The Enron of India.
That's what some are calling yesterday's confession by Satyam Computer
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
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
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.
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
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
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."