Deepak Shenoy

Three Investor Lessons from the Satyam Scandal

If I conveyed the impression that I thought Indian companies were "safe" - I apologise. That was not the intention. My point was that Satyam was a case of fraud - it doesn't happen in India regularly, just like you don't get an Enron everyday. (Maybe right now, when they come out the woodwork..)

This is really not about American investors knowing India or not - even if they did, like many Indians do, Satyam would be a dramatic surprise.

But in general, yes, one needs to know about Indian laws, that we allow our companies to defer tax reporting till the last quarter, that we let companies take non-hedged forex losses on a balance sheet (and then not report balance sheets), that our insider trading laws have very lax enforcement etc. And I learn about American laws everyday - how companies can buy back shares when they continue to throw out options or share sales, how mark-to-market can be thrown out the door for a while, how naked short selling continues to be unregulated etc.

Even enforcement is different: Madoff does away with $50 bn and is out on bail, while Raju does $1.2 bn and is in jail (bail was refused). In other cases, it might be the exact opposite (heck, Raju might never get convicted!)

Having said that we all get the frauds, some blatant and some subtle.

Three Investor Lessons from the Satyam Scandal

This is rich. That SAY's scandal was "simple" and Enron, Worldcom or Tyco "complex" is beyond believable. When it did come out, Enron's scam seemed simple; after all, what they did was funnel money to Fastow's company, and hide the real risk. Sure some of it was in financial statements; but that was just the tip of the iceberg, and only helpful insiders cracked it for us.

Tyco's scandal was probably the closest. Mangement pilfered cash, and they overstated cash flow.

Satyam's hiding of the cash flow through "creative" measures is probably going to turn out to be complex as well, later. And this kind of fraud, it will be found, is likely to happen in the US as well.

Having said that the disclosure norms in India are not exhaustive or specific enough, and companies still need not disclose balance sheets and cash flow statements at the end of each quarter. While the US SOX is nowhere close to successful, but we definitely need more rigorous norms, peer audits, and verification procedures in India.

But the thing is: Such frauds will happen all over the world. After this bank rescue moral hazard, it will only get worse; we've seen excesses already in AIG, and we're likely to see more conventional filching by the newly crowned "bank holding companies", which by definition includes everyone except you and me.

I wouldn't adopt a holier-than-thou attitude on regulation; definitely nt after the recent past. That there is a problem is accepted, that there won't be a similar one in the US is just laughable. Though if anything I must admire the massive amount of reliable data available in the US on everything not in corp balance sheets - CDS prices, real estate, construction, jobs, and even architectural billing! At least that gives you a way to assess an industry.

Three Investor Lessons from the Satyam Scandal

This is rich. That SAY's scandal was "simple" and Enron, Worldcom or Tyco "complex" is beyond believable. When it did come out, Enron's scam seemed simple; after all, what they did was funnel money to Fastow's company, and hide the real risk. Sure some of it was in financial statements; but that was just the tip of the iceberg, and only helpful insiders cracked it for us.

Tyco's scandal was probably the closest. Mangement pilfered cash, and they overstated cash flow.

Satyam's hiding of the cash flow through "creative" measures is probably going to turn out to be complex as well, later. And this kind of fraud, it will be found, is likely to happen in the US as well.

Having said that the disclosure norms in India are not exhaustive or specific enough, and companies still need not disclose balance sheets and cash flow statements at the end of each quarter. While the US SOX is nowhere close to successful, but we definitely need more rigorous norms, peer audits, and verification procedures in India.

But the thing is: Such frauds will happen all over the world. After this bank rescue moral hazard, it will only get worse; we've seen excesses already in AIG, and we're likely to see more conventional filching by the newly crowned "bank holding companies", which by definition includes everyone except you and me.

I wouldn't adopt a holier-than-thou attitude on regulation; definitely nt after the recent past. That there is a problem is accepted, that there won't be a similar one in the US is just laughable. Though if anything I must admire the massive amount of reliable data available in the US on everything not in corp balance sheets - CDS prices, real estate, construction, jobs, and even architectural billing! At least that gives you a way to assess an industry.

Indian Banks Still Interesting

Indian banks must place at least 24% of their deposits into government securities. G-Sec yields have dropped about 200 basis points in the last quarter, and the bonds have gone up nearly 20% in price, in the quarter.

Treasury income is likely to be through the roof, but they can't book all of it (unless they've actually got the profit home by selling stock). They can use part of the mark-to-market profit to set up provisions for potential losses elsewhere (like equity etc.)

It's likely that HDB and IBN get some leeway on treasury which has been losing money the last couple quarters. Indian PSU banks, not listed in the US, are in much better shape and much lower in price. (relatively)

Indian Banks Still Interesting

Indian banks must place at least 24% of their deposits into government securities. G-Sec yields have dropped about 200 basis points in the last quarter, and the bonds have gone up nearly 20% in price, in the quarter.

Treasury income is likely to be through the roof, but they can't book all of it (unless they've actually got the profit home by selling stock). They can use part of the mark-to-market profit to set up provisions for potential losses elsewhere (like equity etc.)

It's likely that HDB and IBN get some leeway on treasury which has been losing money the last couple quarters. Indian PSU banks, not listed in the US, are in much better shape and much lower in price. (relatively)

Cheap Chindian Cars and High Priced Oil Don't Mix

Btw, India pays more than the US per "gallon" of petrol, despite what people think of as huge subsidies, because gas is taxed to hell and back. A liter of petrol costs Rs. 55 in Mumbai, and a gallon is what, 3.5 liters? That, at Rs. 43 to a dollar, gives you the $4 petrol we are ALREADY paying. And guess what, this has always been the case - on a comparison we have always paid more than the US for petrol (okay, we do pay lesser for diesel, but the small car you talk about is petrol for the $2500 price)

Now let's take this $2000 income person. Will probably not drive more than 4000 km. a year. With the fuel efficiency of the small car, they'll pay some Rs. 2.2 per kilometer (25 km/lt). Say Rs. 3 including maintenance.

I think by $2,000 you actually mean someone earning more than Rs. 1 lakh (Rs. 100,000) per year which is $2500 per year. At least that's what I think (we don't think in dollar terms, so a lakh is like the lower minimum) And this is post tax because tax doesn't hit you till you earn at least Rs. 150,000 a year.

On a Rs. 100,000 salary, the cost of getting the car, at $4 per barrel gas, is 12%. That's not much more than the 11.5% that the US spends on gas:
blogs.wsj.com/economic.../

Note then that Rs. 100,000 is the absolute lower end of middle class. If you take tax payers (of which there are officially only 33 million, or 3.3 "crore" in our terminology) who earn a minimum of Rs 150,000 that percentage will diminish. At say 300,000 a year, 8000 kms and 18 km/lt cars, we are speaking of about Rs. 26,000 in [only] gas expenses, which is 9%. I would imagine that people with less than 300,000 a year would only buy two-wheelers which give some 60 km per lt (that's about 130mpg) and the corresponding fuel cost as a % of income is considerably lower.

Of course all this is set to change dramatically. With the highway upgrades nearly done, you can drive the length of the country easier and with power, water and phone/data spreading out people will be willing to drive, to work and for pleasure. Then, the $4 per barrel gas won't make sense - but by that time - a year or so from now - gas may not be at that level. Plus, in a few years, $4 at todays rates is likely to mean Rs. 30 or Rs. 25 with India's growth reflecting in the drop of the dollar against the rupee. (The rate is Rs. 43 now)

Note that government employees form the base of the "middle class" - i.e. they are lower paid that the equivalents in the private sector. The government just raised their minimums to Rs. 10,000 per month and that does not include typical perks like conveyance, phone bills and allowances.

And finally, consider that cars can run on compressed natural gas, which is cheaper, burns better, and is less polluting. India has large reserves of CNG as well, and there are pipelines being built to distribute it across the country. If it becomes a fuel of the small car, then the entire equation can change - where, coupled with a falling dollar, even 2x or 3x growth in car ownership, miles driven or cost of gas may not impact spending power.

What you might not have accounted for is that Chindia can use more efficient fuels before they become a "standard". Kinda like cellular phones.

And kunst: when you make the supply of dollars unlimited, the dollar will not be the currency of oil.

Bangalore Blasts Threaten Indian Outsourcing

Aw c'mon now - don't panic on hearing some bits and pieces. None of this stuff was even CLOSE to the IT corridor in Bangalore and even where the "bombs" were placed, there wasn't too much traffic . What was used was gelatin sticks - commonly used by quarrying miners, some of whom don't like the new government that's in a few months ago. None of the blasts were big enough to even cause more than a small dent in a car - the only unfortunate victim was hit by external shrapnel.

Not to say that this isn't an act of terror - oh it was fully intended to terrorise - and we will prevail over the perpetrators. But it's ridiculous that people all over the world get taken for a ride, including our own silly media.

After 9/11 did individual companies beef up their security? Not really. America as a nation did. And this time India as a nation will be up to the task - so that every little company doesn't have to go nuts. Yes continuity is an issue and as far as I know terrorism is the last on the list of potential issues for continuity, most common of them being submarine cable breaks, power outages and time zone turnarounds.

I may not subscribe to the great outsourcing story India has, but to say that companies must be worried now, after this incident, is way over the line. By saying so you are simply giving in to terrorism. India has prevailed and it will, again.

Sorry but there are times to be worried about terrorism. This is not one of them.

Why the U.S. Credit Crunch Will Not Affect India

I live in Navi Mumbai and travel a lot to Gurgaon and Bangalore, and keep tabs on real estate in both places (relatives and friends are investors here). Prices are coming down and supply is at phenomenal levels. Ghost buildings (complete but zero occupancy) are the norm here in Navi Mumbai and gurgaon and outer bangalore head that way. CBD in Bangalore is starting to crap out - deals are just not happening.

Even in Mumbai deals have fallen though, auctions have failed and prices are dropping fast despite builder cartels vowing to keep them stable.

Gurgaon and Dwarka have a massive oversupply coming up and you can see this happening as builders delay possession (lack of final payments because investors aren't finding buyers).

Real estate loans are comign down - growth slowed to 20% last quarter, and with a CRR hike, rates stay high, andloan offtake slows.

We have our own version of subprime - if people default here, banks have a long long foreclosure process, and recovery can take years.

It may not be US Subprime that affects India - it was never that, we had our own bubble - but the bust will typically take 5 years before growth starts again. Cycles in India have been 10 years long - the last highs were 1985-87, then 1994-96, and then 2005-07. I expect the bubble to have bust completely by 2011.

But it's a non transparent market, so we will only know much after the fact.

India's Selloff: How Bad Can It Get?

I'd written about this at:

blog.investraction.com...

As of Feb 7, the Nifty EPS grew only 13%. Dividend yield in India has always been of the order of 2% or so so let's leave that out. The P/E then was 22 trailing.

The Nifty was at 5133 at the time, down a staggering 1000 points from the Jan highs.

As of today we're at 4600 on the Nifty, a further 500 point drop from when I wrote the article - another 10%. Though to be honest this 10% has happened in the last one week.

I'm still confident we'll recover after a few years, but bottom fishing should happen at the 3500 levels on the Nifty (corresponds to 12000 on the Sensex). My first buy point is 4000 (14,000 Sensex).

Disclosure: Short the index. (Was not short when I wrote the article)

India is Thirsty for Energy: Will the Bulls Take Notice?

Power stocks have had their runups recently, with P/Es going over the roof. Two big recent IPOs have whetted demand - Rural Electrification Corporation (which is a utility financier of sorts) and Reliance Power (which has projects for 28,000 MW production by 2015) RPower isn't doing all that great on the bourses, with all the drama around it, but at current prices it's still quite expensive.

Other listed stocks are Reliance Energy, Cairn Energy, Tata Power, GVK Power, JP Hydro, Suzlon Energy, Areva T&D, and NTPC. NTPC is the biggest player - 27,000 MW of power today - and is at a reasonable P/E of 23, most of hte rest are 30+.

There are power finance and trading companies like PTC and PFC, equipment manufacturers like BHEL, BEML, Siemens, Ing Rand, Bharat Forge etc.

Suzlon, Areva and JP Hydro are clean energy vehicles, and wind energy already gets a 150% depreciation benefit in tax (A huge number of windmills, owned by private parties and operated by Suzlon, have come up to take advantage of this law)

Apart from this there's Moser Baer who are getting into solar cell manufacturing. That's another huge business, and has tax and other benefits attached (homes with solar get a discount on their regular electricity bill etc)

With India's large local gas finds there isn't too much of a problem with supply, and in the next few years there is likely to be a huge surge in power production.

Now for the power plants, there are PPAs in place but given the populist politics there is also significant counterparty risk. (Remember in the Enron plant, the Maharashtra govt. just refused to honour the PPA) This should change with more home grown players who know how to work the government.

India will soon get a regulated energy trading exchange (restricted to only producers and utilities). That will alter the landscape but will take time.

This field is overpopulated and is prone to oversupply (a very good thing for consumers). Unless the grid stretches out to those that need it, reduce T&D losses (there is nearly NO research in India, and no player is funding research either) and contain theft, the supply may only benefit urban consumers. That means huge competition for cities and no benefit to the rural folks who really need it. I hope the coming recession will draw focus to such issues.

Seeking Alpha in Indian Real Estate

Prices are already going down in India (though urban real estate and condos are hugely valued and people tend to pay huge premiums as compared to the US, even in a slump). Specifically, in Bangalore panic pricing is setting in. Even in Delhi and Mumbai prices have slowed down and there aren't too many transactions happening - both in commercial and residential real estate.

I'm in India and I can short them all - but I just don't think it's right to do it now. The national budget, usually a big important thing here, is up on the 29th and could contain sops for the sagging real estate sector, or for real estate investments in general. 29h is also the first day after the current month's futures expiry so if I had to short, I'd choose the end-of-day of the 29th to start.

Are Indian Stocks Getting Too Far Ahead of the Pack?

The Sensex has a trailing 12 month PE of 23.5. Earnings season is just starting so at current levels PE will come down. Why will earnings increase? Most of the non-IT pack based Sensex companies (Reliance, Bharti, Tata Steel) have foreign loans (either as ECBs or FCCBs) which are rupee adjusted every quarter, and the dollar is down about 2-3% from last quarter (Note: in Q1 - Apr-Jun - the dollar was down 5-7% adn resulted in humongous forex gains as other income) Top level IT companies are hedged (at least for hte last quarter) and will probably squeeze their earnings through.

Natural growth, hedged and other forex gains look like they will override the lackluster performance by auto, and the losses incurred by the public sector oil marketing companies.

With the rapid increase in oil prices, refineries are bound to make a killing if they (like the larger ones in India) process heavy crude. Estimates are that margins will be higher than $15 a barrel for hte quarter.

Yet, this is all going irrational, because looking one year ahead or two isn't quite that great. IT companies hedge themselves for like one or two quarters, that's it. Forex gains are other income, but there is a slowdown in the growth of operating income, evident last quarter. High interest rates are affecting interest rate sensitives, though we're easily ignoring that for all the banks.

Furthermore everyone thinks there's no "subprime" problem in India. But hear this piece: Since there's no credit quality checking method in India, all home loans are granted on the basis of paychecks and bank statements. A large part of these loans are taken by people who buy from builders before the house is constructed, a phase that can take three-four years. (Most such houses have been delayed, in my knowledge)

Indian tax laws do not allow tax deductions for principal repaid BEFORE the house is complete, so what do the banks do? Offer "pre-EMI" - meaning pay only interest until the house is complete and when you get possession, start paying back the principal.

These are ARMs but what resets in general is the tenure of the loan, not the payment, so everyone is happy. Until the tenure becomes unmanageably huge, so they have to raise the monthly payment.

Interest only loans, with a potential spike in payments required, and high interest rates prevailing...sound familiar?

If the dollar keeps going downwards, IT employees aren't going to get the huge increments they're used to. Asset prices here (which are typically 5-10x annual salaries) are already slowing down and flippers are starting to find their shoes. Some of the top banks have indicated higher default rates on housing loans; and rates are currently 12% or higher.

I think we'll be hit, except we'll only know after the event. But for now, enjoy the run - nothing better than to watch as your portfolio multiplies itself.

How Much Longer Will Indian Outsourcers Offer Cost Advantages?

I'm in Bangalore where the "maximum" for 10 years of experience (equivalent to the 120,000 a year salary in say Northern California) is about 20-25 lakhs. (2-2.5million rupees) Your mileage may vary of course.

Also it's not just about quality. The time differences is a huge issue in my opinion. Secondly communication skills vary, and the best communicators (in India) demand and get far higher salaries. Thirdly, process management is great for the lower cost jobs, but innovation is more important for moving up the value chain. We have not yet demonstrated our prowess in that field, at least not in the outsourceable dimension, if there is such a thing.

I don't think you can outsource innovation unless you can outsource ownership as well. Innovation comes from the ability to benefit from the ends, not the means.

IMHO, what will happen is that eventually there will be balance sheet transfers. Meaning a division of a big company gets transferred over to Mr. Wipro or Mr. Infosys. This then generates future cash flow, and then the Indian company can choose to have American Employees, or Indian employees or use people in Mexico, Argentina or Philipines - makes no difference.

Now they're competing with HP, IBM and the like, which are a) more experienced in deal making, b) also have offices in India and other lower cost countries and c) have far bigger balance sheets and deal absorbing leverage.

From a stock perspective this means a hit to P&L upfront, dilutions or fund raising if necessary etc. If they go down this route (they have to, in my opinion) we will have to see how they pan out, since they haven't done this in any significant way earlier.

Another thing is to spend money on a product framework that could be cross-sold among customers. It needn't be a software product - those can't be cross-sold effectively - but could be things like TPA services or wholesale agency networks for insurers, deal syndication for banking (buy prosper.com!) and so on.

This is now an acquisition based process rather than the plain old gimme work and I'll do it. It's more like "We know your process well enough to take it over,manage it, give it to you for cheaper than you pay right now, and even use it to cross sell to others". Different ball game, different rules. We'll see how it pans out.

Wipro's Infocrossing Acquisition Could Herald A New Age of Buyouts

IFOX's cash flow is here:
finance.yahoo.com/q/cf...;annual

Net cash flow is about 5.4 million. Even if you take out the "sale purchase of stock" which could be a stock option issue, we're talking 11 million or so. It doesn't add up to 400 mm.

Considering that in India you can get interest of about 6% post tax on free cash, Wipro just gave up $24mm in interest income per year for a company that delivers $8mm in net profits. Assuming it doubles IFOX's profits in 2007, and grows 30% from there, we are talking about 16+21+27+34=98 million in three years of added up netprofits which we can say is equivalent to the free cash flow. Wipro can earn $107 million compounded interest post tax. That means it'll take more than four years to break even on this deal just considering interest (not considering opportunity cost). Not very nice, honestly.

But someone please tell me if my assumptions are way too conservative. Should I consider doubling profits every year? Even that would take two years to break even on interest lost.

Which IT Outsourcing Company Gives Maximum Return on Covered Calls?

Actually, you would write an OTM (out of the money) naked put - not an in the money one. $55 put is already in the money to the tune of $4, and the real price of it should be around $9 ($6.5 looks suspiciously low)

For the covered call, you chose a $55 call, getting $3.5 on it. THat means at a spot (cash) price of $50.5, you are effectively getting the share for $47, which is your break even point on the downside. To get the same thing you should write a $50 put for $4 (meaning a BEP of $46) or a $47.5 put at $2.85, which is an (even lower) break even point of $45 or so. THe former is preferable if you are bullish since you get more commissions (which is the income) and the latter is a play-it-safe strategy. Essentially the put should be out of the money and the break even point should be around the same level as the covered call you would otherwise have written.

Coming to brokers that give this option: I am in India where all brokers allow you to write naked puts on Indian stocks or futures, margin requirements vary from 50% to 10% of (strikeprice x lot size). In the US many brokerages do not allow naked put selling - or if they do they ask you to put up 100% of (strikeprice x lot size). the 100% margin is lousy because then it increases your capital exposure needlessly; obviously you will plan to get out of the trade if it goes against you (same as with a covered call). Still it lets you pay brokerage only one way (for the option) which is cheaper than the covered call (buy trade plus the option). But there might be a few that allow a naked put option for a decent margin - you may have to check...