The complex question of share buybacks in the IT sector
Dilution through follow-on offerings, debt always a possibility but the wisdom of returning cash now and tinkering with capital structure soon thereafter is questionable
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Even in the best of times, stock buybacks have been debatable. Given its penchant for cut and paste, the Indian information technology (IT) sector has been all fired up by Cognizant Technology Solutions Corp.’s recent buyback announcement.
The US has witnessed a staggering $1.5 trillion worth of buybacks by 370 S&P500 companies over the last three years.
Given the Fed’s tightening bias, that boom could well be over soon as buybacks were funded in an ultra low interest rate environment through corporate debt at historically high levels. The hunt for yields has created many arguably risky financial engineering initiatives.
Academic research convincingly demonstrates that buybacks are generally ineffective in long-term value creation, notwithstanding the short-term spikes in stock prices due to an optically better earnings per share (EPS).
Two key shortcomings relate to timing the buyback in the context of the market cycles and valuations and the moral hazard of executive compensation being positively correlated to a financially engineered EPS jump.
The key to successful stock repurchase programs thus requires a transparent disclosure of the purpose, strategy and thinking behind a buyback program, as an integral part of the disclosed long-term philosophy for the company’s capital allocation policy. This rarely happens, and investors over time are thus unable to judge the success of buybacks relative to the established goals.
The current trigger for the frenetic activity in India has been the Cognizant buyback announcement leading to the desperate need to jump onto the bandwagon. This hurried comparison with Indian IT companies is unwise at the very least as there are significant differences.
Cognizant does not distribute dividends and its capital allocation policy hinges on buybacks as an active strategy of returning cash. Its stock repurchase program of $2 billion announced in 2013 was completed recently and the current $3.4 billion program includes a component of $1 billion announced in June last year.
Furthermore, it uses debt to partially fund the program.
So the current announcement is not as radical as it seems. Activist investor Elliott Management Corp.’s contribution has been to make the program much more aggressive in terms of the reduced time period of two years in which to accomplish this, the simultaneous push for scaling the business along with increasing profitability by 3.3 percentage points from the 18.7% this quarter and introducing, for the first time ever, dividend distribution ($700 million) in its capital allocation policy.
While this integrated buyback program will indeed increase its 5-year “Trailing Total Quarterly Shareholder Returns (TSR)” of 11.75% by 1%-2%, the sustainable increase will come only from improving its operating efficiency as mentioned above. It must be appreciated that the key to Cognizant’s TSR outperformance over last 5 years (11.75% vs an industry average of 8%) has not been due to buybacks but its superlative profitable growth from revenue of $6 billion in 2011 to $13.5 billion now vs that of Infosys Ltd from $7 billion to $10 billion.
It was here that Infosys lost out during Shibu Lal’s tenure as CEO from April 2011 to August 2014. In the services business, it is practically impossible to catch up in such situations. Its priority is now to bridge this yawning gap and Sikka’s call to reach $20 billion by 2020 should be seen in this light.
Organically, Infosys can grow to a maximum of $14 billion, thus leaving $6 billion to be generated by acquisitions to bridge the gap.
Given the simultaneous need to reengineer the business model in the context of the digital disruption and accelerate investments in digital capabilities to compete with International Business Machines Corp. and Accenture, Infosys needs innovative product and solutions companies for such acquisitions which are only available in the US, whose markets are at all time highs. The sector valuations of such product companies are presently soaring at multiples of 5.2x of sales.
Even assuming the valuation multiples for all S&P companies of 2x (or 1.8x for Accenture) applies, Infosys would still need $12 billion for the acquisitions as against its current cash of $4.5 billion. This should provide a perspective of the “huge” cash hoard being touted.
Of course, dilution through follow-on offerings and debt is always a possibility but the wisdom of returning cash now and tinkering with the capital structure soon thereafter is questionable.
It is the individual motivation of each company in the context of its overall priorities which determines the prudence of attempting a buyback: following the herd, though popular, is woefully inappropriate.
Tata Sons Ltd, being a 73% shareholder of Tata Consultancy Services Ltd, needed a tax-effective mechanism to use the cash in the aftermath of the Cyrus Mistry affair and would have influenced TCS’s decision. Given the active market for corporate control in the US, Cognizant had limited options in the face of activist shareholders and, in their judgement, this was the best option to reach a “standstill agreement” with Elliot. Infosys is under no such compulsions and must not feel unduly pressured whilst engaging in its liquidity assessments in the long term interest of all shareholders irrespective of the shrill demands being currently made.
A face saver for the founders could well be a factor but, in such a case, I cannot see a possibility of more than a $1 billion-$ 1.25 billion buyback which would be recouped through free cash flows generated within a year.
Given that its dividend payout has been significantly increased to 73% of free cash flows from 33% in 2014, this would seem more than reasonable.
The ultimate judgement on this complex issue must lie with the Board.
Reaching a conclusion is not quite as simple as it is being made out to be.
Prabal Basu Roy is a Sloan Fellow from the London Business School, a Chartered Accountant and has formerly been a Director and Group CFO in various companies.