India's Madoff? Satyam Scandal Rocks Outsourcing Industry

The info tech outsourcer shocks investors with a letter outlining balance-sheet misdeeds. Rival firms may benefit if customers still trust them

B. Ramalinga Raju resigned on Jan. 7, 2009, admitting the firm had falsified accounts and assets and inflated its profits over several years. Noah Seelam/AFP/Getty Images

By Manjeet Kripalani

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On the morning of Jan. 7, Ramalingam Raju, the chairman of troubled Indian IT outsourcing company Satyam Computer Services (SAY), sent a startling letter to his board and the Securities & Exchange Board of India. Raju acknowledged his culpability in hiding news that he had inflated the amount of cash on the balance sheet of India's fourth-largest IT company by nearly $1 billion, incurred a liability of $253 million on funds arranged by him personally, and overstated Satyam's September 2008 quarterly revenues by 76% and profits by 97%. After submitting his resignation, Raju ended his letter by apologizing for his inability to close what began as a "marginal gap between operating profits and the one reflected in the books of accounts" but grew unmanageable. "I am now prepared to subject myself to the laws of the land and face the consequences thereof," he wrote.

The letter shocked and angered corporate India, which has looked to IT executives as role models for a new breed of Indian entrepreneur. The benchmark Sensex stock index dropped 7.3% and Satyam shares fell nearly 78% on the day as investors fled in droves. Goldman Sachs (GS) suspended its recommendations on Satyam "because there is not currently a sufficient basis for determining an investment rating or price target for this company," Goldman analysts Julio Quinteros Jr. and Vincent Lin told investors. Earnings per share, warned JPMorgan (JPM) analysts in a report, "may be 70%-80% lower than reported numbers and consensus estimates for '09-'10." Satyam had become "India's Enron," said CLSA India analyst Bhavtosh Vajpayee, calling the case "an accounting fraud beyond imagination [and] an embarrassing and shocking episode in Indian corporate governance."

As executives at other Indian outsourcing companies nervously assess what impact the scandal will have on them, many industry observers now argue that the Satyam case will damage India's reputation as a reliable provider of IT services. Because of the Satyam scandal, they say, Indian rivals will come under greater scrutiny by regulators, investors, and customers. "The bubble is going to burst in terms of trust," says a fund manager in Hong Kong who has followed Satyam closely. Doubts about the reliability of Indian outsourcers are especially important, since customers often allow the Indian companies access to sensitive systems. "This industry doesn't just make widgets," the manager explains. "It's an intimate relationship." Certainly, says Gartner (IT) analyst Diptarup Chakraborti, "there will be caution in the short term, skepticism, and questioning." After all, "no one wants to do business with a known fraudster."

Investors Want Answers Industry executives are desperately trying to contain the fallout. "The decline in governance and institutions represents a serious challenge to India," says Rajeev Chandrashekhar, president of the Federation of Indian Chambers of Commerce and Industry. Wipro Technologies (WIT) Chief Financial Officer Suresh Senapaty, went on TV to say that Satyam's actions should not infect the entire Indian IT industry. And Mohandas Pai, head of human resources at Infosys (INFY) and the company's former chief financial officer, argued Satyam's behavior is atypical. "We wish the regulators will investigate and punish the guilty," he says. "But this is not representative of our industry." John McCarthy, vice-president of Forrester Research, allays some fears. "I look at Satyam as an isolated case, and don't think the developments would have any impact upon India's No. 1 position as an offshore location."

Still, investors and clients are going to want answers. For instance, they're demanding to know how Satyam's auditor, PricewaterhouseCoopers, endorsed the company's accounts. "Auditors' complicity in what seems to be a multiyear misstatement of financials will also be explored," said CLSA's Vajpayee in his Jan. 7 report. Already, India's Registrar of Companies had begun a probe into a failed acquisition last month by Satyam of companies run by Raju's two sons. Now the country's securities regulator will add its weight by investigating the PwC audit. PwC issued a statement saying it was examining the issue.

Raju's confession is the latest in a rocky ride for Satyam, its shareholders, and its stakeholders over the past year. The company's clients include multinationals such as NestlÉ, General Motors (GM), and General Electric (GE). But in September, the World Bank banned Satyam from doing any of its work after it found Satyam employees had hacked into its system and gained access to sensitive information. It also did not renew their five-year contract. Satyam denied any wrongdoing. Then came a fresh blow on Dec. 16, when Raju announced the company would spend $1.6 billion to buy two infrastructure companies run by this sons, only to reverse the decision a few hours later under shareholder pressure. Satyam ADRs lost 50% of their value overnight. December also brought news of pending litigation by a former client, online mobile-payments service Upaid Systems, which filed a case of intellectual fraud and forgery against Satyam in 2007; a Texas court is scheduled to conduct a hearing on the case Jan. 7.

Tip of the Iceberg In India, the Raju family's non-IT activities had already been viewed with some suspicion, in particular a free emergency ambulance service Raju began in Hyderabad, where Satyam is based. Last year, public-interest activists filed a petition challenging the lack of transparency and arbitrariness in the award of ambulance-services contracts in 12 Indian states—all of which had been awarded to Raju's operation. In November the Supreme Court of India questioned the contracts and demanded an explanation, which could result in the contracts being canceled.

With Satyam's management focused elsewhere, business suffered. Clients complained about lack of attention, and many professional managers began to leave.

Angry Satyam investors' reaction to the botched acquisition led to talk of Satyam being a takeover target. A deal might have been interesting since, as Gartner's Chakraborti says, Satyam had been undergoing a "crisis of confidence, rather than a crisis of revenues." Before the shocking confession today from Raju, there was a long list of reported suitors for Satyam. They included HCL Technologies, Wipro, IBM (IBM), Hewlett-Packard (HPQ), Larsen & Toubro Infotech, Cognizant (CTSH), Cap Gemini (CAPP.PA), and even private equity players KKR and TPG. By Jan. 6, the Indian press added a new one—Tech Mahindra, a Pune-based software-services company focused on the telecom industry in which British Telecom (BT.L) has a 31% stake. Although most companies denied the rumors, on Jan. 6 an executive of a rival company told BusinessWeek that Satyam's value should be between $2.6 billion and $3 billion.

Competition Will Jump In Now, just a day later, Satyam's value has plummeted. Tech Mahindra made a public statement that it would not be interested in acquiring Satyam "in the current environment." CLSA India valued the company, minus its debt, at $600 million. "What happens to Satyam now?" asked Mumbai-based research firm First Global in a note on Jan. 7. "With Satyam's operations failing to generate the required amount of cash, we believe that it will be impossible for the company to continue its operations." Satyam clients are likely to shift to other companies, First Global predicted, as Satyam's stock price continues to fall.

That leaves Ram Mynampati, the Satyam president whom Raju has appointed as interim chief executive, the difficult task of boosting morale. In a letter to Satyam's 53,000 employees, Mynampati reminded them that Satyam had top-notch clients and was acknowledged as one of the three best employers in India by both Hewitt (HEW) and Mercer (MERC), the international human resources firms. But "this quarter will be tumultuous for us," he said. "Rumors will abound and it would be fair to assume that competition will try and leverage it to their advantage."

The competition sure is trying. Already, Satyam customers are getting calls from other Indian IT providers offering their services. And life could get tough for Satyam's thousands of engineers and employees. Despite their valuable skills, IT companies are hiring fresh college grads over the more expensive, experienced hands. Still, with the IT business already suffering from the global downturn, a large competitor out of the way could mean more deals for Satyam's rivals—if they can overcome new doubts about the reliability of the country's IT industry.

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Kripalani is BusinessWeek's India bureau chief.