Ripe time for buyback
Feb 12 2017
IT firms sitting on huge cash piles come under pressure to share a part of the wealth
The investor clamour for capital allocation through buyback has risen on realisation that cash on the books of top 10 IT firms comes to roughly Rs 70,000 crore, with Infosys alone keeping half that amount.
The rising uncertainty in the IT industry, on the back of events like Brexit, spillover effects of emerging market growth issues and potential anti-H-1B visa action, has led to the underperformance of IT stocks over the past year.
According to analysts, while the macro-factors impacting revenue and profits are not in managements’ control, a liberal capital return policy is something they could work on in these uncertain times.
The excess capital is also diluting return ratios, which has a corresponding impact on valuations of IT companies.
“A sizable cash balance and an operating engine churning consistent and strong free cash present a strong case for Tier-1 ITs to pursue a consistent share buyback programme, in our view. Besides being the most tax-efficient means of returning excess cash to shareholders, a structured share repurchase programme offers a good long-term boost to EPS/RoE (earnings per share/return on equity) and a floor to valuation multiples,” says Kotak Securities in a report.
Of the various means of excess cash utilisation, like acquisitions, dividends and buyback, analysts believe share buyback has a strong case as it could boost stock valuation in the light of the recent sharp correction in IT stocks’ forward PE (price-earnings) multiple.
Dividend distribution tax makes dividend payout inefficient from an investor point of view. Theoretically, share buyback is EPS-accretive when the post-tax cash yield is lower than the implied earnings yield (E/P —earnings-price ratio—the inverse of PE) at the share buyback price.
“We highlight that a share buyback assessment should look at EPS accretion and RoE kicker beyond the immediate fiscal year”, Kotak Securities said.
Many feel that a structured, consistent buyback programme would add to the power of compounding and back up the stocks just when the companies are facing pricing pressure and margin squeeze, with no aggressive acquisitions plans on the table.
Though the December quarter numbers were quite encouraging, uncertainty remains. The topline growth of IT companies were a tad soft in the December quarter but in line with estimates. Tech Mahindra led the pack with a 5.4 per cent quarter-on-quarter constant currency growth followed by HCL Technologies (3 per cent), TCS (2 per cent) , Wipro (0.6 per cent), while Infosys reported a 0.3 per cent revenue decline over a ramp down in the RBS project.
The revenue growth rate in the latest quarter was steady overall and came as a positive surprise in the context of languishing stock prices. Ebit (earnings before interest and taxes) margin surprised positively. With the entire near-term market focus shifting to visas, stock price movements will be guided by H-1B rule changes, even as some stocks build in the impact of the proposed $100,000 minimum wage for H-1B holders.
“It’s high time to cash in on cash. We readily see how markedly positive the consequences of a shareholder-friendly capital return policy can be for India IT, provided it is maintained consistently over a period of time—the compounding/cumulative effects of a beneficial policy implemented over a long period is easily under-estimated,” said JP Morgan in a report.
By a JP Morgan analysis, if Infosys flushes out excess incremental cash over the next five years (FY18-FY22) through a judicious buyback programme (addressing the flow issue), while also buying back 10 per cent of its current cash pile ($5 billion, including cash equivalents) every year for five years (addressing the stock issue), its FY22 return on equity (ROE) would stand at 28 per cent, a good 800 basis points more than ROE of 20 per cent now. Under this scenario, Infosys’s FY22 EPS works out 7 per cent higher.
Similarly, in the case of TCS, the spread between ROE /EPS (under a far friendlier capital return policy regime) and ROE/EPS (assuming continuance of existing capital return policy with no buyback) only expands over time, testifying to the compounding power of a consistent, structured shareholder-friendly capital return policy, JP Morgan said.
Analysts say the timing for such a programme for Indian IT has never been better than now, with earnings yield (inverse of the PE ratio) now higher than the post-tax return on cash. Also, high dividend distribution tax rate makes buybacks the preferred route to commit to such a systematic programme. At current valuations, the earnings yield clearly exceeds today’s post-tax returns on cash. For Infosys, the FY18 earnings yield stands at 6 per cent. With cash yields likely to fall in India from declining interest rates, this equation may well stay. Such a situation makes buybacks even more compelling. Greater the difference in earnings yield and post-tax cash returns, greater the thrust to EPS from buybacks. The effect of compounding from a sustained programme in such an environment exaggerates this thrust.
Reasons that companies, such as Infosys, offer for hoarding cash and persisting with their current capital return policies are wearing thin. Infosys’s 2020 plan envisages M&A contributing about $1.5 billion in additional revenues in 2020. Even assuming that Infosys follows through with such an M&A programme—this would mean an overall M&A consideration of $3-4 billion—the firm will generate >$9 billion free cash flows through FY17-FY21. It means, even at such an elevated acquisition activity, Infosys can comfortably structure a far friendlier capital return policy. The 2020 plan cannot be an argument to hoard cash even if Infosys were to get close to its 2020 goal.
In fact, Indian IT should finance reasonable to large-sized M&As (upwards $500million) through debt. This will commit the firms to a sustained and friendlier capital return policy without leaning on excuses like future M&As. Moreover, the earnings yield is now higher than the cost of debt (post-tax), leaving the arithmetic in favour of using internally generated cash for investor payout and raising debt for significant M&A.
Experts say a share buyback assessment should look beyond the immediate financial year. Essentially, share buybacks are not about a one-time impact but having a perpetual impact on EPS growth and RoE.
Unambiguously, the way forward for Indian IT is to have structured and consistent buyback programmes over and above dividend payout to reward their investors.