Free cash flow usage: What buybacks by Indian IT mean for shareholders

The author discusses ramifications of share buyback

Seven software companies in India have either announced or discussed buyback of shares programme within a span of 45 days, between January 31, 2017, and March 15, 2017. Excepting one company (Mindtree), others have also declared the size of buyback totalling US$5.8 billion. The seven companies have more than US$23 billion in cash, cash equivalents and short-term investments. Therefore, the proposed buyback amounts to 30 per cent of the free cash available with these companies. TCS has announced India’s biggest buyback offer till date (Rs 160 billion) surpassing Reliance Industries Ltd’s buyback offer of Rs 104 billion in 2012. The buyback price of Rs 2,850 represents a 13.7 per cent premium to the closing share price of February 20, 2017, when the announcement was made. The buyback will involve 2.85 per cent of the company’s outstanding shares. 

Interestingly Tata Sons, the holding company, has decided to participate in the buyback of TCS shares. Tata Group owns 73 per cent of TCS and hence, if the holding company does not participate in the buyback, the promoter group may reach closer to 75 per cent mark endangering listing of TCS in the exchange. Legal technicalities apart, participation of a holding company in any buyback programme sends a wrong signal to the market.

Reports suggest that the Board of Wipro is seriously considering distributing 25-30 per cent of its free cash reserve to its shareholders. Wipro had a free cash reserve of US$3 billion in March 2016, which grew to US$4.9 billion in December 2016. The expected buyback size is US$1.25 billion. This is in addition to the interim dividend of about Rs 500 crore (US$75 million) declared by the company in January 2017. Cognizant, the US-based Nasdaq-listed company, had announced in January 2017 its decision to return US$3.4 billion cash to shareholders over the next two years through dividend (US$0.7 billion) and buyback (US$2.7 billion). The company has free cash reserve of US$5.3 billion as on December 31, 2016.

Responding to the pressure of select founders, Infosys is likely to soon announce share buyback to the tune of US$2.5 billion. Infosys has more than US$5 billion of free cash and hence the expected buyback would consume almost 50 per cent of the cash reserve of the company. However, Infosys has no plans to implement the buyback programme before 2018. If approved, this will be Infosys’ first share buyback programme. One may note that in the recent past there was a bit of tension between the founders and the Board of Infosys on issues of severance pay to the CFO of the company and compensation for the CEO. Founders at present hold about 13 per cent of the company.

HCL Technologies has announced a share buyback programme to the tune of US$500 million. It represents 2.45 per cent of paid-up equity capital of the company and about 14 per cent of the consolidated equity of the company. HCL has cash reserve of close to US$1.9 billion. The proposed buyback at Rs 1,000 per share reflects a premium of 15 per cent to the closing price of the share on the day before the announcement. Mphasis has obtained shareholders’ nod for its buyback programme of US$200 million, which is 8.2 per cent of the paid-up capital of the company. Similarly, Mindtree is also going to announce its buyback programme soon. 

Signalling 

Buyback is typically used to return free cash flows to shareholders. The announcement of share buyback, therefore, sends several signals. First, large distribution of cash reserves indicates that a firm may not have immediate profitable investment opportunities, thus allowing its investors opportunity to earn better return on their investments. Second, it indicates confidence of the company to replenish its cash reserve quickly after buyback with insignificant negative impact on the net earnings (profit) of the firm. Third, it may also signal lack of confidence on the part of management in facing future uncertainties. For example, in view of severe restrictions imposed by the US on H1B visa, Indian IT firms fear substantial drop in business volume from the USA. If a software firm in such a situation announces share buyback, it may send a signal that the firm is unsure of its future and therefore wants to keep its shareholders happy by way of share buyback.

It is evident (table) that these software firms were earning suboptimal returns on their free cash (yield on free cash is very low) and hence their decision to return the cash to shareholders is justified. It is also noticed that the firms, due to the very nature of their business, need little investment in real assets (capital expenditure) and hence distribution of large cash to shareholders would not materially affect the business. 

Will the proposed buyback offers of the seven companies we have discussed here compromise with the long-term business objective of these firms?

(To be concluded tomorrow)

This is an edited version of a column that has appeared in Artha, an IIM Calcutta e-zine

The author is professor, finance and control, and director, IIM Calcutta Innovation Park