nine months ended September 30, 2005, the Company recorded $0.02 million and $0.46 million, respectively, as compensation cost for dividends paid or accrued on shares of unvested restricted stock. For the restricted stock issued during the nine months ended September 30, 2005 the dividend will be accrued and paid subject to the same restriction as the restriction on transferability. 13. PROVISION FOR UNUTILIZED LEAVE During the three months ended June 30, 2005 Syntel India had changed its leave policy, resulting in a reduction of the maximum permissible accumulation of unutilized leave from 150 days to 60 days. The balance exceeding maximum permissible accumulation is compulsorily encashed at basic salary. Accordingly an amount of $0.51 million was paid at basic salary and $0.88 million was reversed being the difference between the basic salary and gross compensation rates. 14. RECLASSIFICATION Certain prior period amounts have been reclassified to conform with the current period presentation. 14 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS SYNTEL INC. AND SUBSIDIARIES RESULTS OF OPERATIONS REVENUES. The Company's revenues consist of fees derived from its Applications Outsourcing, e-Business, TeamSourcing and Business Process Outsourcing business segments. Net revenues in the three months ended September 30, 2005 increased to $58.5 million from $46.6 million in the three months ended September 30, 2004, representing a 25.5% increase. Further, revenues have increased primarily consequent to our increased workforce. Information technology offshoring is a growing trend with increasing numbers of multi-national corporations aggressively outsourcing their applications development or business processes to vendors with an offshore presence. Syntel has benefited from this trend. Also the Company's Client Partner Program has enabled better relationships with key customers leading to continued growth in business. Worldwide billable headcount, including personnel employed by Syntel India, Syntel Singapore, Syntel U.K., and Syntel Germany as of September 30, 2005 increased by 31% to 3,847 employees as compared to 2,939 employees as of September 30, 2004. However, the growth in revenues was not commensurate with the growth in the billable headcount. This is primarily because a significant growth in the billable headcount was in India, where our revenues per offshore billable resource are generally lower as compared to an on-site based resource. As of September 30, 2005, the Company had approximately 64.2% of its billable workforce in India as compared to 57.2% as of September 30, 2004. The Company's top five customers accounted for 44.5% of the total revenues in the three months ended September 30, 2005, up from 41.7% of its total revenues in the three months ended September 30, 2004. Moreover, the Company's top 10 customers accounted for 64.4% of the total revenues in the three months ended September 30, 2005 as compared to 61.9% in the three months ended September 30, 2004. APPLICATIONS OUTSOURCING REVENUES. Applications Outsourcing revenues increased to $43.9 million for the three months ended September 30, 2005, or 75.0% of total revenues, from $36.7 million, or 78.8% of total revenues for the three months ended September 30, 2004. The $7.2 million increase was attributable primarily to revenues from new engagements contributing $20.8 million largely offset by $13.6 million in lost revenues as a result of project completion and net reduction in revenues from existing projects. The revenues for the nine months ended September 30, 2005 increased to $124.7 million, or 76.1% of total revenues, from $104.9 million or 76.3% of total revenues for the nine months ended September 30, 2004. The $19.8 million increase for nine months ended September 30, 2005 was attributable principally to revenues from new engagements, contributing approximately $48.2 million, largely offset by $28.4 million in lost revenues as a result of project completion and net reduction in revenues from existing projects. APPLICATIONS OUTSOURCING COST OF REVENUES. Cost of revenues consists of costs directly associated with billable consultants in the US and offshore, including salaries, payroll taxes, benefits, relocation costs, immigration costs, finder's fees, trainee compensation and travel. Applications Outsourcing costs of revenues increased to 58.0% of total Applications Outsourcing revenues for the three months ended September 30, 2005, from 56.4% for the three months ended September 30, 2004. The 1.6 percentage point increase in cost of revenues, as a percent of revenues for the three months ended September 30, 2005 was attributable primarily, due to increased offshore headcount. Cost of revenues for the nine months ended September 30, 2005 increased to 58.1% of total Applications Outsourcing revenues, from 56.4% for the nine months ended September 30, 2004. The 1.7 percentage point increase in cost of revenues, as a percent of revenues for the nine months ended September 30, 2005 was attributable primarily to increased compensation cost associated with a special dividend on restricted stock and a performance based incentive program for delivery teams, during the three months ended March 31, 2005, contributing an increase of 0.2 percentage points, the salary revision, effective April 1, 2005, in India, contributing an increase of 0.8 percentage points, visa filing expenses contributing an increase of 0.8 percentage points and increase in offshore headcount contributing an increase of 0.5 percentage points. These increases were partially offset by a 0.6 percentage point decrease due to write back of leave accruals, related to the change in leave policy in India. E-BUSINESS REVENUES. e-Business revenues increased to $7.9 million for the three months ended September 30, 2005, or 13.6% of total revenues, from $6.1 million, or 13.2% of revenues for the three months ended September 30, 2004. The $1.8 million increase was attributable primarily to revenues from new engagements and net increase in revenues from existing projects contributing $3.6 million largely offset by $1.8 million in lost revenues as a result of project 15 completion. The revenues for the nine months ended September 30, 2005 increased to $22.7 million, or 13.8% of total revenues, from $22.6 million or 16.5% of total revenues for the nine months ended September 30, 2004. The $0.1 million increase for nine months ended September 30, 2005 was attributable principally to revenues from new engagements, contributing approximately $6.8 million, largely offset by $6.7 million in lost revenues as a result of project completion and net reduction in revenues from existing projects. E-BUSINESS COST OF REVENUES. e-Business cost of revenues consists of costs directly associated with billable consultants in the US and offshore, including salaries, payroll taxes, benefits, relocation costs, immigration costs, finder's fees, trainee compensation, and travel. e-Business cost of revenues increased to 71.6% of total e-Business revenues for the three months ended September 30, 2005, from 62.4% for the three months ended September 30, 2004. The 9.2 percentage point increase in cost of revenues as a percent of revenues for the three months ended September 30, 2005 is principally attributable to lower utilization of the resources caused by increased hiring and training at offshore. Cost of revenues for the nine months ended September 30, 2005 increased to 66.7% of total e-Business revenues, from 61.2% for the nine months ended September 30, 2004. The 5.5 percentage point increase in cost of revenues, as a percent of revenues for the nine months ended September 30, 2005, was attributable primarily to, compensation cost associated with a special dividend on restricted stock and a performance-based incentive program for delivery teams during the three months ended March 31, 2005 and the salary revision effective April 1, 2005 in India, partially offset by the write back of leave accruals related to the change in leave policy in India. TEAMSOURCING REVENUES. TeamSourcing revenues increased to $4.7 million for the three months ended September 30, 2005, or 8.1% of total revenues, from $3.3 million, or 7.1% of total revenues for the three months ended September 30, 2004. The $1.4 million increase was attributable primarily to revenues from new engagements and revenue from the SkillBay web portal which helps clients of Syntel with their supplemental staffing requirements and net increase in revenues from existing projects contributing $2.4 million largely offset by $1.0 million in lost revenues as a result of project completion. The revenues for the nine months ended September 30, 2005 increased to $12.3 million, or 7.5% of total revenues, from $8.8 million or 6.4% of total revenues for the nine months ended September 30, 2004. The $3.5 million increase for nine months ended September 30, 2005 was attributable principally to revenues from new engagements and net increase in revenues from existing projects contributing approximately $4.8 million, largely offset by $1.3 million in lost revenues as a result of project completion. TEAMSOURCING COST OF REVENUES. TeamSourcing cost of revenues consists of costs directly associated with billable consultants in the US, including salaries, payroll taxes, benefits, relocation costs, immigration costs, finder's fees, trainee compensation, and travel. TeamSourcing cost of revenues increased to 72.8% of TeamSourcing revenues for the three months ended September 30, 2005, from 67.2% for the three months ended September 30, 2004. Cost of revenues for the nine months ended September 30, 2005 increased to 70.7% of total TeamSourcing revenues, from 64.0% for the nine months ended September 30, 2004. These increases in cost of revenues, as a percent of total TeamSourcing revenues were attributable primarily to the higher cost TeamSourcing placements partially offset by net revenues from Skillbay web portal placements. BPO REVENUES. This segment started contributing revenues during the first quarter of 2004. Revenues from this segment were $1.9 million or 3.3% of total revenues for the three months ended September 30, 2005 as against $0.4 million or 1.0% for the three months ended September 30, 2004. The revenues for the nine months ended September 30, 2005 increased to $4.2 million, or 2.6% of the total revenues, from $1.2 million, or 0.9% of the total revenues for the nine months ended September 30, 2004. Both $1.5 million and $3.0 million increase in the three and nine months period ended September 30, 2005 were primarily due the increased billable headcount. Also, as of February 1, 2005, the Company signed a joint venture agreement with a large banking instituition which helped it to ramp up its business in the BPO segment. BPO COST OF REVENUES. BPO cost of revenues consists of costs directly associated with billable consultants, including salaries, payroll taxes, benefits, finder's fees, trainee compensation, and travel. Cost of revenues for the three months ended September 30, 2005 decreased to 37.6% of BPO revenues, from 59.3% for the three months ended September 30, 2004. Cost of revenues for the nine months ended September 30, 2005 decreased to 33.9% of BPO revenues, from 56.0% for the nine months ended September 30, 2004. Both the 21.7% and 22.1% decrease in cost of revenues, as a percent of total BPO revenues was attributable primarily to better utilization of resources. SELLING, GENERAL, AND ADMINISTRATIVE EXPENSES. Selling, general, and administrative expenses consist primarily of salaries, payroll taxes and benefits for sales, solutions, finance, administrative, and corporate staff; travel; 16 telecommunications; business promotions; and marketing and various facility costs for the Company's global development centers and other offices. Selling, general, and administrative costs for the three months ended September 30, 2005 were $10.5 million or 18.0% of total revenues, compared to $8.9 million or 19.0% of total revenues for the three months ended September 30, 2004. This 1.0 percentage point decrease in selling, general, and administrative expenses as a percentage of revenue is primarily due to increases in revenue in the three months ended September 30, 2005 as against the three months ended September 30, 2004, which resulted in an approximately 3.9 percentage point decrease, largely offset by an increase in recruiting expenses of $0.2 million, depreciation of $0.5 million towards the BPO offices at the Hiranandani, Mumbai and the Pune facilities in India, an increase in travel expenses of $0.1 million, provision for doubtful debts of $0.5 million, and office expenses of $0.3 million, which resulted in an approximately 2.9 percentage point increase. Selling, general, and administrative costs for the nine months ended September 30, 2005 were $32.4 million or 19.8% of total revenues, compared to $26.5 million or 19.3% of total revenues for the nine months ended September 30, 2004. Selling, general, and administrative costs for the nine months ended September 30, 2005 include an one time special performance based incentive program for sales teams of $0.4 million and compensation expense related to a special dividend of $1.50 per share on restricted stock held by employees of $0.1 million. After removing the impact of these two items, selling, general and administrative expenses were 19.5% and 19.3% of total revenues for the nine months ended September 30, 2005 and 2004 respectively. This 0.2 percentage point increase in selling, general and administrative expenses as a percentage of revenue is primarily due to an increase in ; compensation costs of $0.7 million in the USA and India, travel expenses of 0.6 million, depreciation of $1.2 million and rent of $0.4 million towards the BPO offices at the Hiranandani, Mumbai and the Pune facilities in India, consulting charges of $0.6 million, legal expenses of $0.2 million, recruiting expenses of $0.3 million, provision for doubtful debts of $0.5 million, office expenses of $0.8 million and telecommunication expenses of $0.1 million which resulted in an approximately 3.3 percentage point increase, partially offset by, increase in revenue in the nine months ended September 30, 2005 as against the nine months ended September 30, 2004, which resulted in an approximately 3.1 percentage point decrease. INCOME TAXES The Company records provisions for income taxes based on enacted tax laws and rates in the various taxing jurisdictions in which it operates. In determining the tax provisions, the Company also provides for tax contingencies based on the Company's assessment of future regulatory reviews of filed tax returns. Such reserves, which are recorded in income taxes payable, are based on management's estimates and accordingly are subject to revision based on additional information. The provision for income tax contingencies no longer required for any particular tax year is credited to the current period's income tax expenses. During the three months ended September 30, 2005 and September 30, 2004, the effective income tax rate was 12.9% and (3.5)% respectively. During the nine months ended September 30, 2005 and 2004, the effective income tax rate was 16.5% and 9.4%, respectively. The tax rates for the three months and nine months ended September 30, 2005 is impacted by reversal of tax reserve of $2.6 million and provison for valuation allowance of $1.7 million. During the three and nine months ended September 30, 2004 the tax rate was impacted by reversal of tax reserve of $1.7 million, tax credit of $0.5 million in Syntel India and the research and development tax credit of $0.5 million in Syntel Inc. LIQUIDITY AND CAPITAL RESOURCES The Company generally has financed its working capital needs through operations. The Company's cash and cash equivalents consist primarily of certificates of deposit, corporate bonds and treasury notes. These amounts are held by various banking institutions including US-based and India-based banks. Net cash generated by operating activities was $27.8 million for the nine months ended September 30, 2005, compared to $32.9 million for the nine months ended September 30, 2004. The number of days sales outstanding in net accounts receivable was approximately 65 days and 66 days as of September 30, 2005 and September 30, 2004, respectively. The decrease in the number of day's sales outstanding in net accounts receivable was due to relatively higher collections 17 during the nine months ended September 30, 2005. Net cash provided by investing activities was $20.6 million for the nine months ended September 30, 2005, consisting principally of $39.2 million for the sale of short term investments partially offset by $11.0 million of capital expenditures, consisting principally of capital work in progress, including capital advances towards construction of a Global Development Center at Pune, India, PCs and communications equipment and the purchase of short term investments of $7.6 million. Net cash used in investing activities was $23.6 million for the nine months ended September 30, 2004, consisting principally of $51.0 million for the purchase of short term investments and $8.2 million for capital expenditures, consisting principally of PCs and communications equipment partially offset by the sale of short term investments of $35.6 million. Net cash used in financing activities was $66.6 million for the nine months ended September 30, 2005, consisting principally of $68.4 million in dividends paid out and $0.7 million in common stock repurchases, partially offset by $2.5 million of proceeds from the issuance of shares under the Company's employee stock option plan and employee stock purchase plan. Net cash used in financing activities was $5.8 million for the nine months ended September 30, 2004, consisting principally of $7.2 million in dividends paid out and $1.5 million in common stock repurchases, partially offset by $2.9 million of proceeds from the issuance of shares under the Company's employee stock option plan and employee stock purchase plan. The Company has a line of credit with Bank One, which provides for borrowings up to $15.0 million. The line of credit has been renewed and now expires on August 31, 2006. The line of credit contains covenants restricting the Company from, among other things, incurring additional debt, issuing guarantees and creating liens on the Company's property, without the prior consent of the bank. The line of credit also requires the Company to maintain certain tangible net worth levels and leverage ratios. The line of credit has a sub-limit of $5.0 million for letters of credit, which bear a fee of 1% per annum of the face value of each standby letter of credit issued. Borrowing under the line of credit bears interest at (i) a formula approximating the Eurodollar rate plus the applicable margin of 1.25%, (ii) the bank's prime rate minus 1.0% or (iii) a negotiated rate plus 1.25%. No borrowings were outstanding at September 30, 2005 and 2004. The Company believes that the combination of present cash balances and future operating cash flows will be sufficient to meet the Company's currently anticipated cash requirements for at least the next 12 months. CRITICAL ACCOUNTING POLICIES We believe the following critical accounting policy, among others, affects the more significant judgments and estimates used in the preparation of our consolidated financial statements. The Company has discussed this critical accounting policy and the estimates with the Audit Committee of the Board of Directors. REVENUE RECOGNITION. Revenue recognition is the most significant accounting policy for the Company. The Company recognizes revenue from time and material contracts as services are performed. During the three months ended September 30, 2005 and 2004, revenues from time and material contracts constituted 51.2% and 45.6% of total revenues, respectively. Revenue from fixed-price, application management, maintenance and support engagements is recognized as earned, which generally results in straight-line revenue recognition as services are performed continuously over the term of the engagement. During the three months ended September 30, 2005 and 2004, revenues from fixed price application management and support engagements constituted 29.0% and 35.7% of total revenues, respectively. Revenue on fixed price development projects is measured using the proportional performance method of accounting. Performance is generally measured based upon the efforts incurred to date in relation to the total estimated efforts required through the completion of the contract. The Company monitors estimates of total contract revenues and cost on a routine basis throughout the delivery period. The cumulative impact of any change in estimates of the contract revenues or costs is reflected in the period in which the changes become known. In the event that a loss is anticipated on a particular contract, provision is made for the estimated loss. The Company issues invoices related to fixed price contracts based on either the achievement of milestones during a project or other contractual terms. Differences between the timing of billings and the recognition of revenue based upon the proportional performance method of accounting are recorded as revenue earned in excess of billings or deferred revenue in the accompanying financial statements. During the three 18 months ended September 30, 2005 and 2004, revenues from fixed price development contracts constituted 19.8% and 18.8% of total revenues, respectively. SIGNIFICANT ACCOUNTING ESTIMATES The preparation of the consolidated financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and judgments that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenues and expenses for the reporting period. By their nature, these estimates and judgments are subject to an inherent degree of uncertainty. The Company bases it's estimates and judgments on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results could differ from those estimates. REVENUE RECOGNITION. The use of the proportional performance method of accounting requires that the Company makes estimates about its future efforts and costs relative to its fixed price contracts. While the Company has procedures in place to monitor the estimates throughout the performance period, such estimates are subject to change as each contract progresses. The cumulative impact of any such changes is reflected in the period in which the changes become known. ALLOWANCE FOR DOUBTFUL ACCOUNTS. The Company records an allowance for doubtful accounts based on a specific review of aged receivables. The provision for the allowance for doubtful accounts is recorded in selling, general and administrative expenses. These estimates are based on our assessment of the probable collection from specific customer accounts, the aging of the accounts receivable, analysis of credit data, bad debt write-offs, and other known factors. INCOME TAXES--ESTIMATES OF EFFECTIVE TAX RATES AND RESERVES FOR TAX CONTINGENCIES. The Company records provisions for income taxes based on enacted tax laws and rates in the various taxing jurisdictions in which it operates. In determining the tax provisions, the Company also provides for tax contingencies based on the Company's assessment of future regulatory reviews of filed tax returns. Such reserves, which are recorded in income taxes payable, are based on management's estimates and accordingly are subject to revision based on additional information. The provision no longer required for any particular tax year is credited to the current period's income tax expense. During the three months ended September 30, 2005 and September 30, 2004, the effective income tax rate was 12.9% and (3.5)%, respectively. ACCRUALS FOR LEGAL EXPENSES AND EXPOSURES. The Company estimates the costs associated with known legal exposures and their related legal expenses and accrues reserves for either the probable liability, if that amount can be reasonably estimated, or otherwise the lower end of an estimated range of potential liability. FORWARD LOOKING STATEMENTS / RISK FACTORS Certain information and statements contained in Management's Discussion and Analysis of Financial Condition and Results of Operations and other sections of this report, including the allowance for doubtful accounts, contingencies and litigation, potential tax liabilities, interest rate or foreign currency risks, and projections regarding our liquidity and capital resources, could be construed as forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements include statements containing words such as "could", "expects", "may", "anticipates", "believes", "estimates", "plans", and similar expressions. In addition, the Company or persons acting on its behalf may, from time to time, publish other forward looking statements. Such forward looking statements are based on management's estimates, assumptions and projections and are subject to risks and uncertainties that could cause actual results to differ materially from those discussed in the forward looking statements. Some of the factors that could cause future results to materially differ from the recent results or those projected in the forward looking statements include the following, which factors are more fully discussed in the Company's most recently filed Annual Report on Form 10-K and other SEC filings, in each case under the section entitled "Risk Factors": - Recruitment and Retention of IT Professionals - Government Regulation of Immigration - Variability of Quarterly Operating Results 19 - Customer Concentration; Risk of Termination - Exposure to Regulatory and General Economic Conditions in India - Intense Competition - Ability to Manage Growth - Fixed-Price Engagements - Potential Liability to Customers - Dependence on Key Personnel - Risks Related to Possible Acquisitions - Limited Intellectual Property Protection - Potential Anti-Outsourcing Legislation - Adverse Economic Conditions - Failure to Successfully Develop and Market New Products and Services - Benchmarking Provisions - Corporate Governance Issues - Telecom/Infrastructure Issues - Confidentiality Issues - New Facilities - Stock Option Accounting - Terrorist Activity, War or Natural Disasters - Instability and Currency Fluctuations The Company does not intend to update the forward looking statements or risk factors to reflect future events or circumstances. RECENT ACCOUNTING PRONOUNCEMENTS On December 16, 2004, the Financial Accounting Standards Board ("FASB") issued SFAS No. 123 (revised 2004), "Share-Based Payment" (SFAS No. 123(R)), which is a revision of SFAS No. 123. SFAS No. 123(R) supersedes APB No. 25 and amends SFAS No. 95, "Statement of Cash Flows." Generally, the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options and issuances under employee stock purchase plans, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative under the new standard. In accordance with the Securities and Exchange Commission's amendment in April 2005 of the compliance dates of SFAS No. 123(R), Syntel must adopt SFAS No. 123(R) on January 1, 2006. Early adoption is permitted in periods in which financial statements have not yet been issued. Syntel expects to adopt SFAS No. 123(R) on January 1, 2006. SFAS No. 123(R) allows for two transition methods. The basic difference between the two methods is that the modified-prospective transition method does not require restatement of prior periods, whereas the modified-retrospective transition method will require restatement. As permitted by SFAS No. 123, the Company currently accounts for share-based payments to employees using APB No. 25's intrinsic value method and, as such, generally recognizes no compensation cost for employee stock options or stock issuances under the employee stock purchase plan. Although the full impact of Syntel's adoption of SFAS No. 123(R)'s fair value method has not yet been determined, the Company expects that it will have a significant impact on its results of operations. The disclosure of pro forma net income and earnings per share as if the Company had recognized compensation cost for share-based payments under SFAS No. 123 for the three months and nine months ended September 30, 2005 and 2004 is not necessarily indicative of the potential impact of recognizing compensation cost for share based payments under SFAS No. 123(R) in future periods. The potential impact of adopting SFAS No. 123(R) is dependent on levels of share-based payments granted, the specific option pricing model utilized to determine fair value and the transition methodology selected. 20 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. We are exposed to the impact of interest rate changes and foreign currency fluctuations. INTEREST RATE RISK We consider investments purchased with an original or remaining maturity of less than three months at date of purchase to be cash equivalents. The following table summarizes our cash and cash equivalents and short term investments:
SEPTEMBER 30, DECEMBER 31, 2005 2004 ------------- ------------ (in thousands) ASSETS Cash and cash equivalents $ 90,592 $109,142 Short term Investments 27,865 58,899 -------- -------- TOTAL $118,457 $168,041 ======== ========
Our exposure to market rate risk for changes in interest rates relates primarily to our investment portfolio. We do not use derivative financial instruments in our investment portfolio. Our investments are in high-quality Indian Mutual Funds and, by policy, limit the amount of credit exposure to any one issuer. At any time, changes in interest rates could have an impact on interest earnings for our investment portfolio. We protect and preserve our invested funds by limiting default, market and reinvestment risk. Investments in interest earning instruments carry a degree of interest rate risk. Floating rate securities may produce less income than expected if there is a decline in interest rates. Due in part to these factors, our future investment income may fall short of expectations, or we may suffer a loss in principal if we are forced to sell securities that have declined in market value due to changes in interest rates as stated above. FOREIGN CURRENCY RISK Our sales are primarily sourced in the United States and our subsidiary in the United Kingdom and are mostly denominated in U.S. dollars or UK pounds respectively. Our foreign subsidiaries incur most of their expenses in the local currency. Accordingly, all foreign subsidiaries use the local currency as their functional currency. Our business is subject to risks typical of an international business, including, but not limited to differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions, and foreign exchange rate volatility. Accordingly, our future results could be materially adversely impacted by changes in these or other factors. The risk is partially mitigated as the Company has sufficient resources in the respective local currencies to meet immediate requirements. We are also exposed to foreign exchange rate fluctuations as the financial results of foreign subsidiaries are translated into U.S. dollars in consolidation. As exchange rates vary, these results, when translated, may vary from expectations. During the three months ended September 30, 2005, the Indian rupee has depreciated, against U.S. dollar, by 0.5% as compared to the three months ended June 30, 2005. The impact of this rupee depreciation positively impacted our gross margin by 10 basis points, operating income by 12 basis points and net income by 12 basis points, each as a percentage of revenue. The Indian rupee denominated cost of revenues and selling, general and administrative expense was 31.8% and 30.7%, respectively, which did not have a material impact on the operating results of the company. Although the Company cannot predict future movement in interest rates or fluctuations in foreign currency rates, the Company does not currently anticipate that interest rate risk or foreign currency risk will have a material impact. 21 ITEM 4. CONTROLS AND PROCEDURES EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES. Based on their evaluation of the Company's disclosure controls and procedures as of September 30, 2005 as well as mirror certifications from senior management, the Company's Chairman, President and Chief Executive Officer and Chief Financial Officer have concluded that the Company's disclosure controls and procedures are designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934 (the Exchange Act) is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms and are operating in an effective manner. There have been no changes in the Company's internal controls over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) during the last quarter that materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. DISCLOSURE CONTROLS AND INTERNAL CONTROLS. Disclosure Controls are procedures designed to ensure that information required to be disclosed in our reports filed under the Exchange Act, such as this Report, is recorded, processed, summarized and reported within the time periods specified in the U.S. Securities and Exchange Commission's (the SEC) rules and forms. Disclosure Controls are also designed to ensure that such information is accumulated and communicated to our management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. Internal Controls are procedures designed to provide reasonable assurance that (1) our transactions are properly authorized; (2) our assets are safeguarded against unauthorized or improper use; and (3) our transactions are properly recorded and reported, all to permit the preparation of our financial statements in conformity with generally accepted accounting principles. LIMITATIONS ON THE EFFECTIVENESS OF CONTROLS. The Company's management, including the CEO and CFO, does not expect that our Disclosure Controls or our Internal Controls will prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system's objectives will be met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the company have been detected. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with its policies or procedures. SCOPE OF THE CONTROLS EVALUATION. In the course of the Controls Evaluation, we sought to identify data errors, control problems or acts of fraud and confirm that appropriate corrective actions, including process improvements, were being undertaken. Our Internal Controls are also evaluated on an ongoing basis by our Internal Audit Department and by other personnel in our organization. The overall goals of these various evaluation activities are to monitor our Disclosure Controls and our Internal Controls, and to modify them as necessary; our intent is to maintain the Disclosure Controls and the Internal Controls as dynamic systems that change as conditions warrant. Among other matters, we sought in our evaluation to determine whether there were any "significant deficiencies" or "material weaknesses" in the Company's Internal Controls, and whether the company had identified any acts of fraud involving personnel with a significant role in the Company's Internal Controls. This information was important both for the Controls Evaluation generally, and because the Rule 13a-14 Certifications of the CEO and CFO require that the CEO and CFO disclose that information to our Board's Audit Committee and our independent auditors. We also sought to deal with other controls matters in the Controls Evaluation, and in each case if a problem was identified, we considered what revision, improvement and/or correction to make in accordance with our ongoing procedures. Conclusions. Based upon the Controls Evaluation, our CEO and CFO have concluded that as of September 30, 2005 our disclosure controls and procedures are effective to ensure that material information relating to Syntel and its consolidated subsidiaries is made known to management, including the CEO and CFO, particularly during the period when our periodic reports are being prepared, and that our Internal Controls are effective to provide reasonable assurance that our financial statements are fairly presented in conformity with generally accepted accounting principles in the United States of America. 22 PART II OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS. While the Company is a party to ordinary routine litigation incidental to its business, the Company is not a party to any material pending legal proceedings. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS. None. ITEM 3. DEFAULTS UPON SENIOR SECURITIES. None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. ITEM 5. OTHER INFORMATION. There have been reports in the India media on Monday, November 7, 2005 and Tuesday November 8, 2005, including the Economic Times referring to a company official as having made forward-looking comments with respect to employee headcount levels for 2005 and 2006, certain real estate investments, future India expansion, capacity plans, capital investments, and a long-term growth vision. These references were not intended to and do not represent company guidance. The Company's position on forward-looking expectations should be limited to comments made on the company's news release and third quarter earnings call on October 27, 2005. ITEM 6. EXHIBITS. Exhibits
Exhibit No. Description ----------- ----------- 1 1997 Stock Option and Incentive Plan, (Amended and Restated). 2 Incentive Restricted Stock Grant Agreement (Amended and Restated). 3 Consent of Independent Registered Public Accounting Firm 4 Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer. 5 Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer. 6 Section 1350 Certification of Chief Executive Officer and Chief Financial Officer.
23 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. SYNTEL, INC. Date November 8, 2005 /s/ Bharat Desai ---------------------------------------- Bharat Desai, Chairman, President and Chief Executive Officer Date November 8, 2005 /s/ Revathy Ashok ---------------------------------------- Revathy Ashok, Chief Financial Officer 24 EXHIBIT INDEX
EXHIBIT NO. DESCRIPTION ----------- ----------- 10.1 1997 Stock Option and Incentive Plan, (Amended and Restated). 10.2 Incentive Restricted Stock Grant Agreement (Amended and Restated). 10.3 Consent of Independent Registered Public Accounting Firm 31.1 Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer. 31.2 Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer. 32 Section 1350 Certification of Chief Executive Officer and Chief Financial Officer.
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