Shooting in the Dark: How Much Is Satyam Worth?

March 26, 2009

A business magazine recently wrote a cover story about A.M.

Naik, chairman and managing director of the US$7 billion
engineering conglomerate Larsen & Toubro (L&T). It was titled
"The Great Gamble." That's a curious phrase to associate with a
solid company and a man who has been with the same
organization for the past 44 years and at its helm for nearly 10.

Naik's new sobriquet is courtesy of Satyam Computer Services, a

company that has seen a massive fraud orchestrated by founder
and chairman B. Ramalinga Raju. When, in mid-December 2008,
Satyam announced a US$1.6 billion deal with sister company
Maytas, the scrip plunged from Rs200 plus (around US$4) to Rs150 (US$3), a 25%
drop. In New York, the ADRs (American Depository Receipts) fell 54%. Naik seems to
have seen in this a buying opportunity. Through its investment vehicles, L&T bought 4%
of Satyam for around Rs140 (less than US$3) a share.

After that, L&T plunged even deeper. When the full dimensions of the Satyam scandal
broke, and the share fell to as low as 12 cents, L&T bought another 8%. Today, it holds
12% of the company and is one of the major bidders vying for the beleaguered firm. But
it is probably as clueless as any of the others on the real state of affairs at Satyam. "The
problem is that there are so many imponderables," says Ganesh Natarajan, chairman of
the National Association of Software and Service Companies (Nasscom) and CEO of
Zensar Technologies.

Another bidder -- Tech Mahindra, part of the US$6.7 billion Mahindra Group -- has also
burned its fingers through dabbling in the Satyam affair. Rating agency Fitch has
withdrawn its coverage of the company after it announced its bid. According to a Fitch
statement, "Given the uncertainties regarding the final closure of the (Satyam)
transaction, the financing, and consequent financial impact on Tech Mahindra, the
agency is unable to take a rating action at the time of withdrawal."

L&T, Tech Mahindra and B.K. Modi's Spice Group have officially announced they are in
the race. They have put in expressions of interest (EoIs) as required by the government-
appointed Satyam board. They have also lined up the Rs1,500 crore (US$300 million)
cash that the board has mandated that all bidders show before they can proceed to the
next round.

It is not known how many companies have submitted EoIs; no one else had declared
themselves in the fray at the time of writing. There are reported to be some
multinational IT majors, private equity players and domestic IT companies. It is unlikely
that all will come out in the open given the de-rating of Tech Mahindra and the
hammering the L&T scrip has received on the stock markets. According to Calcutta-
based daily The Telegraph, "More than 60 entities were reported to have evinced interest
after Satyam kicked off the bidding process on March 9. However, the number dropped
sharply when the bidders were asked to submit detailed EoIs. An indication to this effect
was available when Nasdaq-listed iGate quit the race."

The iGate experience shows some of the difficulties in bidding for Satyam. "Initially, we
were interested in Satyam because we felt that it had a lot of good customers and good
employees," explains Phaneesh Murthy, CEO of iGate Corp. "Then, because the process
was taking too long and, more importantly, we were given to understand that we would
not have any new financial information when the auction happens we lost interest.
Suddenly, a few days ago, we got a call saying that we would get more financial
information but the only way to get that was to put in a formal EoI."

Interest was reignited, but iGate backed out nevertheless. "While there is no one
particular reason, it is the totality of concerns like sliding revenues, unknown margins
and large liabilities that made us pull out of the race," Murthy told India
Knowledge@Wharton after making the decision. "Through market intelligence, we know
that there are enough customer exits happening at Satyam. While the value erosion and
extent of liabilities were a concern, it was the totality of concerns that influenced our
decision. We did not go to the stage of getting formal financials from Satyam's board.
However, we had prepared our own model of financials and in that model it was difficult
to get a reasonable return for any investor. Our private equity fund partner had no role
or influence in our decision to pull out."

Lots of Qestions

Murthy's explanation contains all the questions that Satyam bidders, analysts and the
media are asking. In a nutshell:

 How do you value a company whose financials are unknown and whose chairman
admits he has been cooking the books for seven years?

 Are there really good customers and good employees? How many have jumped
ship and how many more are planning to do so?

 Is the process taking too long?

 What about the huge liabilities that could arise out of the class action suits filed in
the U.S.?

 Why are private equity players interested in this deal? Why are multinationals?

 Has the action of the regulators so far been adequate? Conversely, have they
been bending over backwards to save Satyam?

 Finally, do we need changes in laws to make future resolution of such situations

easier? Does India need an equivalent of Chapter 11 bankruptcy in the U.S.?

Opinions differ widely about possible answers to these questions. Consider valuation.
The winner is supposed to end up with a 51% stake in the company through a
combination of new shares (31%) and an open offer (21%) to ordinary shareholders.
Satyam's current market capitalization at around 90 cents a share is approximately
US$600 million. This is the rationale for the US$300 million (the market value of 51%)
the board has asked bidders to arrange as a pre-qualification for being allowed to bid.
But is 90 cents a share a reasonable price? The stock had a 52-week high (pre-scam) of
US$11. It dropped to as low as 12 cents. How do you value such a company? What are
bidders paying for?

"Satyam's strong client base and its large workforce," answers Ajay Garg, assistant
professor of finance and accounting at the Indian Institute of Management Lucknow
(IIML). Adds Kishor Ostwal, managing director of CNI Research, a Mumbai-based stock
market analysis and data provider: "The buyer is still getting business close to US$1
billion and, going by IT operating margins, he can earn US$100 million to US$120 million
a year. Even as some clients are leaving or contemplating leaving, if Satyam goes into
reputed hands with enough IT bandwidth, then retaining existing clients or scouting for
new clients should not be a problem. The buyer is just trying to leverage the business
and the market cap at which the business is available."

"Valuation models for IT services firms are heavily skewed towards the quality and
quantity of their human capital asset base," says Ravi Bapna, associate professor of
information systems at the Carlson School of Management and executive director of the
Center for Information Technology and the Networked Economy (CITNE) at the
Hyderabad-based Indian School of Business. "Thus, Satyam's biggest asset is its high-
quality workforce, followed by its order book and related tacit knowledge about its
clients' business processes. I would count its physical infrastructure as a distant third,
given oversupply in the real estate sector. Unfortunately, post the debacle, the brand is
more likely to be viewed as a liability. Unlike physical assets, human capital is not
subject to 'lock-in' and can easily be lured by a potential suitor who does not want to
take on the associated liabilities. While such a scenario should, under normal
circumstances, attract bargain-hunting type valuations, one can never underestimate the
hubris factor in the Indian context."

"While it is true that the Satyam name has been hit badly, and employee morale and
customer interest is very low, it is certainly not an organization that can be completely
written off," says K. Raman, practice head (telecom, media & technology) at the Tata
Strategic Management Group (TSMG). "Bidders are looking for an enterprise within
which they can create large future value at an extremely attractive valuation today.
There is still a reasonably large client base intact within Satyam, new orders are being
booked and there are reasonably large acknowledged receivables that the company is
looking to collect. All this indicates that if the management falls in place, then one can
probably have an entity which is viable on its own going forward.

"Also, the way Satyam's business has been structured in the past may be of interest to
certain types of acquirers. For instance, Satyam has typically been more focused than its
peers on package implementation and ERP, which can be a good fit for an acquirer who
is looking to scale. Similarly, Satyam has a reasonably strong presence in the Indian
market especially through its government contracts. This can also be a good stream of
revenues going forward."

"Customers are happy with the work that Satyam managers have done for them in
terms of sheer capability," says Natarajan of Nasscom. "A lot of mission-critical
applications are being done and it is always messy to migrate that to another provider.
What the bidder will get is good employees and good customer names. The bidder -- if
he comes in quickly and has a credible management team which can talk to employees
and customers and show that the company is viable -- can convince them to stay on. But
the worry is that in a period of uncertainty, people will obviously not wait forever."

Rewards vs. Risks

The exodus has already begun. The Economic Times says that 3,500 of the 50,000
Satyam employees have left in the past one month. But it also quotes chairman Kiran
Karnik (who was roped in by the government to rescue the company) as saying that this
was normal attrition and no cause for alarm. The Economic Times also reports that
Satyam has lost 46 customers out of its roster of around 600. Those in the process of
migrating include Abu Dhabi Bank, Applied Materials, Emerson, Kansas State Bank,
Nissan, Sony, State Farm Insurance and Telstra. The Business Standard newspaper
estimates current revenues to be around US$1.4 billion to US$1.6 billion, against the
US$2 billion plus pre-fraud estimates. Ostwal of CNI puts it at a US$1 billion, and there
are skeptics who say the figure could be whittled down even further the longer it takes.
Could the sale process have been speeded up? "The bidding process is going just fine,"
says Natarajan of Nasscom. "The board just has to get it done as soon as possible. They
need to now set a final deadline. Otherwise, it will be a continuing ping-pong battle.
Given all the moving parts, the bidding process is as good as it can get." Concurs Garg
of IIML: "The government acted quickly when it dissolved the old board and appointed
fresh directors in a bid to stabilize the company and restore confidence."

Garg is doubtful, however, that equal alacrity has been shown in the case against the
previous Satyam management. "The legal case is taking a very long time," he says. "But
that has always has been the norm in India. A lot of frauds and crimes take place
because the legal process takes too long to punish the culprits." Adds Ostwal of CNI:
"Although the media and others may think that the government and the regulators have
acted fast by reorganizing the board of Satyam, initiating the bidding process and
arresting the promoters, the fact remains that the case is mired in mystery. This leads
one to believe that, as in other cases of financial misdemeanors in the country, this time
also the culprits will walk free."

The continuing mystery, says Ostwal, has added to volatility of the Satyam share and
given some bidders too much leeway. "It has given enough room for speculation which
has helped players in this stock," he says. "It was on record that [L&T's] Naik had said
that he knew more than minority shareholders in the case of Satyam, which is against
the spirit of the law. Normally, anybody bidding should have been asked to maintain
silence for at least a month before the bidding process -- as happens during IPOs (initial
public offerings). The varying nature of statements from regulators, the directors of
Satyam and interested bidders like [B.K.] Modi who tried to quantify the liabilities arising
from the suits in the U.S. have all led to increased volatility and price speculation by
operators and people in the know."

Modi of Spice had questioned the market valuation of Satyam; he felt it was much too
high. He also told the media about a report from the group's legal advisors, Gibson,
Dunn & Crutcher of the U.S., which stated that the liabilities arising out of the class
action lawsuits could range between US$440 million and US$840 million. In addition,
Satyam faces a forgery case filed by U.K.-based mobile solutions firm Upaid, which
comes up for a hearing in the U.S. in June 2009. The estimated liabilities of this case
could be as high as US$1.1 billion. These numbers far exceed Satyam's current market
valuation of US$600 million. "One can really never put a figure on class action suits and
this also will get factored in the valuation of the company," says Natarajan. "You should
actually be paid to take Satyam," says an equity analyst who does not wish to be
quoted. Most research houses have now withdrawn their official coverage of Satyam.

MNCs and Private Equity

Why are multinationals and private equity (PE) players interested in bidding? There is
likely to be a three-year lock-in for whoever wins the bid, so PE, in particular, seems an
odd contender. "Typically, one does not associate PE players with lock-in periods but,
then, three years is really not too long," says Raman of TSMG. "They do stay invested in
companies for this period of time." Natarajan has a different explanation. "PE players are
probably fronting for larger multinationals," he says. "If PE players come in by
themselves and try to get in a team, it may not necessarily be good for the company.
What Satyam needs right now is not just money but also a strong management team
and stability. There needs to be an umbrella of credibility and trust."

This is something the multinationals could bring; the Indian IT firms, which are
respected names internationally, have declared they are not interested. "MNCs would get
scale in India, [including] capabilities and customers," says Natarajan. Explains Murthy
of iGate: "It will give them a larger footprint and employee base." Adds Ostwal of CNI:
"Over the years, as margins in IT hardware and peripherals decreased, big players like
IBM and HP have been eyeing different revenue streams. In fact, for IBM, IT services
constitute an ever-increasing pie of its total revenues. Satyam would be a perfect fit for
IBM, which will give it capabilities and a skilled workforce. It can then leverage those
along with its brand to create a huge revenue source. HP, on the other hand, also stands
to gain as it can then transfer all its IT services' needs in-house to Satyam and slash
costs as well as acquire a new revenue stream." Raman of TSMG agrees. "While both HP
and IBM have a large presence in India, they have also stated their intentions of scaling
this up further," he says.

New Rules of the Game

The Satyam bidding process has raised some questions that go beyond the company and
the fraud its promoter has perpetrated. In order to enable an easier salvage operation,
the Securities & Exchange Board of India (Sebi) has changed the rules of the game. For
instance, the norm for pricing an open offer is that it should be the average of the past
26 weeks, or two immediately preceding weeks prior to the open offer, whichever is
higher. The 26-week price, the higher of the two, is way above current levels. "The floor
price for the open offer would have been very high had the rules not been changed, and
at that price no bidder would have been attracted," says Garg of IIML. The rule has now
been relaxed and the buyer can make the open offer at the same price at which he is
issued the new shares. There have been other relaxations to allow the bidding to
progress smoothly.

This has been by and large welcomed, particularly as it will apply to similar cases in the
future. "The changes made by Sebi are absolutely warranted," says Murthy of iGate.
"Otherwise, in such cases, no one can step forward to rescue the company." Ostwal of
CNI disagrees. "SOS changes by Sebi are not really warranted," he says. "In fact, it has
become a habit with the regulator to make changes on an SOS basis. First were the
Promissory Note rules, then the disclosure of pledged shares, and then the Sebi
Acquisitions and Takeover guidelines." In his view, some foresight would have made
such fire-fighting unnecessary.

What is necessary -- and not just for Satyam-type cases -- is a bankruptcy law like
Chapter 11 in the U.S. "I am convinced that India needs a bankruptcy law," says Murthy
of iGate. "It does help so many companies to restructure themselves and return. The
entire airline industry in the U.S., at some point, has been in bankruptcy. They would not
have been able to survive if it had not been for the bankruptcy protection that they
enjoy. The asbestos litigation in the U.S. would have killed many companies. But they
were able to reorganize themselves under Chapter 11 and come back." Says Natarajan:
"We definitely need a bankruptcy law. In fact, the strength of Silicon Valley is that if a
company fails, it is allowed to fail fast. Here, shutting down the company or restructuring
it financially is quite a problem. India certainly needs to look at the American bankruptcy
law and try and create something like that."

Ostwal of CNI disagrees. "India does not require bankruptcy laws at the moment," he
says. "India is still an immature market going by the way in which markets and
regulators are functioning. Ahead of bankruptcy laws, we require physical settlement in
derivatives, we require scrapping of creeping (acquisition of shares by promoters) limits
of 5%, we require the 15% acquisition and takeover limits to be raised to 25% and,
overall, we require a fair climate for hostile takeovers."

That's a prescription for the future. For today, everyone is keeping their fingers crossed
that things get sorted out soon at Satyam. As Murthy of iGate notes: "The longer it
takes, the higher will be the erosion in asset value."