Tata Consultancy Services Ltd (TCS) has said it is considering a buyback of shares. Reports suggest Infosys Ltd may follow suit. This comes close on the heels of Cognizant Technology Solutions Corp.’s decision to drastically increase payouts to shareholders, after being prodded to do so by activist investor Elliott Management Corp.
If TCS and Infosys follow through with sizeable buyback programmes, investors will have much to thank Elliott for. Thanks to their penchant for hoarding cash, return ratios of these companies have been unduly low. At end of March 2016, 33.5% of TCS’s and 45.9% of Infosys’s total assets were held in the form of cash and cash equivalents (see chart above). Return on equity (RoE) at the two companies stood at 33% and 22%, respectively, for fiscal year 2016.
In comparison, Accenture Plc, which has been aggressively buying back shares for years, boasted an RoE of over 60% in the year till August 2016. Analysts at Kotak Institutional Equities point out in a note to clients that Accenture’s RoE would have been much lower at 13.6%, assuming it hadn’t bought back the shares it did since 2003. Similarly, thanks to the buybacks, the company’s earnings per share rose at a compound annual growth rate of 15.3% between 2003 and 2016, meaningfully higher than the rate (11.6%) at which net profits have grown.
While Accenture returns nearly all of its profits through buybacks and dividend payouts, top Indian IT companies return only around 40-50% of profits to shareholders.
Accenture’s example shows there is a high opportunity cost for shareholders when companies hold on to excessive cash. Ironically, despite its generous payout ratios, Accenture has also managed a large number of acquisitions, and its growth in terms of incremental revenues has been far ahead of Indian peers lately.
As such, the argument that Indian IT companies would be sacrificing future growth opportunities if they return large amounts of cash doesn’t hold much water. What often gets forgotten is the large amount of cash that gets generated each passing year. In the nine months till December 2016, TCS generated free cash flow of $2.68 billion, and Infosys generated $1.24 billion of free cash flow.
Kotak’s analysts say that the case for buybacks has become stronger for Indian companies in recent times: “The recent drop in cash yield and improvement in earnings yield, due to a sharp contraction in the price-earnings ratio, drives a much stronger case for a share buyback now.” Put simply, it’s cheaper to buy shares now for companies and at the same time less lucrative to park cash. This was not the case earlier, when valuations were much higher and yield on cash holdings were relatively high.
Besides, as pointed out in this column earlier, the government’s taxation policy has made buybacks far more attractive from a shareholder’s perspective. In fact, for this reason, TCS and Infosys should even consider returning most of their cash in the form of buybacks, and bringing down the size of dividend payments substantially.