Morgan Stanely: Another Deception, Now What?

Satyam episode of overstated profits and balance sheet has spooked the market and raised a few questions. We attempt to answer some of those questions here:   • Is this situation different from the two previous episodes? The Harshad Mehta and Ketan Parekh situations were about illegally sourced money driving stock prices. The Satyam issue is different. Corporate profits grew almost six-fold between 2003 and 2008, and the Satyam episode creates a lingering doubt about these earnings.   The other difference between this and 1992 and 2000 is timing. The Harshad Mehta episode triggered a market fall and the Ketan Parekh issue happened at a point that eventually proved to be the middle of a bear market. The Satyam issue has come to light with the market already down 56%. Its incremental impact on the market could be less than the previous problems. In 1992, the market fell 44% in four months whereas in 2001 it fell 28% in two months as these scams were brought into the open.   • What is the short-term impact? The rally from mid-November is under threat. We believe that earnings for the quarter ended December 2008 are going to be bad enough to end the rally. The Satyam disclosure has hastened that end. The Satyam revelations may lead to collateral damage for banks, for real estate prices in Hyderabad, and for other companies involved directly or indirectly. The valuation gap between the stocks of good- and bad-quality companies may expand at least in the near term.   • What is the medium-term impact? Auditors will become more vigilant and do more due diligence. It is naïve to expect that errant companies will mend their ways, in our view. Hence, an all-round improvement in corporate governance standards is not very likely. However, these companies may choose to make adjustments to their financial statements in coming quarters.   The logic for such an adjustment (which leads to an earnings knock) could be that the incremental impact on share prices of such adjustments will be low given how badly stock prices have already fallen. We do not necessarily agree with this logic, though. Like in 1992 and 2001, the regulatory response should be quite strong in the coming weeks.   • What is the state of earnings quality in India? Even without this episode, earnings quality was deteriorating. The rising share of non-cash earnings in reported earnings and the high share of financial earnings in pretax earnings both underpin  the earnings-quality issue. Operating cash flow to net profit is at multi-year lows. The deterioration in cash flows will likely lead to a cut in dividends. The sectors that seem worst affected are Industrials and Materials.   • Which other companies should we worry about? Corporate governance is a question of where one draws the line. The Satyam case may be blatant, but there are others that could be on the edge. The Bloomberg screens on 7 and 9 January tell us very clearly where the market believes corporate governance is weak. We may or may not agree with all the market moves, but our analysts have drawn out the key issues across key sectors that we believe investors should be wary of when they analyze the earnings and cash flows of companies.   • What should investors do? Investors should continue to focus on quality and buy growth at reasonable prices. We think Financials, Industrials and Materials should be avoided given the cyclical concerns – not related to the Satyam episode

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