“We don't give you any forecast numbers. And also, we are not going to stop building the data centers. So we are going to continuously [invest] because India is a good story. We have to invest. So that means we are not stopping after these data centers. We are going to continuously increase. And we will not give you – we are going to aggressively pursuing our business in the government, but we cannot tell you the numbers – we cannot forecast the numbers.”                            

----CFO of SIFY, May 2011

SUMMARY:   The quick pitch is that this is a commoditized ISP/internet café business trading at 5x revs and 60x run-rate EBITDA with no growth (6% revenue CAGR over the last 6 years). One of the reasons for the high valuation is that mgmt did an inside deal in late 2010 that diluted the equity by 300% (deal was done at a 70% discount to market at the time). This transaction was not highly publicized and went largely unnoticed until the company filed its F11 20-F in October 2011 after several delays. Even still, sites like Google Finance misreport the shares outstanding with only 50M shares when in reality the shares outstanding are closer to 180M with a resulting market cap of $770M. Meanwhile, the co. is associating itself with every buzzword out there from SaaS to social media to tablets…and retail investors are eating it up.  There is no street coverage. In reality, the majority of their business is an ISP with extreme pricing pressure and intense competition. Management says it best when they state in their 20-F that “margins are continually shrinking.”  Hype > Reality.  The added kicker is the resignation of KPMG as their auditor and recent CFO departure. The balance sheet is deteriorating and the company has a net debt position with no access to capital markets.  The latter situation is a result of an Indian regulation that prevents SIFY from raising capital in any market unless they are listed in India first. However, the requirement to list in India mandates at least three years of profitability which SIFY does not satisfy. So with capex running at $16M/year and limited room on their revolver, SIFY may be back to doing inside deals with the promoter group though that same group still hasn’t fully paid for the 125M shares they got in the Fall 2010. The stock can be a little volatile with the retail hype and frenzy from time to time over Indian Internet, but the fundamental value here in my view is significantly lower and probably around ~$1/share and that is probably aggressive given the recent dilution. Oh and I forgot to mention, they are starting an undersea fiber cable investment this year…

Short Thesis in a nutshell:

1. Many investors are unaware of highly dilutive equity raise by management (i.e., 300% dilution) as no formal filings have been filed. The 20-F is due on 9/30 and should show substantial dilution and imply a market cap of over $770M vs. what some incorrectly believe to be only 230M today. Many data services today still show only 53M shares out vs. 179M in actuality. There is no sell-side coverage and the company still does not report its shares outstanding number in quarterly results.
2. Implied Valuation due to dilution implies 5x revs and 60x run-rate EBITDA for a business that is not growing and is losing money each quarter.
3. Balance sheet metrics are deteriorating – in the FY ending March 2010, revs grew 8.8% (an only 2% in most recent qtr) while receivables grew 28% and allowance for bad debts grew 47%.
4. KPMG their auditor resigned in Nov 2010. New no-name auditor ASA & Associates fills the spot in May 2011 but is not consulted on prior filings or any interim periods since last year. They still have a material weakness / internal control deficiency outstanding.
5. Business they are in is extremely competitive – one of their risk factors point blank reads “Margin squeeze may affect our operations”. Pricing is fierce and margins are declining. Per their 20-F…”margins in our business are continually shrinking.”
6. Other Vagaries
   1. Increase in useful lives of networking equipment from 5 to 8yrs – largest depreciable asset category
   2. Impairment triggered in March 2010 for previous acquisition in portal category

Fundamentals – Revenue run-rate is roughly $140M run-rate with about $13M in run-rate EBITDA and -2M in Net Income in the latest quarter. The co. has burned through $100M over the last five years.

Quickly what they do – the company has had multiple re-orgs and “new business lines” that it even has a risk factor mentioning this. When you boil it down though 80% of the revs come from business connectivity which is another way of saying ISP and VPN services to businesses, 11% internet cafes and the rest is from an Internet portal and ‘other’.  If you want a good read though, print out the latest conference call transcript where management talks about everything from bandwidth last mile services, disaster recovery, “cloud” services, social media, VPN services, internet cafes, and eLearning.  In terms of assets they have about 600 PoPs with most of their data center space leased. Within business connectivity, the majority of bandwidth customers are already captured by the large telcos in the market like BSNL, Bharti, and Tata.  The Internet café business which used to be 40% of the co before has been a disaster (declining 40% YOY in most recent quarter) and depends on the success of the franchisees. In the last two years, operating costs have increased steeply, particularly rent for retail premises, eroding the margins of franchisees and making the business unattractive. Most of the competition for customers is from the unorganized sector with low rates that have become the industry norm. SIFY’s premium pricing of products/services offered through cybercafés is viewed as being more expensive.

Why has it run – In short, choose your favorite buzzword. “Growth in the social networking, private and public cloud build outs, expansion of mobile network and related smartphone and tablet services, rise in video traffic, exploring the growth in web conference, web commerce, and also some of the major trends that are driving strong growth in our market.”

Share count dilution of almost 300% - In September 2010, management put out a simple 6-K saying the company was offering 125M shares at 69c/share to the founders. This was a 70% discount to the market price and the explanation was that there was no active market for the shares in India. Of the $86M “infusion” only $21.7M was actually funded upfront with another ~$20M or so funded this past year. The remaining $40M mgmt expects to call over the next year despite already issuing the shares. Pro-forma for the deal the diluted shares outstanding is around 178M shares or over 300% higher. Oddly, many of the market cap references (factset, google, yahoo) still cite a lower shares outstanding and a market cap of $230M-$360M when in reality the market cap is over $770M. All quarterly earnings since then have a simple income statement with no shares outstanding number.

Pricing – substantial pricing pressure on bandwidth

• “the one concern has been the drop in pricing on bandwidth on accounts of which that has a fair amount of competition. But the way we are able to hold up on that front is in terms of acquiring a larger customer base”
• “pricing trends on the Internet Bandwidth segment are extremely competitive”evt

Consumer business failed – now “re-engineered as an enterprise player”. Per above the Internet café is down 40% YOY and pricing competition from unorganized labor is fierce. Per the 20F, they are competing now on “ambience”.

Investments in Undersea Cable + Capex – unclear how this will be funded from a money losing business without further equity dilution. They have invested $8M in undersea cable so far and expect to invest $52M over the next couple years. One of the reasons in the 6-K the co cites for the equity raise is due to “tight liquidity position”.

October 2010 – SIFY was unable to file audited statement for the fiscal year end March 2010 due to incomplete audit results from a minority owned venture.

November 2010 – 20F is filed but KPMG says that it will resign and not stand for re-election as auditors for the fiscal year ending March 2011. ASA & Associates was appointed in the interim to fill KPMG’s spot.

November 2010 – as part of the 20F Company had a material weakness in internal controls relating to the failure of a control intended to carry out an accounting evaluation of certain transactions relating to the purchase of goods for onward sales. Certain transactions which otherwise qualified for being accounted on a net basis were reported on a gross basis as “revenues” and “cost of goods sold”. The root cause of the error was the result of a failure in the operating effectiveness of an internal control relating to carrying out an independent accounting review of the trading transactions of the System Integration business.

2011 – Company again delays timely reporting of 20-F until October 2011.

History of SIFY

• Founded in 1995 and was majority owned by Satyam (SAY) until 2002
• 1995-1997: developed and tested private data network for businesses (EDI, email, VPN)
• 1998: developed portal and launched ISP business
• 2000: launched Internet café business and colo business
• 2010: provide data connectivity to 2500 businesses and run 1200 Internet cafes