In search of new opportunities

Author explains why buyback offers would not compromise long-term business objective of these firms

Experts believe that the recent developments in the US have provided an opportunity to the Indian firms to revisit their strategy and tweak their model away from labour-intensive low-margin business. These firms have to explore opportunities in the area of artificial intelligence, machine learning and cognitive analytics much of which are outside the present domain of these entities. Indian firms need to adopt the “acquisition” route to quickly get into these new areas of high-margin business.

Inorganic growth requires availability of cash reserve. The leading software firms (table) have already distributed more than US $9 billion in the past three years by way of dividend and still hold more than US $20 billion of cash and short-term investments. This implies that proposed buyback offers of the seven companies would not compromise the long-term business objective of these firms. The only challenge it to learn how to identify potential candidates for acquisition.

Shareholder activism

Another reason for a company to announce share buyback could be the pressure of large shareholders. Promoters majorly control equity ownership of most of the software companies in India. Cognizant Technologies, which is a US-based company, is an exception where investment and hedge funds hold major shares. One may wonder why all these seven companies have either announced or are planning a share buyback this year?  The reason could be pressure from the institutional investors. For example, foreign portfolio investors are known to exert pressure on companies to distribute cash to shareholders. It is observed that foreign portfolio investors held 40.24 per cent of Infosys shares, 26.94 per cent of HCL’s and 10.93 per cent of Wipro’s in 2016 and these group of shareholders did not hold any shares of these companies in 2015 or earlier. Empirical evidence suggests that shareholders often put pressure on firms to distribute idle cash, which is not earning optimal returns.

Such active shareholders always demand a transparent capital return policy. For example, Elliott Management, which holds four per cent stake in Cognizant Technology Solutions (CTS), demanded a $2.5-billion share buyback, interim dividend and a shakeup in management of the company to improve profitability. Incidentally, CTS has never paid any dividend since its inception. Similarly in 2014 two former chief financial officers and a serving board member of Infosys had formally written to the board of the company demanding share buyback worth US $2 billion. Generally shareholders of IT firms in India were not happy with the returns over the past three years and believed that buyback may boost the share price and hence value of their investment.

Market reaction

The IT firms had three choices with regard to their capital return policy: (a) do nothing (that is, retain the free cash), (b) distribute the free cash as a special dividend, and (c) share buyback. The accompanying table shows the implications of these three choices.

It is assumed that if every firm does nothing with existing free cash, the share price would not change and the price shown is the share price on the date of announcement of buyback. Further, the special dividend is assumed to be equal to the size of buyback announced or discussed. The ex-dividend price is estimated by deducting dividend per share from the share price under “retain cash” option. Loss of income due to the use of free cash (equivalent to yield of free cash multiplied by the proposed buyback size) is deducted from earnings estimates for dividend and buyback options.

It is observed that earning per share (EPS) would not increase in most of the cases after buyback. The market reaction, based on share price change in one week after the announcement of buyback), has been positive in three out of five cases. Market reaction is estimated as excess return over NIFTY (NASDAQ in case of Cognizant). Thus, there is no guarantee, as some shareholder activists argue, that share buyback would improve EPS and share price. Buyback should be used more as a signalling mechanism.

(Series concluded)

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