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Hello Fools,

I posted the following over in Stock Advisor in the wake of the Satyam implosion (Satyam was an active recommendation of that service).

The intent was to assess whether the numbers, particularly through an IETC lens, might have suggested warning signs in advance.

My conclusions were that I believe the story at Satyam was marred by aggressive accounting (or, at least, poor receivables management), and that neither the defensive nor enterprising income statements told as compelling a story as the more celebrated GAAP financials.

However, imagine yourself an investor in June 2008 and you've just found Satyam - taking those caveats into consideration, I suspect more than a few of us would be likely interested (that's a nice looking Earnings Power Staircase over the past 5 years....even though the Quality of Profits graph leaves me comparatively lukewarm). I concluded that we'd perhaps be thinking about what buy-in price would offer us a suitable margin of safety (and I have no idea as to what the appropriate price would have been - higher or lower than the then-trading price in June 2008 - based on what we now know was fiction).

Anyway, thought I would share over here, since A) I'm using Hewitt's methods, and B) He said those nice things about me the other day (and made my dad's day....yes, my dad reads these boards...) I'd be really interested in hearing specific IETC thoughts on the QoP and EPC's, remembering, of course, that we're trying to avoid tainting our impressions of the 'then', with our reactions today.

Basically, I'm thinking that few investing filters can protect us when the company is literally shifting a small amount of cash from one pocket to the next, fooling everyone including the auditors. All of the great 'warning sign' IETC charts I've seen over the years - Enron, Nortel, Lucent, Tyco, et cetera can't save us from the big hurdle in the case of Satyam - namely, that massive cash hoard, which the auditor signed off on, and then the company comes out with 'Gotcha! We just made that number up!" Frankly, the now-revealed Satyam actions remind me a little of the great American Express Salad Oil Swindle.



Hello Fools,

Satyam is a little outside my bailiwick, but like most Fools today, it's probably one of, if not the top, investing story of the day. So forgive me for wandering into your pond (I'll hop back over the green wall in a moment...)

I thought Andrew's (TMFRedwood's) post is simply top-flight, and would encourage those who might have missed it to read it before my mild scribbings.

So the question I've been pondering is whether the problems with SAY were visible, hiding in the numbers, in advance (and yes, TMFGebinr already outed me as have an immediate, visceral, sell reaction when I initially heard about the plan to acquire the two family associate businesses, but I'm hoping that this post will expand simply beyond the visceral).

And full disclosure: I'd never heard of Satyam before talking to Jim Mueller/TMFGebinr in mid-December, have spent nary a second thinking about the company after we chatted, and only noticed that something had gone terribly, terribly, wrong this morning, when I saw the headline on the Globe and Mail (Canada's national newspaper don't 'cha know) website. So my knowledge of the company has only been shaped when bad things have come to light (the proposed acquisition of the family businesses, and then today's subsequent implosion). Whether or not that taints the thoughts I put down here is an open question.

Tools of Detection
What I'm going to set out here are some fairly straightforward tools available to anyone who wants to try to do their own check for potential problems. They most definitely WILL NOT catch any and all problem situations - indeed, while I think they might raise some yellow flags in regards to SAY, I do not believe they would (as you'll see in a moment) have definitively caught out the corruption. (So what use are they, you might ask?)

Anyway, we have several tools in our quiver to take a quick 'scratch and sniff' test of companies.

Quality is Job One
The first is a rough cut of 'earnings quality'. A company can trumpet 'earnings' all it likes, but all earnings are not created equal (as any number of financial implosions over the past two years, built as they were on accounting 'earnings', but with little, no, or negative cash underlying them). Earnings are fine....but are they translating to cash?

One of my quick 'acid tests' for earnings quality is to compare cash flow from operations (CFFO) versus reported net income. On the statement of cash flows, CFFO starts with Net Income, and then sees non-cash charges like depreciation, amortization, and stock-based compensation added back. Ergo, you expect (in the case of most companies - financials, closed-end funds, and other oddballs are different) to see CFFO greater than earnings. When you don't see this, it's a yellow flag - that borders on turning into a red flag as it persists.

Converted from rupees into USD, you can see that SAY had a persistent habit of underperformance in this area.

$ millions USD FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08
Net Income $ 9.0 ($ 6.9) $ 56.6 $ 16.1 $ 73.0 $118.3 $163.1 $256.7 $325.4 $422.1
CFFO $ 14.2 $ 14.1 $ 3.9 $105.6 $101.3 $ 94.6 $139.1 $168.9 $230.8 $332.2
CFFO-Net Income $ 5.2 $ 21.1 ($ 52.8) $ 89.5 $ 28.2 ($ 23.7)($ 24.0)($ 87.8)($ 94.6)($ 89.9)

You can see that, through FY03, things generally look okay. Even though FY01 was negative, the fat rebound in FY02 suggests to me that the FY01 shortfall was more a timing issue, than anything to be concerned about.

However, the next five consecutive years - FY04 through FY08, we see that the yellow flag would have been raised, and perhaps the red flag would be readied. SAY's quality of earnings was somewhat poor.

Now, in and of itself, this absolutely DOES NOT say fraud. What this DOES suggest, is that the company was really quite bad - it was such a prolonged period - at managing its working capital, particularly collecting on its receivables. The fraying of working capital is completely unsurprising in a rapidly growing company, but we'd like to see the company get out ahead of the trend at some point.

Takeaway from this Test: Probably not a dealbreaker, but rather a question of valuation. Seeing this type of performance, were I to have come upon SAY last spring (long before any of this mess surfaced), this type of performance would not necessarily keep me out of the company - rather, it would have me insisting on paying a lower relative price for the earnings stream, knowing it was off lesser quality.

It's Earnings That Count
In various places scattered around the Fool (the free boards, Hidden Gems, Pay Dirt, probably Global Gains) I've often discussed a more complicated methodology based on Hewitt Heiserman's book It's Earnings That Count (IETC).

Full disclosure: Hewitt's a friend of mine, and apparently had a few nice things to say about me on the public board in the past day or so, which might have the skeptical among you think that this write-up is simply a quid pro quo for his kind words. I assure you, it is not - obviously, I'd not be talking over here without the extraordinary events today associated with SAY.

Anyway, Hewitt puts forth another variant of assessing 'earnings quality' with his IETC framework.

The central premise of IETC is that traditional accrual accounting is flawed, with four principal problems:

1. Investment in fixed capital is ignored.
2. Investment in working capital is ignored.
3. Intangibles are expensed too quickly (expenses such as advertising
and R&D likely produce benefits beyond one year).
4. Shareholders' equity is considered free (there is no recognition that
there is an opportunity cost to investing).

These problems are solved by recasting the income statement into two additional income statements. What he calls the defensive income statement fixes problems 1 and 2, producing defensive profits, analogous to free cash flow (FCF). This shows whether the company is self financing - generating free cash to finance growth, pay dividends, buy back shares, or pay down debt.

The enterprising income statement fixes problems 3 and 4, producing enterprising profits, akin to the creation of economic value (or economic value added, EVA, if you're so inclined). This illustrates whether a company is earning a return greater that that demanded by the opportunity cost of its capital. Fools are best to avoid value-destroying companies.

These aren't particularly new concepts, but Hewitt expanded upon them by bringing in the old saying of a picture being worth a thousand words. Taking the recast income statements, we create two pictures. The first is the quality of profits (QoP) chart -- a simple bar graph, where we want to see all positive numbers, or all bars above the zero line.

The second is the earnings power chart (EPC) -- a simple scatter plot with four quadrants. The upper right quadrant is where companies with both defensive profits (generating free cash, self-financing) and enterprising profits (creating economic value) are situated. This quadrant is where we want our companies to be. Moreover, companies that are pushing further out into this quadrant are said to be forging an earnings power staircase, which is the holy grail of what IETC practitioners seek.

Quickly reviewing the other EPC quadrants: Upper left belongs to companies that generate FCF but are not creating economic value. Lower right features companies that are not creating FCF but are still earning a positive economic value. And finally, the lower left quadrant is for companies that are neither FCF positive nor creating economic value. Companies in this quadrant are the "Danger, Will Robinsons!" of the investment world.

With all of that preamble dispensed with, I've downloaded SAY's recent history into my IETC sheet to get a better glimpse of what's gone on. Again, imagine I'm an investor completely ignorant of the SAY story, showing up sometime last May (before all of the nonsense erupted).

Here's how the 'defensive' and 'enterprising' profits line up with reported GAAP earnings:

Defensive Accrual Accounting Enterprising
Diluted EPS Diluted EPS Diluted EPS
FY99 ($0.05) $0.02 $0.00
FY00 ($0.08) ($0.01) ($0.05)
FY01 ($0.26) $0.10 ($0.14)
FY02 $0.09 $0.03 ($0.18)
FY03 $0.13 $0.12 ($0.01)
FY04 $0.13 $0.18 $0.11
FY05 $0.16 $0.25 $0.16
FY06 $0.19 $0.38 $0.20
FY07 $0.21 $0.49 $0.28
FY08 $0.31 $0.62 $0.32

You can find QoP and EPC pictures at the following links:


For comparison purposes, at the following link, you can see the QoP and EPC for Enron leading up to its unfortunate demise (since I've seen a lot of references to Satyam being the Enron of India).

Takeaways from this Test:
1) SAY was not near as profitable when viewed through either the lens of FCF - which is generally consistent with the conclusion of our simple earnings quality test - or of EVA. Again, this is evidence of nothing more than perhaps aggressive GAAP reporting.

2) Things seem to have taken a decided up-turn no matter how you measure profitability, with FY04. Suddenly everything is growing high double digits annually (even in the face of the CFFO vs. Net Income test above going simultaneously sour). Sure, you could argue that the trend to IT outsourcing probably accelerated concurrent with this time. But as Tim Hanson (TMFMmbop) has said elsewhere today, he was skeptical of SAY's ability to continue posting fat margins (which would translate to the outstanding profit growth) in what is basically a commodity business (profits can be expected to gradually be competed away).

Still, suspicion of sudden turn for the better is probably tainted by today's revelation. It's more likely that a newcomer to the SAY story who came upon this obvious uptick would be enthusiastic about it - not suspicious.

3) Further to the first two points, even though defensive and enterprising profits are lagging accrual profits, the EPC from FY04 through FY08 is exhibiting a classic 'Earnings Power Staircase'.

In other words, an IETC framework would have newcomers to SAY enthusiastic...not suspicious. The lagging defensive and enterprising profits are not a fraud's more a valuation issue (as in, you probably would be willing to pay less for a company with such a lag, versus one with no lag).

This analysis is, by definition, incomplete. I'm not a member of the SA team - just an interested Fool strolling through. I had no role in the underlying work leading up to the SAY recommendation.

From the perspective of the tests I've presented above that delve into the company's reported financials, I conclude that, while there is evidence showing that SAY was reporting somewhat aggressive accounting earnings, and that free cash flow and economic value creation lagged those aforementioned aggressive earnings, there's no readily obvious sign pointing to a fraud. The comparative charts on Enron (available at that link) were flashing all sorts of danger signs for years before its eventual implosion. SAY appears to have been something of a model company.

I have no idea as to whether there are smoking guns buried in obscure corners of the SEC filings - I won't be looking for them in any event. This is strictly a financial review.

In summary, I see no evidence that fraud should have been suspected before today. A deeper dive by others might dispute this conclusion.

Thanks for reading,

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