Satyam Fraud - Ethical/Moral Crisis

In my previous post I had covered my analysis of the Satyam fraud. In case you haven't read it here's the link. In this blog I will be covering some of my thoughts on what led to this crisis and what can we do to prevent this in future.

How did we get here?

I read couple of interesting posts in the net that the world is going through not just economic crisis but also ethical crisis with the mis-management of banks & financial institutions, Ponzi schemes, Corporate frauds, Bribes etc. This is very true. While we can have rules, compliance procedures, multiple levels of cross-checks etc, end of the day if someone wants to cheat he very well can find his way around the system. All our systems and processes are built on the basis of trust & ethics. When these fundamental qualities of an individual/organization fails the whole systems comes crashing down.

What happened in Satyam's case is precisely that. It was a breakdown of trust and ethics. Satyam was bound by SEC, GAAP, SOX regulations, they have independent third party audits etc and still managed to get away with their fraud that too for around 7+ yrs (This came from Raju's statements during enquiry). The current society is becoming more and more materialistic and power, greed, fame, market/peer pressure etc are taking over and some of the basic human values are forgotten. As history has shown us repeatedly those who don't operate in a moral and ethical manner will eventually fail as in the case of Satyam/Raju.

What can we do to prevent this?

In the near-term as an outcome from investigations/analysis Govt will come up with more rules, regulations and compliance procedures. These are more like patchwork and will address some of the outcomes of this fraud and add more overheads to the system (similar to SOX regulations in US where businesses spend millions/billions of $'s). However putting more regulations will not address the root-cause of this issue. This whole episode will keep repeating itself time and again till we reach a stage where our rules and regulations become more of an impediment to our businesses instead of enabling them and defining boundaries/acceptable norms. I'm not saying that we don't need rules & regulations just that rules and compliance alone can never be sufficient.

For us to fix this issue each of us need to look within and ask ourselves if we are doing the right thing. Just like there are rules & regulations for the society, each of us need to operate under the boundaries of personal ethics and values. We as a society need to encourage moral values like honesty, integrity, ethics etc and reward people who follow them. The value system needs to imbibed into the future generations through our education systems and by parents setting an example to their children. While this may sound very philosophical it is essential that we fix this as failure of personal ethics and values is root cause of this issue.

We as individuals need to take ownership and drive this change both in us and in our societies. Lets start with ourselves and kick-off this change one at a time!

Nandu Muralidharan's Resume in Wordle!

Attached above is the 'word cloud' of my resume generated through Wordle. This is a visual form of representing your profile. Text appearing multiple times in the profile are shown in bigger fonts. For a high resolution version of the above image click here.

Sathyam Fraud - An Analysis

In my earlier post i had covered my thoughts on the Maytas debacle. For those who haven't read it here is the link. I will be covering about my analysis of the Satyam corporate scandal/fraud in this blog.


Overview

Satyam has been topping the media charts for the last few weeks and have been rattled by a series of shocks. The whole mayhem started with the announcement & subsequent cancellation of Maytas acquisition, it was followed by World Bank contract termination & allegation of bribery by Satyam and then came the resignation of 4 independent directors from its board. Today Ramalinga Raju delivered the coup-de-grace when he made a press release that Satyam's books were fudged; that they have been reporting inflated revenue/margins for the last few years and the stated cash reserves of $1.2B are non-existent. The overall revenue impact of this fraud was a whopping Rs.8000 Crores ($1.66 Billion). This is the biggest corporate scandal in Indian history. This whole episode has not only impacted Satyam but this has created lot of negative publicity for Indian IT and Industry as a whole and impacted its corporate reputation.

Here's a summary of the misreported amounts as claimed by Raju in his letter to Satyam Board:

1. The Balance Sheet carries as of September 30, 2008

• Inflated (non-existent) cash and bank balances of Rs.5,040 crore (as against Rs. 5361 crore reflected in the books)
• An accrued interest of Rs. 376 crore which is non-existent
• An understated liability of Rs. 1,230 crore on account of funds arranged by me
• An over stated debtors position of Rs. 490 crore (as against Rs. 2651 [cr.] reflected in the books)

2. For the September quarter (02) we reported a revenue of Rs.2,700 crore and an operating margin of Rs. 649 crore (24% Of revenues) as against the actual revenues of Rs. 2,112 crore and an actual operating margin of Rs. 61 Crore ( 3% of revenues). This has resulted in artificial, cash and bank balances going up by Rs. 588 crore in Q2 alone.

Pls check out the complete draft of Raju’s mail in this link.


What beats me about this whole incident is how can a company with $2B revenue get away with $1B+ mis-reporting/fraud. Here are some glaring questions that pop-out of this episode:

• Satyam is a publicly listed company in both India and US and are bound by Indian/US (GAAP) accounting standards. I don’t know much about comprehensiveness of Indian accounting standards, However US GAAP standards and SoX regulations are very stringent(especially post-Enron scenario). They need to go through mandatory 3rd party audits as well. Given this how can Satyam fudge their books?

• This whole mis-reporting has been going on for a few years now. How can the external auditing company(PWC) make a mistake and not find this out all these years. If it has been consistently missing all these quarters then its an 'incident' not an 'accident'.

• I guess most of these inflated amounts have been reported in terms of inflated revenues(both top line & bottom line) for each of the quarters. Auditors are required to validate the customer invoice amounts, receivables, outstanding amounts, bank statements etc and tally them with each other? How can a gap of tens of millions dollars each quarter not be noticed by the auditors?

• If a company claims to have $1.2B of cash reserves they need to report and provide proofs of how the amount is invested/maintained to Auditors and also provide it as part of their regulatory filings. How can a company conceal a whopping $1B cash surplus without showing proofs of investment?

• The additional revenue reported will attract Income tax. It will be interesting to see if Satyam paid tax on inflated amounts. Wouldn’t IT department/RBI scrutinize their bank accounts, Forex transactions, annual/quarterly reports to validate the tax collections?

Based on the above thoughts I feel that the auditing firm has received some kick-backs and is involved in the whole fudging exercise. There is no way this could have been pulled off without involvement of Auditor. I wouldn’t also be surprised if Satyam provided falsified proof for some of these claimed investments (Auditor could infact have guided Satyam on the same so that their bases are covered).

Next I am trying to explore what could be the possible motive behind this whole fraud. The obvious fact is that numbers were inflated to drive up the stock price. It’s a no brainer that it is just a matter of time before this is exposed and when it does get exposed the stock will have a freefall and might even lead to dissolution of company(as its happening now and as it happened in the case of Enron). I am sure Raju is smart enough to understand this. If so why would he try to take this undue risk especially when he is not planning to sell any shares when the market was high (as he has mentioned in his letter)? This leads me to believe that there is a more deep underlying cause than just propping up stock price. I am not sure what it could be, this needs further investigation. There is definitely more to it than meets the eye.

The whole story around pledging stocks to financial institutions and using that money to run the company (as stated in his letter) sounds very fishy to me. I have a feeling that he took that route to realize the value for stocks without selling them in the open market and panicking the investors (The other advantage also being that since these were mortgaged when the market was high he would have got higher amounts based on prevailing stock price at that time). I doubt if that mortgaged money made its way into Satyam operations. I’m fairly certain that at least a sizeable portion of that is stacked away safely most likely outside India. Here again the question that comes to my mind is when an individual is pledging stocks and borrowing upwards of Rs.1,200 crores($250M+) how did it not come under IT purview? There is a distinct possibility that IT dept/political big-wigs could have a hand in this.


To be continued.. Pls post your comments/feedback/thoughts on the same.

Social Networking

Social Networking seems to be one of the hottest trends in the tech space these days. The social networking space is really exploding and more and more people are jumping into it as we speak. Over the last couple of years Web 2.0 technologies have become lot more mature and integrated and its changing the way we interact with our network of friends and families. This is also changing the way companies operate and interact with their customers leading to the rise of a whole new area called 'Social CRM'. Check out the attached link on introduction to Social CRM. This was created by one of my friends.

The whole social networking area (Blogging, Micro-blogging, Video/Photo sharing, Social network sites like Facebook, Orkut, My Space etc, Professional networks like Linkedin etc) is all about personal branding and marketing. While these Web 2.0 technologies are very useful for keeping in touch with friends and for personal networking, I see a bigger role for these in the professional world. Like the reference checks of the yester years, companies are now checking the online presence/profiles of candidates before hiring. This practice is really catching on and the day is not too far out when personal branding would be one of the key factors influencing your career prospects and professional growth. Establishing a unique identity/brand and marketing should be a key priority for individuals as it is for corporates, this will determine how successful you are as an Individual.

In addition to personal branding having the right network is important. The social network is very powerful, It can help you develop your thought leadership and open up lot of opportunities that you never knew existed. So its essential that you have the right people on your network. Quantity doesn't matter, quality of the network is critical. Activating your network through thought leadership, interactions and discussion is key in order to reap the benefits.

Below is the 'Social Technographic Ladder' from Forrester. Check out their blog for more details. I came across this in one of the blogs and its a very interesting post. The below ladder is self-explanatory. I was in the 'Spectators/Joiners' level beginning of 2008 and over the course of year i have moved to the 'Collectors' level. I aspire to get into 'Creators' level this year. In fact this is one of the target areas I have set out for improvement this year.

Where do you see yourself in this ladder? Pls respond back with your comments.

If you haven't started your social networking journey yet better get into the bandwagon soon, else you will be a Dinosaur! Its better late than never.

Why is Petrol price high in India - An Analysis (Part 1)

The global crude prices have fallen more than 70% in the last few months from a high of $147/barrel in July to a low of $36 in mid Dec. This is a 5yr low for the crude price. In most countries that have market linked pricing the price of gas at the petrol pumps has come down by a similar margin. However in India there has hardly been any movement in price. Whatever hike the Govt implemented in mid-year (Rs.5/lt for petrol, Rs.3/lt for Diesel, Rs.50/cyl for LPG) has been rolled back partially (Diesel was reduced by Rs.2/lt only and LPG price has not be revised). The objective of this article is to analyze why the petrol price in India is still high despite crude prices being at 5yr lows.

As part of my research I checked out the following aspects. I will be detailing each of these below:

• Crude price movement in 2009 & Average crude basket price in India
  
• Pricing components of Petrol price in India
  
• Comparison of pricing components in India with pricing components in US
  
• Gross Refining Margins of OMC’s
  
• Profit/Loss of Govt owned Oil Marketing Companies(OMC’s) which control a 80%+ market share
• Govt policy- Administered Pricing Mechanism(APM)/De-regulation of oil industry

Crude price movement in 2009 & Average crude basket price in India

While the price of crude has reduced drastically over the last six months if you notice the attached chart(Source: CBS Marketwatch) a big chunk of the reduction has come in Q4, 2008 only. The price came below $100/barrel in early October, below $60 in November and below $50 in early Dec. Technically price has been below $100/barrel for a little over 2 months now. This needs to be taken into consideration for the timing of price roll-back. We will come back to this later in this article.

One more factor that needs to be considered is the Exchange rate. US Dollar has appreciated by close to 20% this year against Indian Rupee. While the crude price has gone down the OMC’s will be paying around 20% higher price in Indian Rupee terms due to the exchange rate.

India imports around 70% of our crude from outside and the rest 30% is produced locally thru upstream oil companies like ONGC, Oil India ltd etc. The crude sale price of these upstream oil companies is fixed and they sell oil to OMC’s at $55/barrel irrespective of international crude price. So the average price of crude basket of OMC’s will be lesser than market price of crude as around 30% of the crude is purchased at $55 fixed price. As an example if the market price of crude is $140 the average Indian crude basket price will be $114.5 (average of 70% crude at $140 & 30% crude at $55). The average monthly crude basket price for IOC for last several yrs (Average price of imported crude only) can be found here:

http://www.iocl.com/Products/CrudeOilPrices.aspx

You could use this to arrive at average crude basket price for IOC overall.

Pricing Components of petrol price in India

The pricing of the petrol in India is pretty complicated. I have detailed the same in the below table:

Based on the attached calculation the price of crude is only around 36-40% (based on how you calculate) of the total price that we pay at the pumps. There are way too many levels where we are taxing this needs to be simplified. Secondly there is lot of fixed price components in this. This needs to be changed to variable component as a % of crude or petrol cost so that it can vary relative to crude price. The current fixed pricing structure is beneficial for Govt whereby irrespective of crude price changes Govt get fixed revenue(easy for budgeting). At higher crude prices the overhead is reasonable/comparable to global standards however at lower crude prices the overhead is really high.

Comparison of pricing components in India with pricing components in US

In order to see how our petrol taxation compares globally I wanted to compare the various price components of petrol in India with US. Refer the attached chart for details.

Though the refining cost in India seems to be much lower than US in the attached chart in actual it is similar. Here refining cost if represented as a % of the price of petrol and petrol price in India is much higher than US. Hence the numbers looks skewed. In the same context our distribution costs are much higher than US.

At $65/barrel the average price per gallon of petrol in US is $2.6 & average price per gallon in India is $4.1 (arrived at based on above table). The gas price in US is around 35% cheaper than in India. Due to fixed rate structure of duties/tax on petrol price in India the gap will become bigger as the crude price goes below $65 and will become smaller as crude price goes above this mark.

To be continued. In the next part I will be covering about GRM, profit/loss analysis of OMC's, APM/de-regulation and my prediction on if and when gas prices would be reduced in India.

Happy Holidays!!

Satyam Debacle - Failure of corporate governance

The Maytas Infra and Maytas properties acquisition announced, and later cancelled by Satyam(SAY) earlier this week was a classic example of failure of corporate governance. I can understand the Chairman(Ramalinga Raju) wanting to buy these family companies at an inflated price for personal gains, however i am astounded that the board approved the purchase of these companies. They have some solid  people like Krishna Palepu (Harvard Business School), Vinod Dham (ex-Intel/AMD exec & father of pentium), Rammohan Rao (ISB dean) etc. as part of their board. How these guys bought into this whole idea is a big question and it will definitely impact their credibility in the market place. Alternatively were these guys out-voted by some of the other folks on the board? We would never know what happened in the backend.

If the decision to diversify into real estate (Sector affected by the current market conditions) was a bad one and it was precipitated by the artificial inflation of the price of these companies (almost 5x!!!!). Maytas properties price was pegged at $1.3 billion when the actual market value of its holdings is only around $255 million. This company is held by Raju's family and it raises serious questions around the credibility of Raju. Raju himself holds only little over 8% of Satyam and he was planning to use up around $1 billion of Satyam's cash reserves for his personal gains. If indeed the acquisition would have gone thru it would have led to Satyam ending up with $400M of debt from over a billion dollar cash surplus. The board should be fired for approving Raju's plan without doing the necessary due-diligence. In addition Raju should be sacked. The biggest irony is that Satyam won the ICSI National Award for Excellence in Corporate Governance earlier this year. They don't deserve it and should be stripped of that award.

The way the press release was handled during this whole ordeal was pathetic. Some of the terminology used like 'Risk in Core IT business' 'diversifying into real estate to derisk' etc can have some pretty serious repurcussions. It leads investors/customers to perceive that you are not doing well in the core business and would result in bad analyst reports/downgrades and customers looking for alternatives. It confounds conventional wisdom of sticking closer to the core and investing to improve your core capabilities during tough market conditions.

Here are some of the impacts that Satyam is going to face due to this incident:

Ø  Market credibility and reputation impacted

Ø  Downgrades by Financial analyst and possibly industry analysts as well

Ø  Loss of customer confidence leading to existing customers/prospects moving away in the near to medium term. I am positive that no new customers will want to do business with Satyam.

Ø  They will definitely lose some business in the next few quarters probably pushing Satyam into negative growth which again will have an impact on their share price/market cap

Ø  Loss of investor confidence due to credibility loss of the management/board & failure of corporate governance

Ø  Their stock has been hammered down and it has fallen more than 40% to around $7.8/share. Their market cap at the current price is $2.64B. They are an attractive acquisition target with considering that they have around $1B in cash reserves. I wouldn't be too surprised if someone mounts an hostile takeover bid for Satyam.

Ø  In the current market conditions some of the above factors can have a significant impact and may even lead to the fall of Satyam

This is a classic example of how a company can dig its own grave!! One of the lessons from this debacle is the importance of having strong corporate governance for sucess of the company.

2008 Economy & Stock Market Highlights

2008 will go down as a record year in the history. Most analysts and economists were predicting a slowdown in the economy and a soft landing earlier this year. However no one was even in the ballpark w.r.to the actual events. The complete world was taken by shock with the magnitude of the financial mess and global recession/slow down. There was unprecedented volatility in global stock markets, commodities like oil, Gold etc, Currencies, interest rates and a whole bunch of key economic fundamentals. This is expected to be the worst recession (some are even calling it depression) since the great depression in 1929. Almost all developed countries and key emerging/developing countries like China, Russia, Brazil, India etc are impacted in this global crisis.

Some of the key highlights/statistics from an economic perspective are listed below

ü All major stock markets down from their record highs in Oct 2007

o Dow is down almost 40-45% from its peak

o NASDAQ is down by around 45%

o S&P 500 is down by 40%

o BSE Sensex is down 55-60%

ü S&P 500 market has lost $6.17 trillion dollars in Market cap in the last year

ü S&P broad market index which has around 11,000 stocks in developed and emerging markets has lost around $17.7 trillion YTD

ü The entire Investment banks segment has been wiped out – Bear Sterns & Lehmann doesn’t exist anymore, Merrill Lynch has been acquired by BoA, Morgan Stanley and Goldman Sachs have converted into commercial banks

ü After Lehmann collapse the entire global credit market was frozen and there were massive money injections from multiple governments (US itself is investing over a trillion dollars this year to re-energize the market)

ü Several large & reputable US financial institutions have failed – Wachovia, Washington Mutual , Fannie Mae, Freddie Mac, AIG etc.

ü 25 US banks have failed so far this year and has been acquired by FDIC

ü US Federal Reserve interest rate is at a 50yr low of 0.25% with today’s cut

ü Oil started our 2008 at little under $100/barrel and reached a peak of $147/barrel in July and dropped to $40/barrel in Dec

ü In the last 15 months Gold which is typically the most stable asset went from <$700/ounce to a peak of $1020/ounce and is now back to $800/ounce

ü US Dollar has bucked a multi-year trend of weakening against global currencies and has appreciated against major global currencies by almost 15-20%

ü The US auto industry is in Doldrums and giants like GM, Ford and Chrysler are on the verge of going bankrupt

o GM’s stock is at a 80 yr low

ü US unemployment rate has gone up to 6.7% and number of unemployed people has increased by around 2.7 million during this year

ü All major global economies are either in recession or in the verge of getting into recession

o Ireland, New Zealand, France, UK, Germany, USA, Japan, Italy, Singapore, Spain to name a few

o China growth is expected to slow to 7.5 – 8 %. This is its lowest since 1990.

o India growth rate is expected to slow to 7.5% (from the 5yr average of close to 9%)

After reading the above the first question that comes to mind is have we seen the worst of this crisis?

I think we are in the middle of this crisis what we have seen so far is the first half of the crisis. There is more of financial crisis that is yet to come, Lay-offs are just starting out and has accelerated in the last 3 months and it will continue thru most part of 2009. There will be budget and spending cuts leading to reduction in customer spending and consequently impacting a wide range of industries etc. To cut to the chase the current scenario will continue thru the first half of 2009 and should start flattening out as we go thru the year. I expect the stock market to be volatile and fluctuate within a band during most of 2009 and start the climb up in 2010.

Is this shake out/recession good for us?

At the outset some of the news we hear and what we see in news would seem scary. However this is part of the economic cycle. The best part of open markets/economy is the self-correction. Companies start becoming inefficient and add lot of fluff over the years. These economic downturns are the times when some of the weak players are eliminated and strong players become more efficient and focused. While we go thru lot of pain in the near term it is good from a longer term perspective. Stock valuations, real estate valuations etc are very attractive now and while there is a little down side to it in the near term over the medium to long term they will start climbing up and this is a good time to start investing.

Stop worrying & start investing!!!