When back in 2005 Roubini said that the home prices were riding a speculative wave which would soon sink the economy, he was called a Cassandra. Cut to present, and he is a sage.
Satyam fraud hit the India Inc when the global economy was in shambles and ours had caught this bad cold because of their fever. But one's loss is a gain of the other. There are a plethora of those who understand that the best and infact the only way to grow given the current scene is through mergers and acquisitions. Of all, Tech Mahindra grabs the lucrative deal of purchasing a 31 equity in Satyam at Rs 58 a share which is a tenth of pre-fraud-hit satyam share price. The company is betting it can plug the leak, cut the flab and yet make a meal out of Satyam Computer Services.
The actual cost for acquiring Satyam is just the money that has to be paid towards open offer. The fund being used to subscribe to the equity will anyway be with the company itself. With the expected Rs 200 crore profit, it would take about five years for Tech Mahindra to get its entire money back. In fact, it is a low-risk game for Tech Mahindra. Satyam will also bring in non-telecom expertise for the company. TechM plans to finance the deal through debt.
The main challenge for Tech Mahindra is to maintain value proposition to Satyam clients. It needs to iron out conficts of interest. It would be useful to examine how the implicit walk away option can prove so damaging to the current Satyam shareholders and how it can be hugely beneficial to Tech Mahindra. This analysis confirms what has been argued for some time now: the decision to sell a partial controlling stake instead of selling the whole company was not in the interests of the shareholders.
The implied valuation of probably less than six months revenues for the transaction is quite low except for the unknown liabilities of the company in several US class action law suits. It is these unknown liabilities that make the walk away option hugely valuable. What makes walk away feasible is the fact that Satyam’s value is not in the form of tangible assets, but largely in the form of its customers and employees.
Over a period of two to three years, Tech Mahindra which is itself in the same industry could transfer the entire Satyam business to itself. This could be done as new contracts are signed or existing contracts are renewed. Over the same time frame, the employees of Satyam could also be shifted to the Tech Mahindra payroll. Once this process is complete, Satyam would have some cash and other assets and potentially huge liabilities.
The walk away option is that if the liabilities turn out to be larger than the cash and other assets, Tech Mahindra can walk away and put Satyam into bankruptcy. If the liabilities turn out to be small, then Tech Mahindra can merge Satyam into itself and absorb the surplus assets. Option pricing theory teaches us that the more the uncertainty (volatility) the greater the value of this walk away option. Since the uncertainty today is huge, the option is hugely valuable.
The fact there were (as some people put it) only two and a half bids for Satyam suggests that a number of potential bidders who thought that they would never exercise the walk away option (for reputational or other reasons) chose not to bid at all. Without the walk away option, the risks were simply too high.
There are two other reasons why Tech Mahindra would prefer to transfer the Satyam business to itself. First, it owns only 51% of Satyam and therefore earns only 51% of the revenues of Satyam. If the contract is renewed with the parent company itself, it gets 100% of the revenues. Second, Satyam commands a low valuation in terms of price-revenue multiples (less than 0.5 at the bid price) while Tech Mahindra commands a higher valuation (about 1.0). Moreover with the Satyam acquisition, Tech Mahindra would try to position itself in the league of the top tier software companies which command multiples of about twice revenues.
Even if we consider a price to revenue multiple of 1 for the parent and 0.5 for the subsidiary, a dollar of revenues at the parent adds a dollar to the market capitalization, while a dollar of revenue at the subsidiary adds only 0.25 to the parent’s market capitalization. The financial motivation for shifting business to the parent are very high even without the walk away option.
What this means is that while today’s sale is great for the employees and customers of Satyam and for the Indian software industry, it is not so great for the shareholders. They get very little money now (except for the 20% open offer) and might find after three years that they own shares in a shell company that has little or no value.
The shareholders would certainly have preferred a sale of 100% of the company that gives them cash now.
Satyam fraud hit the India Inc when the global economy was in shambles and ours had caught this bad cold because of their fever. But one's loss is a gain of the other. There are a plethora of those who understand that the best and infact the only way to grow given the current scene is through mergers and acquisitions. Of all, Tech Mahindra grabs the lucrative deal of purchasing a 31 equity in Satyam at Rs 58 a share which is a tenth of pre-fraud-hit satyam share price. The company is betting it can plug the leak, cut the flab and yet make a meal out of Satyam Computer Services.
The actual cost for acquiring Satyam is just the money that has to be paid towards open offer. The fund being used to subscribe to the equity will anyway be with the company itself. With the expected Rs 200 crore profit, it would take about five years for Tech Mahindra to get its entire money back. In fact, it is a low-risk game for Tech Mahindra. Satyam will also bring in non-telecom expertise for the company. TechM plans to finance the deal through debt.
The main challenge for Tech Mahindra is to maintain value proposition to Satyam clients. It needs to iron out conficts of interest. It would be useful to examine how the implicit walk away option can prove so damaging to the current Satyam shareholders and how it can be hugely beneficial to Tech Mahindra. This analysis confirms what has been argued for some time now: the decision to sell a partial controlling stake instead of selling the whole company was not in the interests of the shareholders.
The implied valuation of probably less than six months revenues for the transaction is quite low except for the unknown liabilities of the company in several US class action law suits. It is these unknown liabilities that make the walk away option hugely valuable. What makes walk away feasible is the fact that Satyam’s value is not in the form of tangible assets, but largely in the form of its customers and employees.
Over a period of two to three years, Tech Mahindra which is itself in the same industry could transfer the entire Satyam business to itself. This could be done as new contracts are signed or existing contracts are renewed. Over the same time frame, the employees of Satyam could also be shifted to the Tech Mahindra payroll. Once this process is complete, Satyam would have some cash and other assets and potentially huge liabilities.
The walk away option is that if the liabilities turn out to be larger than the cash and other assets, Tech Mahindra can walk away and put Satyam into bankruptcy. If the liabilities turn out to be small, then Tech Mahindra can merge Satyam into itself and absorb the surplus assets. Option pricing theory teaches us that the more the uncertainty (volatility) the greater the value of this walk away option. Since the uncertainty today is huge, the option is hugely valuable.
The fact there were (as some people put it) only two and a half bids for Satyam suggests that a number of potential bidders who thought that they would never exercise the walk away option (for reputational or other reasons) chose not to bid at all. Without the walk away option, the risks were simply too high.
There are two other reasons why Tech Mahindra would prefer to transfer the Satyam business to itself. First, it owns only 51% of Satyam and therefore earns only 51% of the revenues of Satyam. If the contract is renewed with the parent company itself, it gets 100% of the revenues. Second, Satyam commands a low valuation in terms of price-revenue multiples (less than 0.5 at the bid price) while Tech Mahindra commands a higher valuation (about 1.0). Moreover with the Satyam acquisition, Tech Mahindra would try to position itself in the league of the top tier software companies which command multiples of about twice revenues.
Even if we consider a price to revenue multiple of 1 for the parent and 0.5 for the subsidiary, a dollar of revenues at the parent adds a dollar to the market capitalization, while a dollar of revenue at the subsidiary adds only 0.25 to the parent’s market capitalization. The financial motivation for shifting business to the parent are very high even without the walk away option.
What this means is that while today’s sale is great for the employees and customers of Satyam and for the Indian software industry, it is not so great for the shareholders. They get very little money now (except for the 20% open offer) and might find after three years that they own shares in a shell company that has little or no value.
The shareholders would certainly have preferred a sale of 100% of the company that gives them cash now.
