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Axon: costly in a cheap market

Axon: costly in a cheap market
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First Published: Sun, Sep 28 2008. 10 40 PM IST

Updated: Sun, Sep 28 2008. 10 40 PM IST
At a time when technology stocks around the globe are getting cheaper by the day, HCL Technologies Ltd has begun a bidding war with Infosys Technologies Ltd for the consulting firm, Axon Group Plc. Among the shareholders of the companies involved in the deal, those of Axon are the biggest gainers.
Their shares have risen by 35% since Infosys’ bid in late August. Since April, Axon shares have risen by more than 70%. Technology shares represented by the Nasdaq composite index have fallen by an average of more than 5% since April and by nearly 20% since January.
Axon may be a good fit for both companies, as it helps strengthen their enterprise solutions portfolio. But the key point to note is the UK-based company’s assets will now be acquired at a considerable premium to market valuation at a time when uncertainty about the future is driving down valuations of technology companies. Many analysts viewed Infosys’ original bid itself as costly, considering that yield on the investment of £407 million (Rs3,476 crore now) was only about 6.5%, using estimated earnings for 2008. Infosys earns a higher yield (roughly 8%) with its treasury operations.
HCL’s bid at £441 million causes the yield to drop further to 6%. In HCL’s case, it will be borrowing £400 million, while the rest will come from internal accruals. If the interest rate for the loan (not disclosed) is higher than the post-tax yield, the acquisition would be a loss-making proposition in the near term. The probability of this seems quite high, because the company management told analysts that it’s more interested in the long-term prospects of the Axon acquisition, rather than focusing on whether the deal is earnings accretive in the near-term.
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Of course, by taking a large loan, HCL would save more on taxes, since Axon pays tax at 30%, while the tax on investment income is much lower for Indian companies. On the other hand, if the liquidity crunch worsens, borrowing costs may rise further and extend the break-even timeline for HCL.
Of the two companies, HCL perhaps needs Axon more badly, considering that its enterprise application services division accounts for just 11.1% of its revenues of Rs7,640 crore. For Infosys, consulting services and package implementation accounted for 23.8% of its annual revenue of Rs16,692 crore. Analysts point out that HCL has been a laggard as far as its growth in enterprise application/package implementation revenues go, and the Axon buy could take the proportion of revenues from this segment to 30%.
On the flip side, since Infosys is already a strong player in this area with revenues of nearly Rs4,000 crore, it may be able to integrate an acquisition of Axon’s size better.
One major positive Axon brings to the table for both companies is its low reliance on the financial services sector and high exposure to sectors such as government and utilities, where Indian firms are not present in a strong way.
Also, its business hasn’t been affected as much as some other technology services vendors in the current crisis. Still, price cuts are happening and the higher growth in the lower-margin North American region means that company-wide margins are set to taper off from 2007 levels. In this scenario, and at a time when Indian companies themselves are expected to take a hit due to the global slowdown, it’s absurd for them to be paying a high premium for acquiring assets.
Global trends: a test case of uncertainty hitting the markets
The period after the Lehman Brothers Holdings Inc. failure has been one of tremendous uncertainty in the markets, uncertainty that continued till the end of trading last week because of the inability of the US Congress to cobble together a bailout plan. Trends in global markets in the last two weeks can, therefore, be seen as a test case of what happens when uncertainty hits the markets.
For starters, despite the US being at the centre of the damage, its stock market has done rather well. Between the close of business on 12 September (the Friday before the Lehman crash) and 25 September (last Friday), the Dow Jones Industrial Average was down a mere 2.4%, compared with a fall of 6.4% for the Sensex, India’s benchmark stock index, over the same period. Most markets did worse than the US.
Is this an indication of a flight to safety, with investors selling desperately in other markets? Selling by foreign institutional investors (FIIs) was certainly a big factor in the Indian market, which has done worse than others in the region recently only because it had done relatively well earlier, after crude oil prices started declining. The flight to safety is clearly seen in the yield on short-dated US treasuries.
The three-month treasury bill yield, for instance, fell from 1.46% on 12 September to 0.75% on 25 September. The yield on the two-year treasury note also fell. Investors clearly rushed to the safety of T-bills.
But the yield on the US 10-year treasury bond rose to 3.88% from 3.74% over the same period, indicating a possible rise in inflationary expectations. That’s because the huge bailout plan being proposed could very well lead to a much higher US fiscal deficit, the Federal Reserve printing more dollars and to higher inflation. That is also seen from the behaviour of the dollar. Although the dollar appreciated against most emerging market currencies as investors cashed out, it fell against major currencies over the period. The nominal major currencies dollar index for the US dollar fell from 76.0693 on 12 September to 74.2382 on 25 September.
In short, the message the markets were signalling in the past two weeks is that the US economy and corporate earnings remain robust despite the financial disaster, the bail out will be inflationary and will have a negative impact on the dollar. But risk aversion, including aversion to emerging markets, should decline once the bailout package is in place.
Write to us at marktomarket@livemint.com
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First Published: Sun, Sep 28 2008. 10 40 PM IST