Should IT companies return more capital to shareholders?

Most analysts believe increasing dividend payouts and buybacks could support stock prices

With many large and small information technology (IT) services companies sounding an alert on revenue growth in the past few months, concerns around global IT spends have risen. The sector faces headwinds such as Brexit and US elections, which could impact client spends on IT services in the near to medium term. These pressures will add to the woes of IT companies, which are already busy aligning their business models to digitisation. The deal sizes as well as tenures in digitisation are smaller compared to the traditional IT outsourcing model. All these factors will only lead to higher volatility in these companies’ revenues and earnings. In this backdrop, analysts are incrementally questioning the huge cash piles in the balance sheets of Indian IT companies.

“We believe the top four Indian IT firms need to increase payouts significantly to allocate capital more efficiently, which in turn would translate into a material dividend yield of four-six per cent,” says Sandeep Muthangi, technology analyst at IIFL. While dividends have been the predominant choice of returning cash, buybacks are a more efficient way, due to the dividend distribution tax of 17 per cent, he adds.

This view is echoed by Madhu Babu, IT analyst at Centrum Broking. “While mid-size IT companies could focus on M&A (mergers and acquisitions) to drive scale, we believe larger IT companies can focus on efficient capital allocation during this tough phase by increasing dividend pay-out ratios substantially or choosing share buybacks.”

Higher dividends or buybacks would also aid Street sentiment. The weakening demand environment has led to the S&P BSE IT index falling eight per cent in the past three months, underperforming the Sensex (up four per cent). Second, lower cash balances will aid return ratios, as witnessed in the case of Accenture, which has paid most of its profits via dividends over the past decade. In fact, Accenture has done buybacks in each of the past three years and also strategic acquisitions thanks to a consistent rise in its cash balances. Not surprisingly, Accenture’s return on equity stands at 50 per cent versus 21-37 per cent for the top four Indian IT companies. Not surprisingly, Accenture’s stock has done better its Indian peers, aided by good results in August quarter and better management commentary about the future.

Currently, the top four IT companies pay 40-50 per cent of their profits as dividends. Analysts believe this can move up to 80-100 per cent without affecting these companies’ prospects as they have a high cash conversion ratio, with almost all of their net profits being converted to cash from operations. Although IT companies can also deploy the excess cash to make strategic acquisitions, most of them have been cautious.

On this front so far.