THE fraud at Satyam Computer Services and the claim of its former chairman, Ramalinga Raju, that the actual revenue earning capacity of the company was much lower than reported has turned the spotlight on the information technology (IT) industry. Two questions immediately arise. First, did the Satyam fraud come to light because the period of high growth in the software services industry had come to an end with the global recession, given the dependence of the industry on export revenues? Second, is it likely that the practice of inflating revenues and profits was confined to Satyam?
It is well known that over the 17 years since 1991-92, when the Indian software services industry and to an extent the hardware industry were still in their infancy, industry revenues have grown by more than 150 times or at a compound rate of 34 per cent per annum. This growth benefited a few firms, among them Satyam, which was ranked fourth within the software and IT-enabled services (ITES) sector in terms of revenues. If we consider the IT industry as a whole, consisting of hardware, software and services, the share of the top 20 firms has fluctuated between 47 and 57 per cent throughout this 17-year period, standing at 55 per cent in 1999-2000 and 56 per cent in 2006-07. That is, concentration as conventionally measured has been high and relatively stable.
What is more, there is evidence that concentration is in fact increasing at the core of the industry. According to the results of Dataquests most recent survey, the share of the top 20 firms in the revenues of the top 200, which has increased consistently over the past few years, rose sharply from 54 per cent in 2005-06 to 64 per cent in 2006-07 compared with the rise from 50 to 54 per cent between 2004-05 and 2006-07 (Dataquest, July 15, 2007). Acquisitions such as that of i-Flex by Oracle and a sudden, sharp 136 per cent increase in the revenues of Tech Mahindra partly explain this trend. But the fact of a high degree of concentration cannot be denied.
The implication is clear. Firms such as Tata Consultancy Services (TCS), Wipro, Infosys and Satyam were prized possessions churning out profits and recording extremely high equity values in stock markets. High and rising market capitalisation resulted in this industry delivering millionaires and billionaires in short periods of time, though the value of the wealth held by the owners of these companies gyrated with the markets. Thus, the wealth of these owners rose during the stock boom at the turn of the millennium, when the stock price index for IT companies quoted on the Bombay Stock Exchange (BSE) rose faster than the Sensex. During those years, IT companies came to dominate the market. This comes through from the following quote from a report in Business Line dated January 2, 2000:
Though corporate India has undergone many changes over the last 10 years of reforms, the year 1999 would undoubtedly be one of the most decisive periods in terms of accretion to shareholder wealth. Over the last one year, the shareholder wealth (represented by the market capitalisation of the BL 250 Composite Index) has increased by 90 per cent from Rs.3,42,553 crore to Rs.6,51,471 crore. Though the top 25 companies still account for around 64 per cent of the total market cap, the composition has undergone significant changes. There were just four information technology companies among the top 25 in the beginning of 1999 with a total market cap of Rs.24,563 crore. Whereas at the end of the year the number had increased to seven with a total market cap of Rs.1,65,747 crore. While the four companies previously accounted for just 7 per cent of the total market cap, the seven companies now account for 25 per cent. The information technology companies have pushed their way ahead of companies belonging to FMCG [fast moving consumer goods], pharma, commodities and economically sensitive sectors. Over the last one year, the weightage of major information technology stocks (in terms of market cap) have gone up quite significantly. While that of Wipro has gone up from 2.48 per cent to 8.87 per cent, the weightage of Infosys Technologies has jumped from just 1.39 per cent to 7.34 per cent.
The benefits that promoters derive from high stock values are obvious inasmuch as they allow them to buy into real wealth outside the company and give them the invasion money to acquire large stakes in other firms.
Needless to say, rising market capitalisation was the result not just of rapidly increasing revenues but high profit shares as well. It was the promise of high earnings per share that triggered surges in stock values to levels that were often not warranted by the profit-making capacity of firms. Of course, expectations of rapidly rising profits are greater in new industries, especially those that are based on recent innovations in technology. This is what made the software, software services and ITES industry, where India gained an early advantage, a front-runner in terms of stock market performance.
What Ramalinga Rajus confession did was to suggest that it was not just valuations that were running ahead of profits, but that those profits themselves were inflated figures aimed at realising high valuations. According to Raju, the profits of Satyam in the second quarter of 2008-09 was much lower than reported because the ratio of operating margins to revenues was just 3 per cent rather than the reported 24 per cent. Since figures had been inflated thus over a long period, it had resulted, according to him, in a hole in the balance sheet of more than Rs.7,000 crore, with Rs.588 crore of that having been dug in just the second quarter of financial year 2008-09.
This is indeed difficult to believe. Satyam Computer Services was engaged in activities similar to those undertaken by other similarly placed IT companies and had a fair share of Fortune 500 companies on its client list. Many of these companies have shown operating margins that are closer to Satyams reported 24 per cent than its confessed 3 per cent.
According to the corporate database of the Centre for Monitoring Indian Economy (CMIE), the ratio of profits before tax to total income in the financial year ending March 2008 was 32.3 per cent in the case of Infosys, 23.1 per cent for TCS, 27.8 per cent for Satyam and 19.2 per cent in the case of Wipro.
This implies that either Raju is exaggerating the hole in his balance sheet or other firms in the industry are also inflating their revenues and, more importantly, profits. Rumours are rife about revenue- and profit-inflation elsewhere. Allegations of manipulation have, for example, been levelled against Educomp, a company that recorded rising revenues and stock valuations. The company has dismissed these allegations, attributing them to a bear cartel that wants to beat down its shares. But investors, analysts and regulators are bound to look at its figures as well as those of other companies in the industry more carefully. Yet, it does appear that the difference between 24 per cent and the 3 per cent claimed by Raju to justify the Satyam financial shortfall seems too large to be the industry standard.
What remains is to ask whether the recession has affected the industry adversely so that we are seeing an end to at least the recent phase of high growth and profitability. Even here the figures reported in the third quarter ending December 2008 are reasonable. TCS, the countrys largest IT exporter, recorded a 24.13 per cent increase in revenues from Rs.5,863 crore in the previous year to Rs.7,277 crore this year and a 2.68 per cent rise in consolidated net profit. Wipro reported a consolidated net profit of Rs.1,003.9 crore against Rs.854 crore in the third quarter of last fiscal, with revenues growing sequentially at 3.5 per cent in constant currency, according to its chairman, Azim Premji. Infosys reported a 35.5 per cent rise in revenues, to Rs.5,786 crore from Rs.4,271 crore in the previous year, with net profits rising by 33.3 per cent to Rs.1,641 crore compared with Rs.1,231 crore in the same quarter a year ago.
Even if the performance has been muted, this resilience in the face of recession is indeed remarkable. Most people see it as an indication that either Rajus confession is wrong or Satyam is an exception. Others, however, are still sceptical.