Higher tax outgo, contracting margins and higher working capital requirements have added to IT companies’ woes
While factors such as shrinking volume growth, falling rates and increasing vendor consolidation for information technology (IT) biggies have been adequately factored in by the markets, a key financial metric seems to have been ignored.
Though most of these companies have seen significant uptick in their earnings since financial year 2009 (FY09), free cash flow to the firm (FCFF) has not gone anywhere. FCFF is the “free” cash available with a company. This means it is cash-free of any obligations and these can be used by the company for its future growth strategies. It is also used by brokerages to estimate future growth of companies.
This means the earnings quality of these firms is on a downtrend. Given that large deals and bargaining power have come down, this trend does not come as a surprise. Further, higher tax outgo (due to removal of STPI benefits and introduction of MAT, amongst others), contracting margins and higher working capital requirements have only added to their woes.
Strong revenue (13-26 per cent) and earnings growth (12-27 per cent) posted by the big four companies of the Indian IT sector since FY09 have not come easy. A look at the shrinking cash flows of these companies is a reflection of this. Notably, consistent financial outperformance relative to their peers has resulted in a sharp re-rating of the price/earnings (PE) ratio of TCS and HCL Tech in the past two years. However, they are at parity with Infosys and Wipro when it comes to growth in free cash flows. While Infosys leads the pack on the FCFF front, Wipro has been the clear laggard. A look at the Enterprise Value (EV) to FCFF ratio shows that markets have been rewarding companies with low FCFF generation, such as TCS and HCL Tech as against Infosys, which has generated superior cash flows (see table). Thus, in addition to the PE multiple, one should also consider FCFF-based metrics such as, EV/FCFF while valuing a company, believe analysts.
| Muted cash flow growth (%) | ||||
| Cagr | Revenue | EPS | OCF/share | FCFF/share |
| TCS | 21 | 27 | 6 | 2 |
| Infosys | 16 | 12 | 3 | 3 |
| Wipro | 13 | 12 | -5 | -3 |
| HCL Tech* | 26 | 22 | 6 | -1 |
| All figures are growth rates on a compounded basis from FY09 to FY12 cagr: Compound annual growth rate;OCF: Operating cash flow; FCFF: Free cash flow to the firm *FY12 data based on BNPP estimates, HCL follows June quarter year ending Sources: Companies; BNP Paribas estimates | ||||
“From a medium-term perspective, Infosys and Wipro stand out as relatively inexpensive, while TCS needs significant FCFF improvement to justify current valuations. HCL Tech continues to look overvalued to us,” Abhiram Eleswarapu, IT analyst at BNP Paribas Securites, writes in a recent report on the sector.
Higher working capital, taxes eating into cash piles
Importantly, while two key components of FCFF, working capital and tax expenses, have moved unfavourably for all the IT companies, some relief has come from the lower capital expenditure incurred by them. Over the past three years, these companies’ change in net working capital to sales ratio has increased by 19 to 623 basis points, largely attributed towards investment to get new deals. HCL Tech, with a mere 19 basis points increase in this metric, has done better than others, but the company's growth has largely come at the price of lower margins. Also, the tax to sales ratio has grown by 135 to 574 basis points across these companies. Infosys has witnessed the highest jump in this number, now at about 10 per cent as against four to seven per cent for the other three. The impact of these factors on the cash flows was restricted to some extent by a fall of three to 303 basis points in the capex to sales ratio across these companies.
Given the weakening macro, analysts believe, cash flow generation is likely to remain under pressure. “We believe new deals in the market require more investment, which, coupled with slower growth ahead, could continue to strain constant curency margins and balance sheets.Our analysis suggests growth appears to have been as much a function of the type of deals companies chose to pursue as their capabilities,” believes Eleswarapu.
Industry players, too, agree with this fact. V Balakrishnan, chief financial officer (CFO), Infosys, believes, “The possibility of continued pressure on IT companies’ cash flow cannot be ruled out. But financial discipline is very important whether it is good or bad times. Large companies that are well disciplined will manage the environment well.”
Notably, most large cap companies are investing in new platforms, such as cloud computing and mobility, among others. A large part of these investments are likely to bear fruit only in the long term, straining near term cash flows. S Mahalingam, CFO and executive director, TCS, says, “We watch the operating cash flow very closely. As of now, I think, we are in a comfortable position, given that we are in a growth phase. For us, cash flow is about two factors — debtors position and my order to cash time. Controlling debtors is important and any deterioration in the same is a cause of concern. Order to cash time is about unbilled revenue, or revenue that is yet to be realised which has gone up slightly, but it is not a big concern. So, while the debtors days have gone down to 80 days in dollar terms, in rupee terms it has gone up. Last quarter my debtors day was 86 days, for the recently closed quarter it is 89 days. My working capital has also increased impacting the cash flow.”
Net-net, Infosys' strategy of choosing margins over high growth seems to have borne fruit in terms of the best cash flow for the company. Higher margins than peers coupled with lower growth in net working capital are the key reasons for the same. Given the company's conservative approach, analysts expect them to retain this cash flow. However, the company continues to witness sluggish growth, largely due to client-specific issues at its end. Thus, consistent improvement in operating performance is a must for any re-rating of the stock, believe analysts.
On the other hand, HCL Tech and Wipro have lagged primarily due to lower margins. Any improvement in their cost-structures and margins will aid cash flow generation for these companies.
TCS, on the other hand, has witnessed strong uptick in margins, limiting further upsides in its cash flow, given its working capital needs are likely to inch up, going forward. Overall, the sector does not appear to be out of the woods yet with a worsening demand environment and a stronger rupee.
(With contribution by Shivani Shinde)
