SGA’s Research helps clients extend their research coverage by providing a complete range of Investment Research Services. We work with our clients in one of the following mentioned models

• Support or extend in-house research teams and/or
• Provide end to end research reports

All our research is white labeled and undertaken exclusively for our clients.

Our analysts, from a pool of qualified CFA’s and MBA’s with experience across sectors, can work as virtual analysts for our clients and provide either financial modeling or end to end equity research support. We are proud to have senior analysts with more than 4 years of sector specialization to provide sector thematic reports.

To Know more, please visit:

http://www.sganalytics.com/index.php?option=com_content&view=article&id=151&Itemid=138

A simple analysis of Crude and natural gas prices over the years would depict that these two energy sources have generally traded within a specific range when measured in relative terms with certain periods of divergences as exceptions.

When we look at Natural gas as just another source of energy substituting crude demand then the rule of thumb says that natural gas prices should be driven by and closely linked to Crude prices. However, given that both these energy sources use different pricing conventions the best way to compare these would be to first bring them on a common measurement platform and look at their relative price. Crude (WTI) is measured in barrels and Natural gas (Henry Hub) is measured in MMBtu, wherein a barrel of crude energy equivalent would be approximately 5.8 MMBtu of natural gas. In other words, crude prices should hover around 5.8 times the natural gas prices i.e. based on this multiple with natural gas (Henry Hub) trading at USD 10/MMBtu, the Crude (WTI) prices should be around USD 58/bl. However, an analysis of the natural gas and crude prices over the past two decades confirms that this has not been the case. Crude has generally traded at a premium with the average multiple being much higher around 9.6 times natural gas prices. This premium is primarily due to wider use of crude over natural gas as well as other factors in favor of Crude such as ease of supply; ease of inventory storage; and a presence of a unified body such as OPEC which keeps a check on unusual drop in crude prices by way of controlling the supply

Natural gas pricing mechanism and the structural shift:
A very long-term historical analysis of these two commodities reveals that in US natural gas and crude have acted as close substitutes with natural gas prices closely tracking the oil prices. This can be traced back to the prevalence of dual powered industrial and electrical power generators, which left room for swapping to the cheaper commodity, whenever it turned undervalued. However, over the years, especially in the past two decades the dwindling number of such dual powered facilities has led to huge divergences in the general price relationship.

While oil prices is one of the major determinants of natural gas prices, it’s the shortage of these facilities to switch from one fuel type to the other that generally brings into picture the other dynamics, such as seasonality, extreme weather fluctuations, natural gas inventories as well as supply/production disruptions.

How does Seasonality affect the Crude/Natural Gas relationship?
The premium that crude trades at over natural gas generally narrows down during the winter months in US. This can be attributable to the fact that the natural gas prices generally tends to be higher during these winter months due to the higher demand for heating equipment. Coincidentally, oil demand and prices tend to be softer during these months given the closure of most US refineries under their annual maintenance programs.

On a structural basis the supply markets and inventories stand out as the major determinants of natural gas prices apart from their linkage to the oil prices. The current inventory levels undermine natural gas’ prices relative to oil going forward. As per EIA, US, currently, sits on a crude inventory for 24 years, while current natural gas inventories represent as high as 70 years’ domestic consumption demand. Moreover, given the fact that the US is Natural gas-rich, the marginal cost of production going forward is expected to stay subdued. Although the current estimated cost of production is an incentive for demand switch in favor of natural gas in the US, as per EIA the costs are not low enough for the global market to support a broad-based shift in favor of natural gas.

Furthermore, the constraints in substituting natural gas for oil would also cap the natural gas demand going forward. Substitution in sectors like residential, commercial, and electric power sectors would not be of much difference given the low contribution of these sectors to the total fuel consumption. Moreover in industrial sectors, which contribute to a major portion of the overall fuel consumption, there are many operational hindrances to a switch to natural gas as primary fuel source.

What drives natural gas prices apart from oil prices or rather what led to their apparent disconnect in recent terms?
Since 2Q09, the relationship started deviating from the historical norm to a noticeable extent. The ratio shot up to an unforeseen level as it topped 30 by the 4Q09. In fact between June ‘09 and November ‘09 the ratio averaged 22. This deviation was on account of strong recovery in crude prices from its lows and on the other hand weakness in natural gas prices. In fact, such was rally in crude prices that in first three quarters of 2009, the commodity appreciated by almost 138% after bottoming out in late ‘08; comparably natural gas underperformed crude with a relatively meager 78 % appreciation.

The answer to this again lies in the demand-supply fundamentals of both these commodities. First of all, crude oil derives its demand curve from higher number of variables than natural gas does. To further elaborate, oil has a global consumption base, which is supported by strong logistics which make consumption of crude in any part of the world possible. So, the natural gas demand is grossly concentrated in the developed world. What’s adding to the woes of natural gas market is that the current recovery is being driven by strong growth in developing economies, while developed economies are lagging behind on economic growth terms.

The supply side also explains the phenomenon to a large extent. The robust rally in energy prices, which preceded the correction, provided a strong incentive to increase the exploration and production of oil and natural gas. This created a huge supply glut, and though the supply concerns eased out for crude due to a stronger and diversified demand base, natural gas continues to see inventories at record levels.

Road ahead for the natural gas/crude relative metric?
Going forward, the above mentioned factors would continue to determine the course of relationship between the two commodities. However, as per the EIA, in a low oil price scenario the ratio is going to average 7.7 between 2009 through 2030, while it is expected to average 14.6 and 20.2 in the base case and high oil price scenario, respectively.

Introduction
Bank stress test is test performed to evaluate the health of the bank and its readiness to endure the impending economic collapse. This test provides clarity to the investors on the health of the banks and in picking out the weak from the strong. Stress tests reflect conditions that are severe but conceivable. These are generally conducted by financial institutions and supervisors in their traditional risk management practices as it provides information on the vulnerability of the bank by examining how it might fare under different economic scenarios. Generally the macroeconomic factors used are real GDP growth rate, unemployment rate and the house prices growth rate. An adverse scenario of theses growth rates is assumed and its impact on the banks balance sheet is ascertained. The stress test entails the bank to project its credit losses and revenue and the level of reserves it would need to cover expected losses.

Stress test per se would not help to assess the financial health of the bank if not conducted properly. The adverse scenario may not have the same kind of impact on every type of asset. It would have a drastic impact on a risky asset and a milder impact on a less risky asset. All assets cannot be considered at par for the stress test irrespective of their qualities. Stress tests may be done to restore confidence in the financial system and to bring lending and raising capital back on track. However the tests should not be a ploy to restore the confidence. The ultimate motive should be not just to restore the confidence but to overhaul the financial system through effective regulation and review.

The US Banks Stress Test
US Government conducted stress tests on its 19 biggest banks, which hold two-thirds of the assets and more than one-half of the loans in the US banking system. As there is great uncertainty as to where the US economy is heading, the Government thought it would be sensible for the banks to hold additional capital so as to make them enough capitalized even in an economic collapse. The banks were asked to estimate losses, revenue and reserve needs in 2009 and 2010, including the level of reserves that would be needed at the end of 2010 to cover expected losses in 2011 under two alternative macroeconomic scenarios. One scenario was the baseline scenario, which reflected the consensus among professional forecasters on the depth and duration of the recession, while the other scenario was the adverse scenario, which was designed to characterize a recession that is longer and more severe than the consensus expectation. This exercise was expected to indicate the need for the banks to raise capital or improve the quality of their capital to endure the losses they may incur under worst situation. These stress tests were conducted by the Government to regain the confidence in the financial system. It may be good to conduct these tests but these may not serve as a substitute for prolonged supervision. They are just one-off tests, which would not help revamp the asset quality of the banks. The current financial crisis has been caused mainly because of poor quality of assets, the complex financial derivative assets which were held by the banks. So a careful examination needs to be done to review these assets and overhaul the balance sheets of the banks rather than just going for a stress test. The economic collapse would only exacerbate the banks balance sheets having these kinds of assets. So, more than stress tests a prolonged assessment of the banks balance sheets is required until the banks come up with a balanced portfolio of assets getting rid of complex derivative assets. Also the stress tests have been conducted in a span of 45 days, which seem to be largely insufficient for tests of that stature. The tests were administered by the industry based on the scenarios provided by the industry and the banks had to use their own risk models, which got them into trouble. The independent verification of the quality of accounting was lacking and the number of examiners per bank was well short. The results of stress tests may have profound impact on the financial markets, whether the results are positive or negative. However concluding whether the financial system is sound based on the results of the stress tests is spurious. But the effects of stress tests on the financial markets are two fold. If the stress tests reveal that the banks are sound and do not require to raise capital, then it’s good news for the markets at least in the short term as it may bring back some confidence in the financial system and the markets may start recovering. In case the stress tests reveal that some of the banks need to raise capital in order to equip themselves for the future disaster, then that may again be good news for the various financial institutions, involved in helping raise capital, as they can improve their underwriting income. So, in a way the stress tests apparently have a positive impact on the financial system at least in the short term. And the institutions required to raise capital may also have the option to request the same from the Government.

Government’s Investment in Financial Institutions
With the recent spate of bailouts, there has been a huge debate on whether the Government has to come to the rescue of the big financial institutions, once considered industry bellwethers, to restore the confidence in the economy. It is a sensitive issue as the tax payers money may be risked in the process. The Government, by helping these institutions, is exposed to a moral hazard as the institutions may lack the incentive to avoid unwarranted risks. Government has two modes of investing in these financial institutions – equity and debt. There could be different problems which could be perceived in these different modes of investment. If Government takes a majority control in any institution or if the institution is nationalized, then there is a risk that the Government could exploit the institution to gain political mileage by giving away cheap credits before an election. As such the institution can run into a risk of becoming a not-for-profit organization. However it would depend a lot on the attitude of Government in force. In any case extending unsecured credit to banks may not be an ideal solution as this would enable lenders to create more debt without diluting their equity. So, it would be wise for the Government to take something in return, may be in the form of equity stake for the debt they provide to the banks. It’s difficult to salvage the financial system by buying all the troubled debt of the banks and letting them run business as usual. This is what probably the US is doing right now by trying to bail out the banking and the auto industry. In fact the Government can nationalize the big banks if required and then try to introduce some effective reforms and regulations and through proper management can try to recuperate the health of the financial system. Once the financial system gets to its earlier state before the collapse, if not to a better state, the Government can sell the banks back to the market. The Government should expedite this entire process so as to refrain themselves from holding the banks for long. This would leave no room for the Government to exploit the banks for their political mileage. Also for the small and medium financial institutions, providing the debt in return for an equity stake may not be the right option as there would be too many small and medium institutions and Government may find it difficult to manage its investments in these institutions with limited resources available. So, the Government can encourage consolidation of these institutions by facilitating their acquisitions by larger institutions.

Conclusion
The Government as far as possible should try not to be long term investors in financial institutions. They may intervene in a state of economic collapse in an effort to restore the confidence in the system and may take a considerable stake in the behemoth institutions. But over a period of time, they must try to salvage these institutions to their earlier state and once successful in doing so, should dilute their stake by selling them to the market. This would enable them to make substantial gains on the tax payers’ money and in turn would help the tax payers in the form of increased subsidies.

In our earlier discussion, we spoke of negative EV companies in the Financial Services sector. We also discussed the reasons as to why these companies have a negative EV, laying stress on the possible calculation errors on part of the database providers and structural problems on part of these companies. We also spoke on banking regulations and geographical distribution of these companies.

In our current discussion we intend to focus on sectors other than Financial Services, and try and understand the reasons as to why companies in these sectors could fall in the negative EV category, and more importantly are these prudent investment opportunities?   

In our study, we noticed that other than the financial services sector, a significantly large number of companies with negative EV belonged to sectors such as Metals and Mining, Computer Hardware & Software Services, Electricals and Electronics, Retail and Telecom along with Biotech, Health and pharmaceutical companies to name a few. We continue to discuss these sectors below.

Metals & Mining: Prior to the recent market meltdown, the mining companies had already been experiencing a severe correction since the commodity prices peaked in 2007. Despite rising and historically high metal prices, the market witnessed a flight of capital, since the summer of 2007. The credit markets collapsed in September 2008 causing another dip in both prices of mining stocks and the underlying commodities. Most are down over 80% from their 2007 highs and hence, many mining stocks are now trading at a market capitalization much lesser than their cash holdings. This again leads to negative EV for companies within this sector.

Computer Hardware and Software Services: Outlook for the information technology (IT) sector is negative based on weak market demand as capital investments decline and consumer spending reduces significantly. Financial services sector, which is the worldwide leader in terms of IT spending, is experiencing the most severe reduction in spending with the hardware sector being most affected. While this sector’s revenue is strongly correlated to general economic conditions, some subsectors suffer more than others. Hardware is most susceptible to this downturn due to its large exposure to the financial services sector, while most IT services, with the exception of the consulting and systems integration business and software companies receive a significant amount of predictable recurring revenue from long-term maintenance contracts. Overall, the technology sector seems to be struggling and market caps in most cases are at their lowest, but many of the biggest names aren’t hurting for cash. In fact, they’re swimming in it. So the question facing companies and investors is what can be done with all that cash. The options, however, are actually rather limited — buy another company, buy back shares, boost research and development spending or increase dividends. Thus negative EV companies in this sector may not necessarily be a good buy.

Electronics Manufacturing Services: A negative outlook on the EMS (Electronics Manufacturing Services) sector largely reflects expectations for a weakening global economy to pressure operating results, particularly due to revenue decline particularly from IT hardware, mobiles and consumer electronics. The sector’s ability to sustain profit margins near current levels and produce positive net returns on capital are being, and will further be challenged in the weakened economic environment. Conversely, solid liquidity and minimal near term maturities for the EMS companies should provide significant margin in managing through this downturn.

As for the EMS companies, these are expectedly conserving cash and liquidity supported by reduced working capital requirements in a slow down environment and minimizing their debt. With market caps at their lowest levels these companies are hence prominent in the list of companies with a negative EV.   

Retail: Retail sector has a strong correlation with people’s income and spending. Given the market slump, Retail has experienced a very strong decline in demand. Retail sector covered in this study includes a broad range of sub sectors such as Apparel Retailers, Broad line Retailers, Clothing & Accessories, Diamonds & Gemstones, Durable Household products, Footwear, Furnishings, Home Improvement Retailers, Nondurable Household Products, Personal Products, Specialty Retailers and Toys.

We noticed an interesting fact – for this sector, enterprise value provided by financial information providers may not have captured all of the debt outstanding in the firm. With a retail firm, EV should ideally include the present value of all lease commitments as its debt. EV, which we see for Wal-Mart, Target and Best Buy, is hence understated and not many companies in this sector would actually have a negative EV. Secondly, the cash that is netted out to get to enterprise value is usually from the most recent financial statement (rather than the current date used for market cap). Given how quickly firm’s burn through cash, what can be seen on the balance sheet may not reflect what the firm currently has as a cash balance, thus flawing the EV calculations.

Healthcare, Pharmaceuticals and Biotech: In the Biotech space, numerous companies are currently trading under their cash value, meaning they could theoretically empty their bank accounts and pay out a dividend greater than their stock price. Or put another way, these companies currently are at their lowest on market capitalization and lye in the negative EV category. This, prima facie looks like a good investment opportunity, however, actually may not be so. When this last happened on a widespread basis, in 2003, buying companies under cash in the Biotech space made for a good short-term play in a few cases. But in the long run, it was more often than not a losing bet. Companies that get that beaten down, even in a brutal market that doles out punishment for little reason, find it hard to climb back. For e.g. buying Human Genome Sciences when it traded under cash value in 2003 was smart, as long as it was sold in 2004 or 2005. Currently, the stock is worth far less than it was at its post-genomic nadir, because its cash pile has continued to dwindle. A few bits of bad clinical news have recently added new members to the negative enterprise value club, Avigen, for instance, which currently has $1.89 per share in cash but a stock price of only 61 cents after the failure of its multiple sclerosis drug in phase 2.

Amidst consistent reports that there is plenty of cash especially in the U.S. pharmaceutical industry, there may be concerns about the challenges of accessing that cash due to the serious tax implications if the cash earned overseas comes back to the US. Pharmaceutical companies seem to be in no mood to repatriate this cash back home. A Moody report looked at nine companies: Amgen, Bristol-Myers Squibb, Eli Lilly, Genentech, Johnson & Johnson, Merck, Pfizer, Schering-Plough and Wyeth, noting that almost 70 percent of the companies’ rise in investments is in offshore cash and that bringing it back could cost nearly 30 percent in taxes. Hence, even though we notice plenty of Biotech companies falling in the negative EV category, in the current economic scenario these may not necessarily be prudent investment opportunities.

Closing remarks

Hoarding cash and its equivalents isn’t always a good thing. Cash doesn’t tend to return much, and having a big pile of it around could either invite a takeover or tempt a company to make a bad acquisition. Still, cash provides an important cushion if business slows down, particularly for those companies carrying significant debt. However, a company with a low debt, high cashand negative EV, would ost likely be susceptible to an acquisition.

Equity and ETFs

The total number of equity launches in December was significantly lower as compared to that observed in November. The number of active equity launches was high in the first and third week of the month as compared to the second and fourth week. The total active equity launches in the month declined by almost 50% as compared to November. The regional focus of the active equity launches was Europe and Americas which included three funds focusing on Latin America. No funds exclusively focusing on MENA and Asia were noted during the month.  Similar to last month, sustainability and undervalued companies were the important themes amongst new active equity launches. It included a fund investing in companies producing sustainable products, a fund of funds offering the highest yield and focusing on climate change and sustainability and one European and one global fund investing in undervalued companies. The new passive equity launches featured themes such as real estate, airlines, agriculture, water and energy. Some ETFs focusing on commodities such as gold, silver and crude oil were noted during the month. Some interesting passive equity launches included currency ETF investing in Euro and Yen, a US ETF based on an Islamic index, three SRI ETFs focusing on sustainability and a carbon ETF-like product focusing on global carbon emissions.

Fixed Income

The total number of new fixed income launches in December was comparable to the number of launches in November. The new launches increased on a weekly basis and posted the highest number in the third week of December. Similar to last month two important trends of investing in government securities and in undervalued securities were noted even this month. It included a fund taking advantage of undervaluation in convertible bond markets, a value bond fund focusing on undervalued bonds and two government bond funds one investing in high quality Euro denominated securities and one US government securities fund. Some interesting launches this month were a commercial credit fund investing in medium term loan notes secured on UK commercial property and a Korea debt fund intending to purchase debts from financial and non-financial institutions.

Multi asset and structured products

In December the total number of multi asset and structured products remained stable as compared to November. Second week of the month showed the highest number of launches in the month. The number of balanced products declined as compared to November with the launch of only one product investing in emerging markets equities and European government bonds. Three life cycle products were also noted during the month including two life settlement funds, one investing in life assurance policies in the US. The new structured product launches included a product offering a defensive auto call feature, a product linked to the performance of 20 major global stocks, two derivative plans, several fixed and growth income plans and several capital protected products.

Alternative investment

In December the total number of alternative investment launches was slightly less than those in November. The total launches were at the highest during the third week of the month. All categories under alternative investments showed a consistent increase in number on week-on-week basis. Most of the single hedge funds focused on event driven strategies followed by multi strategic approach. The trend of distressed assets in last month continued even this month with the launch of distressed debt hedge fund investing in distressed capital in Europe and Asia, a US distressed asset fund and a media focused fund investing in distressed debt. Additionally there were two funds of hedge funds focusing on distressed opportunities. New private equity funds featured themes such as carbon, hotel, nursing home, wine, timber, logistics, technology, healthcare, infrastructure and agriculture. Some interesting private equity launches were a Sharia compliant fund focusing on the South American agricultural sector, two distressed funds, one focusing on European and Asian companies and the other focusing on US bonds, a fund focusing exclusively on Middle Eastern mid cap companies and a fund offering funding to early stage life sciences companies. Carbon was the important theme amongst new alternative investment launches which included two carbon hedge funds focusing on reduction of carbon gas emissions, a carbon trading fund focusing on clean development and buying carbon credits and a fund investing in low carbon projects in Asia.

Real estate

The number of real estate launches in December was stable as compared to November. The trend of focusing on mixed investments including residential as well as commercial properties continued even this month. Europe including the UK was the mainly focused region amongst new real estate launches which was followed by Asia. A noticeable trend in the month was distressed and undervalued property which included two American funds one investing in commercial distressed properties and one investing in distressed and value added real estate projects and high yield property assets, a fund focusing on undervalued properties in ASEAN and two European funds concentrating on falling commercial property valuations.

We recently presented at the Outsourcing ventures 2008 in Pune on the overall supply side challenges in the KPO industry with specific focus on recruitment challenges. The key takeaways from the analysis were:

The market for KPO is huge. Based on conservative estimates, we think the market is worth $10 billion by 2014, growing at a CAGR of 20% from 2003.

There are demand side challenges currently such as the financial crisis which has resulted in a freeze of business decision making in the financial services firms this quarter. In addition, KPO sale still requires a leap of faith for the client (and convincing from the KPO sales) that an outsourced arrangement can work, it carries value and results in overall reduction in costs.

But we think the supply side challenges are more severe. As a statistic, only half of the business school graduates are fit for KPO jobs. The key skills required for KPO work such as the ability to take a complex business problem and break it up into workable components, scheduling those components, applying smart ways of completing the tasks, effective client communication and strong business writing skills are not necessarily taught in business schools directly. The KPO industry also needs to get involved in the training of the students to transfer this practical business knowledge to the students.

The other major issue from the supply side is that the project management level resources in this industry are hard to find and take a long time to groom internally. These type of resources are the the foundation on which a scalable organization can be built.

To read more, see the attached presentation:sga_recruitmentchallenges_presentation

Negative EV Companies: Are these really good investment opportunities?

In today’s global economic scenario, ‘Cash is King’, and why not? Overall, the liquidity has dried, and companies are finding it difficult to fund even their working capital requirements, leave alone acquisitions, expansion and growth plans. According to a recent article on Bloomberg, ‘Cheapest Stocks Since 1995 Show Cash Exceeds Market’, dated Dec 8,2008, stocks have fallen so far that approx 2,267 companies around the globe are offering profits to their shareholders ‘for free’. This is eight times as many companies as compared to the ones noticed at the end of the last bear market in 2001. The article speaks about companies with a negative EV, especially in the Financial Services sector such as Asset Managers, Banks, Consumer Finance, Financial Administrators, Investment Services, Mortgage Finance and Specialty Finance companies. The companies with negative EV span across various market caps, i.e. Nano (market cap < 50 mUSD), Micro (market cap 50 mUSD - 300 mUSD), Small (market cap 300 mUSD - 2 bUSD) and Large. The companies covered in this study prominently include approx 50 companies with a market cap of more than a billion US dollars. Also, the companies covered under this study belong to a plethora of industries ranging from, Financial Services as the most dominant one followed by Metals and Mining, Computer Hardware and Services, and Electronic/Electrical Components and equipment to name a few. Since the maximum number of companies in the negative EV category, belong to the Financial Services sector, we intend to focus on the Financial Services sector in this part of our discussion, and include the other sectors in subsequent discussions.

Is the supporting data misleading?

We noticed that some or most of these companies with negative EV’s covered in our study were actually profitable. Since EV is a function of Market Capitalization, Debt and Cash, for a firm to have a negative EV, its market cap and debt need to be substantially low vis-à-vis its cash position. This phenomenon is generally seen in cash rich companies. We were rather intrigued to see that most of the companies with a negative EV belonged to the Banking sector, and with further research, we noticed that the financial information used, which was sourced from Bloomberg along with other similar financial information providers were applying a standard calculation for a classical company to a bank.

Can banks have a negative EV?

Banks can’t have a negative EV, as their EV is effectively their market cap and a share price cannot fall below zero which makes negative EV an impossible feat to achieve. Banks are unusual in that they don’t have ‘net debt’, as the product they ‘buy’ as in deposits or ’sell’ as in lending is ‘cash’. What banks are owed should be higher than what they owe and this is the book value of equity, and it’s EV. As financial information providers don’t differentiate between different industries in their calculations they can come out with negative numbers for banks. Hence, we need to treat their numbers with a pinch of salt, particularly the EV and beta numbers. One probable reason for this being, the financial information providers are attempting to oversimplify the industrial or sectoral categories for better and comprehensive understanding, but in their attempt to do so, may mislead the investor into taking fallacious investment hypotheses.

Why do banks have so much cash?

Another observation made for the banks with negative EV is that in times of a recession or a global slowdown, such as the one we are experiencing, stock markets plunge and stocks trade at extremely low values, thus reducing the market cap of the companies. With a large number of financial institutions failing and filing for bankruptcy, banking stocks are trading at extremely low levels, shrinking the market cap of these banks. Thus, the first factor (market cap) in the EV calculation is affected significantly. Secondly, in todays economic markets the demand for debt by corporations, is relatively high, but the borrowers may not necessarily qualify for the stricter covenants setup by banks and other financial institutions. This is a ’structural problem’ faced by the overall Financial Services sector particularly the banks. Hence, even if banks do have potential customers or corporations willing to borrow, lending is slow, leading to high cash balances. On the contrary with increased cost of borrowing and uncertain demand, borrowers have also slowed down capacity expansion or acquisitions reducing the demand for banks cash. High cash balance combined with relatively low market cap results into negative EV, if the standard EV calculations are applied to a bank.

Banking sector

Speaking about the banking sector alone, we also felt a need to justify as to why these banks with negative EV have such high levels of cash. Do these banks maintain a high percentage of their cash and equivalents with the respective central banks in terms of SLR or CRR? Post data analysis, we noticed that the cash component in the banking companies used for EV calculations, by Bloomberg and other similar databases and search engines, consisted of cash and balance which the banks maintain with their respective Central bank in terms of a CRR or SLR, which is a mandatory requirement. Inclusion of these cash reserves, in the overall cash position of the Banks by any means, is natural and expected. However, in an economic downturn like today’s, the market capitalization of these Banks and Financial Institutions would shrink significantly and in many cases would seem trivial compared to the total cash held by these banks, including the cash deposited with the respective Central Banks in the form of CRR and SLR. This may further create a negative EV for the Bank. We also feel that, the degree of negative EV would increase or decrease over different geographical regions depending on the CRR & SLR limits set up by the central banks in respective regions.

Geographical distribution of negative EV companies in the banking sector

The geographical distribution of negative EV companies in the Financial Services industry represents a significant number of companies (38) in East Asia, with companies primarily based out of Japan. A close second is North America (US) with 34 companies. South East Asia which consists of Indonesia, Malaysia, Philippines and Vietnam has around 19 companies and South Asia comprising of India and Pakistan has 16 companies falling in the negative EV category. Other notable regions include North Africa and South America which consist of 14 and 13 companies respectively in the negative EV category.

In the short term, there is bound to be pain for the KPO’s as the retrenchment in the western markets for financial services companies leads to cuts in the offshore centers (either captives or contracted outsourcing). But there are some structural shifts that we think will drive long term growth of the KPO sector. These are:

1. Investment banks have usually been ‘fat-cats’ and though the top tier firms have had substantial offshore presence through captives, the layer below (mid-tier and small tier) have not had much much of a global workforce. Now, with the financial crisis hitting hard on consumers and businesses, there is going to be additional scrutiny by investors on the costs and profit margins of the banks (including these investment banks that have become commercial banks now). After the excesses of compensation and greed that has been evident to the market (and the reason for failure), investors are going to demand more austerity. They will not want to pay so much for research. They will also demand more research (productivity), higher quality research (depth and connection with reality) while forcing the banks to keep costs down. This is going to force the banks of all sizes to think deeply on the composition of their workforce for the future with greater global component to it. The parting comment here is that we might see the equivalent of the Microsoft business model where there is grassroots adoption of outsourcing across all tiers of banks, not just bulge or large bracket. This will drive the volume and breadth of work.

2. Traditionally we have seen ‘back-office’ outsourcing for KPO. Examples are external financial reporting, fund reconciliation, internal reporting and analytics to support decision making and many other such activities where the primary driver was cost arbitrage (just like Y2K was for IT outsourcing). We think the BIG shift to notice here, is that global sourcing will come into play for front end support now. As an example, our firm SG Analytics is involved in client projects that range from M&A diligence support, analytics support for restructuring business divisions, strategy projects for acquisitions (sector analysis, identifying targets, building business case studies etc). We think this is still the tip of the iceberg. The opportunity (and now the willingness of banks to actually outsource this type of work) will only increase. We would like to hear what other analytics KPO’s are seeing in their markets such as pharma, legal, business analytics and others.

3. Lastly, the pendulum of investments is (and will continue) to shift towards emerging markets like China, Brazil, Russia, South Africa and India. As more money flows in from institutional investors of all type (HNWI, PE’s, Corporate funds, Sovereign funds etc), you will see the need of quality investment research work being done by local KPO’s in these countries for local investment. The one’s that will be successful are the one’s that will leverage their experience gained serving the global markets to their local markets now.

In our opinion the equity markets are looking interesting with P/E ratios at low levels even considering that company earnings will decline. The situation seems similar to that of Japan in the 1990’s and the challenge will be to choose the survivor sin each industry.