Just When You Thought It Couldn't Get Any Worse

The Enron of India.

That's what some are calling yesterday's confession by Satyam Computer (NYSE: SAY  ) founder and (now former) chairman Ramalinga Raju that the company has been fraudulently inflating profits for "several years." Indeed, it got so bad that the company recently reported having more than $1 billion in cash on its balance sheet that, in actuality, did not exist.

And I would have gotten away with it, too ...
This revelation explains the harebrained scheme Raju hatched in December to acquire a real estate and a construction company -- Maytas Properties and Maytas Infra, respectively -- from his family for a cost of $1.6 billion without putting the proposal up for shareholder approval. 

Satyam ostensibly would have paid out $1.6 billion to acquire the two firms (far more than they appear to be worth), but given the close family ties, would have actually paid out much less or delayed making the payments for many years. Thus, the balance sheet gap would be erased in the eyes of shareholders and auditors.

Alas, because shareholders protested, it was, in Raju's words, "not to be." Now, we'll refrain from judging Raju, but let's look back and see if we could have diagnosed Satyam as a fraud.

 ... if it weren't for you meddling kids
Satyam is/was an outsourcing company. That means Western companies such as Microsoft (Nasdaq: MSFT  ) and Oracle (Nasdaq: ORCL  ) paid Satyam to perform back-office design, consulting, customer service, and other work. And because Satyam was based in India, where labor continues to be relatively cheap, Western companies realized a cost savings relative to paying people in the United States or Europe to do the same work.

Now, Satyam was actually in this business. Its clients were real, and in June 2007, our Motley Fool Global Gains research team visited its palatial campus outside Hyderabad and saw for ourselves that workers were working. But there were reasons to start getting suspicious of Satyam.

The red, or at least orange, flags
First, the company kept live peacocks. Sure, this is an innocent act in and of itself, but the peacocks were part of the company's zoo. The HQ also boasted a nine-hole golf course, a swimming pool, basketball courts, and other impressive facilities built to impress visitors.

This is not to say that companies with notoriously impressive corporate campuses -- think Google (Nasdaq: GOOG  ) as another example -- are inherently frauds. But when we analyze our investments at Global Gains, we, like Peter Lynch, like to see businesses operating on efficient budgets. As Lynch wrote, "I got positive feelings when I saw that Taco Bell's headquarters was stuck behind a bowling alley. When I saw those executives operating out of that grim little bunker, I was thrilled. Obviously they weren't wasting money on landscaping the office."

Indeed, looking back at our meeting notes from that day, I see that I was overwhelmed by the lavishness. We also noted that our discussion with members of management -- without any C-level officers (like the CEO, CFO, or COO), since they declined to meet with us (another flag) -- centered around what the company was doing to counter deteriorating margins. 

See, at that time the U.S. dollar was weakening against the rupee, competition in the industry was increasing, and salaries were skyrocketing as Satyam, Infosys, Wipro, and Patni competed to hire qualified workers. Satyam's employee turnover at the time was 15%. The company's solution to this problem was to raise salaries and increase benefits such as subsidized housing and meals.

Put those facts together
Thus, Satyam should have seen costs rise substantially as its competitors did over the 16 months since our visit. Margins on earnings before interest and taxes (EBIT) at Wipro dropped from 18% to 16%, and EBIT margins at Patni fell from 22% to as low as 10% before bouncing somewhat. After all, outsourcing is essentially a commodity business with little to no price stability.

Yet quarterly EBIT margins at Satyam hovered right around 20%-21% -- sometimes slightly better, sometimes slightly worse -- even as the company was being subjected to the same industry dynamics. This is evidence of either an extremely good operator or manipulated numbers. We now know it was the latter.

The takeaway
There was no way to confirm that Satyam was cooking its books, but there were signs that this was not a stock you wanted to own. The lesson, as always, is to do your homework when it comes to stocks, stay on top of them, ask good questions, and don't stand for even a whiff of executive impropriety.

More broadly, however, this is frightening news on the end of a year that saw foreign markets suffer enormous downside volatility. We've even read opinions that something like this is the reason why you shouldn't bother investing overseas.

We think that opinion is short-sighted and wrong.

Fraud, unfortunately, is a fact of life in the financial world, be it Enron, Satyam, Bernie Madoff, or the thousands of mortgage brokers and bankers who wrote bad loans and inflated their values. So instead of viewing this scandal as a reason to swear off foreign investing at a time when we believe you should be increasing your foreign exposure, view this as a reminder to stay on top of your stocks. And when a commodity business is able to post stable, outstanding margins for a multiyear period even as its competitors' margins contract, well, that's a reminder that when something seems too good to be true, it probably is.

And now for something completely different
Of course, it's not all fraud and peacocks in the emerging world. Three weeks ago, as you no doubt read in our last installment, Mexico took advantage of historically low rates on Treasuries -- most emerging-market debt is priced in relation to U.S. Treasuries -- to issue $2 billion worth of 10-year, dollar-denominated debt. Earlier this week, Brazil and Columbia each raised $1 billion, and Chile is considering its first dollar-denominated debt issuance in four years.

Raising dollar-denominated debt is significant because it increases the risk profile of these countries. By owing money in dollars, countries expose themselves to fluctuations in currencies. If the dollar strengthens against Brazil's real, for example, servicing this new debt will become more expensive because the government's income -- real-denominated tax revenue -- will be worth relatively less.

With the turmoil in financial markets and the rush to the safety of the dollar last year, several companies were caught on the wrong side of currency movements. In one of the more dramatic examples, Mexico's third-largest supermarket chain, Comerci, a joint venture partner of Costco (Nasdaq: COST  ) , was forced into bankruptcy because a gamble on the value of the peso went south.

Timing is everything
Taking on dollar-denominated debt right now, however, might not be a bad idea. With the dollar experiencing a recent boost and the commodities these countries export in a slump, now may be the perfect time to take on dollar obligations.

The global economic slowdown has reduced demand for commodities, but this is likely just a short-term pause. This isn't to say we'll see the sky-high prices of mid-2008 any time soon, but once economic activity, especially in China, picks up, prices for raw materials should solidify.

At the same time, the Federal Reserve is doing its best to inflate us out of this recession, and President-elect Obama's stimulus plan has been boosted toward $1 trillion. Long-term, these actions, combined with the already fundamental weakness of the dollar, suggest a less valuable greenback.

And they are right on time
In fact, these emerging markets may be issuing their bonds now because of the proposed U.S. and European stimulus plans. You see, the U.S. is expected to issue nearly $2 trillion in Treasuries, and European governments are likely to break all records for debt issuance this year. Add to this significant borrowing by companies such as GE (NYSE: GE  ) and Tyco International (NYSE: TYC  ) , and you have a recipe for a very crowded debt market.

This means it is likely that long-term rates will be rising as we move through 2009, and given the current preference for low-risk investments, it is probably best that emerging markets get their borrowing out there first, before it gets more expensive, and put themselves on firmer financial footing for the long haul.

As always, that was this week in the emerging markets ... and quite a week it was. Learn more about investing in emerging markets by reading "Why China's Stimulus Plan Will Change the World."

Tim Hanson is a co-advisor of Motley Fool Global Gains. Nate Weisshaar is a senior analyst for the service. Neither owns shares of any company mentioned. Microsoft, Costco, and Tyco are Motley Fool Inside Value recommendations. Google is a Rule Breakers pick. Satyam is a former Stock Advisor selection, while Costco remains a current pick. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is the truth.


Read/Post Comments (10) | Recommend This Article (17)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 08, 2009, at 12:08 PM, Terch wrote:

    Tim,

    I subscribed to your reports on your GG trip to India. I remember at the time being shocked at the lavish-ness of the SAY campus and the 15% increases in salary. That simple email you sent out was enough to make me avoid SAY despite the recomendation by the SA newsletter. I cant thank you enough for your help there. I may never have invested in SAY anyway, but your email kept me out of it for good.

    Thanks!

  • Report this Comment On January 08, 2009, at 2:54 PM, matcha695 wrote:

    "The takeaway

    There was no way to confirm that Satyam was cooking its books, but there were signs that this was not a stock you wanted to own. The lesson, as always, is to do your homework when it comes to stocks, stay on top of them, ask good questions, and don't stand for even a whiff of executive impropriety."

    And thank goodness, MF is here to "teach" us a good lesson that we won't soon forget.

  • Report this Comment On January 08, 2009, at 4:49 PM, Mapletoast wrote:

    Apart from the other glowing comments, I have to say that as a subscriber to the Motley Fool Stock Advisor, I followed their advice and bought a significant amount of SAY stock. No, I am not saying I can outsource my responsibility to MF for this terrible waste of my funds, but certainly you pay money to them because you respect their opinion at the very least.

    So I find it a bit self-serving for them to NOW say, "there you go, I told you so". Actually MF, you didn't, you told me this was the hottest idea you had that month.....and I bit.

  • Report this Comment On January 08, 2009, at 4:54 PM, davidkubica1 wrote:

    What better investment in order to gain international exposure than commoditied? And how do you diversify in commodities easily? By investing in managed futures. Here is a program that has returned 128% this year alone and has an average MONTHLY return since inception over 5 years ago of over 8%.

    http://www.managedfuturesdepot.com/shadrachprogram.php

    Remember people, I can't possibly be lying because all managed futures earnings reports are regulated. Oh yeah, and did I mention that these returns are NET OF EXPENSES.

  • Report this Comment On January 08, 2009, at 7:09 PM, watersm wrote:

    I'm with Mapletoast. When SA makes a recommendation, it presents the pros and cons. I also bit bigtime on SAY based on SA recommendation, but I certainly would not have if I had seen Tim's notes... and that is information known before yesterday.

    I have a real problem with MF having in-house information that is not shared with the subscribers of the recommending newsletter! If SA is saying buy, I should not have to subcribe to GG to hear don't buy! This should be the 11th Commandment and part of the MF disclosure policy.

    I expect the market fluctuations. I don't blame MF when they recommend a stock based on available information that doesn't pan out to huge gains. I do blame MF for not asking the right questions, and especially for not sharing the information with subscribers. Shame on MF! If Bill Mann, Tim Hanson, or Rick Munarriz have info about a Stock Advisor pick, it better make it to the SA staff and subscribers. Likewise, Andy and the Gardners better be sure their "flags" get to the subscribers of Hidden Gems, Rule Breakers, Inside Value, etc.

    I can't blame MF for insider fraud at Enron, Worldcom, Satyam, etc. I do blame them for witholding information across newsletters. As a "regular guy" who works all day, doing my research before buying a stock consists very largely of relying on newsletters to dig up that information and screening it for me. I depend on the newsletters to tell me if EBIT is out of the norm, family members are trading assets (SA did tell me), or if the parking lots are full of Rolls Royces and private jets, etc.

    I'll continue to subscribe as long as I trust MF. My trust in MF has been shaken. I have a completely different feeling for PriceWaterhouseCooper for not catching this!

  • Report this Comment On January 08, 2009, at 9:39 PM, matcha695 wrote:

    " Satyam is a former Stock Advisor selection,..."

    "Former" as in as of yesterday?

  • Report this Comment On January 08, 2009, at 10:18 PM, OceanJackson wrote:

    Tim Hanson and Nate Weisshaar, you are right, there "were signs that this was not a stock you wanted to own", and you make excellent points. But the subtle problem with your article, which it conveniently does, is not admit that by the same token the Motley Fool and specifically the Stock Advisor service is itself guilty of every 'reminder' you mention. The Motley Fool Stock Advisor service did not "stay on top of their stock", yet did "stand for a whiff of executive impropriety", and "didn't ask good questions", or properly do "their homework". It is unbelievable to me, that you admit you caught all of the whiffs of executive impropriety in June of 2007 during a personal visit, and yet knowing that SA only sold Satyam YESTERDAY after the fraud news broke, a year and a half AFTER your visit, you write an article stating that you should not stand for a whiff of executive impropriety.

    Here is a news flash: you represent The Motley Fool corporation and ALL of it's services as employees of The Motley Fool. You do not get to separate yourself from any of the Motely Fool's services.

    A better article for the MF's credibility would have been to put up some sort of "it happens to the best of us" defense for not catching the 'whiff's' you smelled over a year ago, rather than state that 'there were signs that this was not a stock you wanted to own'.

    If the Motley Fool does not have a united front for its own services, which services can we trust, and which should we not?

  • Report this Comment On January 08, 2009, at 10:26 PM, OceanJackson wrote:

    ...And I'll put it another way, what do you think would happen if Motley Fool Stock Advisor wrote the above article today?

    Just because you're 'Global Gains', doesn't dissociate you from Stock Advisor.

  • Report this Comment On January 10, 2009, at 8:28 PM, wsteveww wrote:

    I now feel you withheld information from subscribers. I used to have some trust for MF. I no longer have any trust in MF. I will never pay you money again. I used to be amused. I am not even amused now. Goodbye

  • Report this Comment On January 12, 2009, at 3:59 AM, normgarnett wrote:

    I shall still enjoy reading SA and MF but using a large dose of salt in future!

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