Will IT majors follow TCS in giving cash back?

The rational for holding high levels of cash was the need to fund inorganic growth

Tata Consultancy Services’ (TCS) decision to announce a share buyback raises two questions. First, will other Indian IT firms who are sitting on massive piles of cash follow suit? Second, will this be a one-off event or does it mark the start of a new trend where cash rich IT companies give money back to shareholders?

Traditionally, Indian IT companies have maintained high levels of cash. At the end of the third quarter of FY17, Infosys had a cash balance of Rs 26,113 crore. It also had investments to the tune of Rs 9,872 crore. Similarly, HCL technologies had a balance of Rs 10,258 crore at the end of the second quarter of FY17. It has investments worth Rs 684 crore.

The rational for holding such high levels of cash was the need to fund inorganic growth. “Cash was held on the balance sheets of IT companies to acquire companies” says Subrata Ray, Group head corporate sector ratings, ICRA.

But, Indian IT firms haven’t really made big acquisitions. According to data compiled from Bloomberg, TCS hasn’t acquired any company in 2016. It last acquired two firms in 2015 for a total cost of $70.4 million. But Infosys has been prolific in acquisitions. It acquired eight companies in 2016. But the total value of acquiring six of these companies, for whom information is available, was a mere $31 million. Simply put, the value of these deals is nowhere near their cash holdings.

Apurva Prasad, analyst at HDFC Securities, offers an interesting parallel. “In the last two years, Accenture has spent $1.7 billion on acquisition, while the tier-1 IT companies in India have spent $2.3 billion,” he says. Others also concur. “The number of large acquisitions by IT firms has been rare,” says Ray, adding that “the overall deployment has not been large”.

On various matrices, Indian IT firms hold on too much higher levels of cash.

While Accenture has a cash to market capitalisation ratio of six per cent, for Infosys it is at 14 per cent. Wipro is even higher at 20 per cent. Their payout ratios are also lower by comparison. According to estimates by HDFC Securities, in the last three years, Accenture’s payout ratio (dividend and buybacks) has been more than 100 per cent of its free cash flow. For Cognizant, it is likely to be around 75 per cent by FY19. For Indian IT majors it is way lower, around 54 per cent.

Investors fret that a higher cash balance on the balance sheet depresses a company’s return on equity and thus its stock valuation. Typically, cash is either held either as fixed deposits or invested in government securities, or invested in debt and liquid mutual funds. But yields on cash are low are adjusting for taxes and inflation. This depresses a company’s overall return on equity. Excluding cash, core returns for IT firms are significantly higher.

“It’s fair to state that core return on capital employed (ROCE) or return on invested capital is higher by 10-15 per cent than ROCE for large Indian IT due to the high cash composition and low cash yield,” says Prasad. This has led to pressure from investors, especially institutional investors, for buybacks. Analysts expect the top IT firms follow TCS’ example.

“The trend of buybacks is likely to be limited to the top tier IT companies. Quite a few mid-sized IT companies have a fair amount of debt and/or the cash build up is not significant,” says Anuj Sethi, senior director, CRISIL Ratings. It is also likely that this is not a one off event for a variety of reasons.

First, the growth rates of Indian IT companies are maturing. These are unlikely to go back to historic levels. Thus there is need to reward shareholders. Second, as Sethi points out, “the capital intensity of IT firms is not very high.” This reduces the requirement for holding cash. Third, the scope for big acquisitions is limited, especially marked by size of acquisitions. In areas where there is scope, such as digital and automation segments, valuations are a problematic.

Fourth, yields on cash held by companies is typically low. And lastly, buybacks are also more tax efficient way of giving money back to shareholders.

“It is likely that other IT companies will follow this trend. But this is a continuous process, not a one off event” says Prasad. Though the manner in which it is given back will also depend on tax policy.