Vanity!

The Curse of Satyam

by John Needham, The Daniel Code Report | January 16, 2009

Ecc 1:2 Vanity of vanities, saith the Preacher, vanity of vanities; all is vanity.

The demise of Satyam Computer Services, India’s 4th biggest IT company has had eye popping consequences, not only for it’s shareholders and staff but for a host of Fortune 500 companies who entrusted their back office functions to Satyam.

The drama began with an unlikely T.03 Sell signal from the Danielcode for India’s NIFTY 50 index, two hours after the market closed on Tuesday 01/06/2009. These signals are always mimicked in India’ other major Equity Index, the SENSEX. At the opening of Wednesday’s trading session, the founder and Chairman of Satyam, B. Ramalinga Raju, delivered an extraordinary letter to the Mumbai Exchange admitting to falsifying the accounts of this significant and important company. Satyam was listed on Mumbai’s Stock Exchange as well as NYSE where its depository receipts traded, and EURONEXT.

Shares in the Mumbai and New York-listed business crashed after company chairman B Ramalinga Raju, the company's chairman, confessed to falsifying the earnings and assets of India's fourth-largest software and outsourcing services provider. Raju's criminal activities surfaced when shareholders blocked his bid to sell two companies to Satyam in order to plug a 50.4 billion rupee ($A1.84 billion) hole in the company's balance sheet. Confessing to the crime in a letter to directors, Raju acknowledged that he had inflated company profits over several years. Satyam shares slumped 78 per cent in Mumbai trading and in New York its American depositary receipts plunged 90 per cent before the NYSE intervened and halted trading. Apart from its Australian clients Satyam provides outsourcing services for the giant Citigroup and Japan's Nissan Motor Corp among other big corporates. Worldwide more than 53,000 people are employed by the company, mostly in Bangalore, Chennai and Hyderabad.

Qantas, which signed a $71 million software development and maintenance contract with Satyam two years ago, said yesterday that if necessary it could activate alternative arrangements. National Australia Bank has outsourced at least 500 positions to India after engaging Satyam and other providers over the past three years.

BusinessDaily also learned that a team of Satyam IT consultants from India were deployed last year to work on a technology project at Medibank Private's headquarters in Melbourne.

Medibank spokesman James Connors told said yesterday that there were contingency plans in place if the Satyam staff needed to be flown back to India.

Wesfarmers subsidiary Coles also has Satyam staff working at its Melbourne head office. The fraud, involving Hyderabad-based Satyam Computer Services, also throws into doubt plans for a $75 million software laboratory at Deakin University's Geelong campus.

The laboratory, a joint venture between Satyam, Deakin and the State Government, was slated to create 2000 jobs and inject an annual $175 million into the Victorian economy within the next decade. Satyam Australia, which employs about 1700 local staff, has its headquarters in Collins St.

The reason we are interested in Satyam’s demise is that it is no run of the mill, fly by night operator. Indeed it was one of the gems in India’s push into global outsourcing and a darling of financial media and major analysts all over the world. Well connected and with a great sales record, Satyam epitomised the very best of Indian corporates.

Ecc 1:3 What profit hath a man of all his labour which he taketh under the sun?

Satyam is being described as India’s Enron, a reference to its blue blooded connections. Its auditors were PriceWaterhouseCoopers. Mr. Raju, the chairman and co-founder of one of India’s largest outsourcing companies, described to his board on Wednesday how a small discrepancy had mushroomed into one of the biggest scandals in Indian corporate history.

Herald-Sun “What started as a marginal gap between actual operating profit and the one reflected in the books of accounts continued to grow over the years. It has attained unmanageable proportions as the size of company operations grew,” he wrote. “It was like riding a tiger, not knowing how to get off without being eaten.”

In the end, the scandal threatened to gobble up not just Mr. Raju, who resigned, but his company, Satyam Computer Services. Far beyond Satyam, it raised fears that similar problems might lurk in other Indian companies, particularly in its vaunted outsourcing industry.

A huge piece of Satyam’s finances was a fantasy. Of the 53.6 billion rupees in cash and bank balances the company listed as assets at the end of its second quarter, 50.4 billion rupees ($1 billion), were nonexistent, according to Mr. Raju’s letter. Revenues for the quarter ended Sept. 30 were actually 20 percent lower than the 27 billion rupees reported, and the company’s profit for the quarter was just 10 percent of what it reported at the time.

Many analysts said it was unthinkable that Mr. Raju had acted without accomplices, and regulators in India, Europe and the United States were likely to take action against Satyam for false accounting. In addition to being listed in India, its shares have traded on the New York Stock Exchange since May 2001, and on Euronext since January 2008.

Satyam’s auditor, PricewaterhouseCoopers, which has audited the company since its NYSE listing, said it was “examining” Mr. Raju’s statement and could not comment further. Four of the company’s directors resigned recently and the company hired Merrill Lynch for strategic advice, a move that is generally a precursor to a sale. On Wednesday, Merrill Lynch sent a letter to India’s stock exchanges, saying it had terminated its relationship with Satyam after the bank “came to understand that there were material accounting irregularities” at the company. Merrill Lynch officials declined to comment further.

Historically, several characteristics have been considered important ingredients of excellent corporate governance. These include outsider representation on the board, boards that aren't too large, boards that meet often, etc. Unfortunately, these characteristics were not sufficient. Satyam not only had a reputation for of excellent corporate governance, but was the recipient of international awards for governance standards. Personally, I think this whole PC concept of “governance” and “transparency” is a sham, and just another gravy train for the nannies who hover on the edge of corporations. Decent auditing standards, really meaningful penalties (like jail for auditors, accountants and directors) and an unambiguous statement with the accounts that: “these accounts present a complete, true and fair view of the company’s financial position,” to be signed by all officers and the auditors, under oath, would put some backbone into what is now just an expensive joke. Perjury is much simpler to prove than conspiracy.

In the case of Satyam, one of the biggest auditing firms in the world signed off on the financial reports without so much as verifying the cash balances. Amazing!

Ecc 1:4 One generation passeth away, and another generation cometh: but the earth abideth for ever.

Fudging the books is a story as old as time in financial markets. Some of these methods are simply fraud, as when cash balances and debtors are intentionally falsified. These simple frauds should always be picked up as auditors have a primary duty to verify assets and liabilities independently through third party confirmation. Apparently PriceWaterhouseCoopers failed over a period of years to perform this basic task. With analyst coverage from Goldman Sachs Group Inc, Citigroup Inc, HSBC Holdings and Credit Suisse, Satyam had all the trappings of a successful, modern IT company. Merrill Lynch was its capital structure adviser.

So we have an apparently well connected and well run business, accepted internationally as a credible partner by governments and major corporations. No less than the World Council for Corporate Governance awarded Satyam its Golden Peacock Award for Corporate Governance in 2008 and Ernst & Young, had awarded Raju with the Entrepreneur of the Year Award in 2007. Have a read of the Golden Peacock award website. Sponsored by a global name in accountancy its most embarrassing moment has come at the hands of another major accounting firm. Enron took down Arthur Anderson and now Satyam will have a severe impact on the partners of PriceWaterhouseCoopers. Ironic! With all the compliance boxes ticked and fame and approval heaped both at home and from afar, Satyam’s path looked golden. But it was a fraud. The most discerning investor conducting due diligence on this company could not have found fault. This highlights for us again that if the accounts are wrong, the assessment must of necessity be wrong.

Whilst the intent to deceive at Satyam is risible, just on the other side of the fence, major banks and corporations, with the explicit consent of regulators provide false accounts continually. Banks worldwide set up SIVs to hold leveraged assets without disclosing that they were liable to support any fall in value of those assets. Fannie and Freddie for years used an implied guarantee from US Government to flog toxic securities and as we now are painfully aware, securitisation issues ranging from false assessments of credit ratings to failure to value these instruments properly, have and are continuing to ensure that analysts and investors cannot make informed decisions of a company’s true worth. Whether the cause is fraud, incompetence, negligence or just taking advantage of poor accounting standards and regulations, the effect is the same. The investors are wrong at every critical stage of their assessment and suffer accordingly. Bernie Madoff showed us that if you can paint the picture, fools will gladly part with their money. Satyam was just such a pretty picture.

Ecc 1:9 The thing that hath been, it is that which shall be; and that which is done is that which shall be done: and there is no new thing under the sun.

In Asia, the global credit crunch rolls on with machinery orders down 16.9% in Japan yesterday. This is a good leading indicator of future capital expenditure so the coming months look bleaker as data continues to make a nonsense of the disconnect theory for Asian markets.

If there is a disconnect, it is in Australia where housing prices have fallen just 5% year on year. To understand the differences between US and Down Under housing markets it is necessary to look at the different lending regimes which prevail. In Australia and New Zealand, all home mortgage lending is full recourse, that is the mortgagor (borrower) unconditionally guarantees principal and interest to the lenders. There is no jingle mail. Even after foreclosure the borrower remains liable for any short fall on realization and lenders are known for using the full weight of the law to enforce collections.

Whilst there were endless 100% plus LTV mortgages available up until just two months ago Down Under, the norm was full documentation and the loss rates in full doc loans have been minimal. For the lo doc loans, the arrears rate is approaching 15% but this comprises a very small percentage of the Australian market. The Australian Federal government was quick to jump on the bandwagon of guaranteeing individual and corporate bank accounts, and early on, went the whole hog of guaranteeing real estate, credit card and auto loan securitization. In other words they have effectively nationalized the fund raising industry without taking control of the banks or other lending entities. naturally the banks are milking this with all their might. This from Business Spectator today:

Australian banks have issued about $40 billion worth of government guaranteed, AAA-rated bonds in five weeks – two-thirds of the amount they raised from global markets in the whole of 2007.

It’s also 40 per cent of their entire 2009 debt maturity needs. While the share prices of US and European banks continue to crash as they fight for survival, the Australian banks are engaging in a once-in-a-lifetime dash for cash – wildly distorting the market in their favour thanks to the Rudd government’s decision to guarantee their offshore debt raisings. As a result the banks are mopping up all available cash at the expense of corporations. With so much AAA, sovereign guaranteed bank paper available at quite healthy yields, the international credit market (such as it is) has little interest in the A+, A and A- paper being offered by Australia’s leading corporations, even at triple or quadruple the margin.

The banks are like kids let loose in a lolly shop: they are paying as little as 100 basis points over the bank bill swap rate (BBSW) and getting plenty of money at that price. (BBSW is Australia’s version of Libor; yesterday it was set at 3.86 per cent, 40 points below the RBA cash rate, in anticipation of a rate cut in February. Usually BBSW and cash are roughly the same.) On top of that margin, the banks have to pay the government 70 basis points for the guarantee, but it’s worth it. Oh yes, indeed.

They have a captive corporate market for the funds that produce a very handy interest margin to help make up for all the loan losses they are wearing from the past follies of now-departed hotshot credit marketers whom they used to employ. According to an ANZ presentation last month Australian companies must replace $15-20 billion in syndicated debt in the next six months. For the whole of 2009, I have heard estimates of anything up to $90 billion as a result of credit boom conditions three years ago.

But the debt markets are closed to these corporates because the banks are crowding them out with a government guaranteed monopoly. They have to go to the banks for the money and, naturally, get screwed. They are being forced to pay margins over the banks’ cost of funds of up to 400 basis points, and the banks’ lending officers are shackling them with the most horrendous covenants and charges. No more “covenant lite” baby – it’s “covenant heavy” nowadays.

The good news is that the benchmark rate – BBSW – is collapsing with the cash rate, although not as much as Libor in the US and Europe. Currently below 4 per cent, it was as high as 8 per cent last year. In the US, Libor, which stands for London Interbank Offered Rate, was 5 per cent, now 1.08 per cent; in Europe it is 2.56 per cent, and last night the European Central Bank cut the cash rate again, by 50 basis points. So thanks to the global recession, blue chip local companies can still borrow money at a rate of less than 10 per cent and falling – it’s just that there is a long way between the official RBA rate and what they are paying. When they go shopping for cash there are only four stores in the mall: ANZ, Commonwealth, Westpac and NAB.

Did the Australian government have to offer to guarantee the offshore debt raisings of local banks? Who knows, but it did it. The result is that 2009 is the year of the banks’ revenge.

This is the path that US will go down as they attempt to put Humpty Dumpty, the fallen proxy of banks and broker-dealers, back together again.

Ecc 1:10 Is there any thing whereof it may be said, See, this is new? it hath been already of old time, which was before us.

The determination of governments of every hue and from Asia through to US to mitigate the effects of the credit crisis and restore the prior status quo, has bought some interesting side plays. In US, the hope of free enterprise, no significant business is being allowed to fail. In China, a communist country with barely a decade’s brush with capitalism, sectors of the manufacturing base are being decimated as western consumption slows and freight rates for shipping containers go to zero. In China, takeovers, rationalisation and restructuring are everyday fare whilst in the West, the genius of reinvention and the growth of new, successful business models is on hold as the dead hand of government supports failure and inefficiency in the name of protecting jobs or their mates.

International markets continue to languish, as well they might. The worst is still in front of us!

This is the weekly Danielcode chart of the International Market Index. It found its DC target with some precision although that statement is not apparent from this chart.

One of the quirks of the Daniel number sequence is that although price targets are usually recognised on a high/low basis, occasionally the recognition will occur on a close only basis as the following chart shows:

It is instructional to observe in particular the DC black price line on all charts. This is the last level of DC support for the operative swing. In this way we can compare relative strength across markets quite easily. By comparison the S&P has already broken the DC black line, but not yet on a closing basis.

A monthly close below the black line is an ominous signal.

Hong Kong’s Hang Seng index made its October low about 25 points from the DC black line, and so far, is just correcting the minor swing.

This is Japan’s Nikkei index which is plumbing new lows. I have left the black line on this chart so you can see what usually follows a confirmed break of that support. The black line level for Japan was tested exactly in December 1998. Then followed a confirmed break of the DC black line, a multi year rally and now the inevitable failure. This is the likely pattern for the major US equity indices.

Gold is still holding a strong position on the weekly chart and continues, together with US Equity indices to provide the best trading market for short term and swing traders.

Our last Gold trade gave us some part of a $43 move, as Comex Gold responded to the T.03 sell signal posted 3 hours after the markets’ close on 01/09, and adds to an outstanding 2008 for the T.03 signals.

The Australian SPI flirted with the DC black line in November but declined to make the trip and rallied 90 points from its nemesis. It’s heading back to the dreaded black line again.

Crude Oil prices continue to languish at levels unimaginable just two quarters ago.

Commodity deflation is alive and well.

I invite you to visit the Danielcode website where there are a large number of articles and videos of the Danielcode’s adventures in many different markets including Gold and the major US indices as well as grains and forex. They will be of great interest to traders worldwide.

Ecc 12:13 Let us hear the conclusion of the whole matter: Fear God, and keep his commandments: for this is the whole duty of man.

16 January 2009

CAUTION-The Daniel numbers on these charts are from historic sequences that may not be current at the time of publication. They are appended for historic interest only. Do NOT use these numbers to trade markets. Current Daniel sequence numbers for most currency crosses are available to subscribers at the Danielcode website.

John Needham is a Sydney Lawyer and Financial Consultant. He publishes The Danielcode Report and writes occasionally on other markets. He lives with his family in Australia and New Zealand.

“The fox knows many things, but the hedgehog knows one big thing. A Hedgehog Concept is not a goal, intention or strategy to be the best. It is an understanding of what you can be best at. The distinction is absolutely crucial”. ~ Isaiah Berlin, The Hedgehog and the Fox

contact information

John Needham | The Danielcode Report | Taupo, New Zealand | Email | Website

The opinions of FSU contributors do not necessarily reflect those of Financial Sense.