Satyam sale and the walk away option

Now that the government appointed Board of Satyam has sold a controlling
stake to Tech Mahindra, it is 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 I have been arguing 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.