Infosys is one of the global leaders in the IT services business, with an enviable foot-print across the world. It has had a sustained growth over its history of more than two-and-a-half decades. This article focuses on capital allocation and shareholder value creation, and not around other factors that seem to besiege the firm. If you look at parameters like market cap, revenue growth and the operating margin from 2001 to 2016, they tell a compelling story. Needless to say, now there are issues brewing in the press around governance, growth and capital allocation and go-forward strategy.
There are always emotional undertones that overshadow the economic imperatives, or the lack of it, when the founders and others—who have built the business—and still have a 13% stake question the outlook and the competency of the board over capital allocation and risk management (growth and competitive and skill base).
This is against a backdrop of $11 billion revenues, $5.2 billion cash reserves and cash flow of 20-plus percent annually and diminishing EPS growth—a below-par 7%—and a stock that has not kept up with the market over the last five years.
Against this backdrop, it is probably prudent to break the themes into three categories—where are the growth opportunities, what are the profitability and efficiency drivers, and finally capital allocation. All, with an intent to create shareholder value and demonstrate to the market—and the founders—that there is a clearly articulated program with defined metrics against which reporting can be done to track progress, not a vague under-defined large “aspirational goal”.
We will focus on the latter two themes and, for the time being, set aside the growth piece. Infosys is a $32-billion market cap, $11-billion global IT services firm, and the question is whether it can sustain or even attain double-digit growth in a highly-competitive market organically when market spending is not growing more than 2-3% and it is itself so large. With the OECD as its major market—where GDP is growing at 2-3%—growing at 7-9% is a decent achievement. In a commoditised market-space, sustaining operating margins at 20-plus percent is also highly commendable.
This begs the question: How do you optimise this model—assuming Infosys sustains these margins—for a 7-9% organic growth and generate better outcomes for the shareholders via a share repurchase programme? This is so when you have a fortress like reserves not generating a good yield and ROE being at 25-plus percent despite having 50-plus percent of equity invested in low-return bank deposits.
Capital allocation is a bug-bear that seems to haunt all IT majors in India, and Infosys is no exception. Overseas, Accenture has had a great programme over the last five years, due to a wonderful strategy that has resulted in double-digit annualised returns for shareholders. Recently, Elliot Capital forced the board of Cognizant to start a share buy-back of $3.5 billion, restructure the Board, start an expense reduction programme and engage with investors to improve shareholder value creation—the stock went up, delighting investors.
In India, boards of IT companies with huge cash on the balance-sheet seem to live in denial, institutional investors accepting blindly the stories fed to them about cash needed for transformational growth, when a service company has cash of more than 50% of annual revenues. Capital allocation is all about—creating manageable cash reserves, allocating internal capital for R&D (sustaining competitive advantage), allocating capital for M&As and, the most important last piece, capital return programme or share buy-back.
One can define a set of metrics after internal modelling—and many industries have defined benchmarks. Allocating a part of total revenue for R&D and creating new services is not unreasonable: allocate capital with maniacal focus around target returns and hurdle rates, make businesses compete for internal growth capital, report to the markets the revenue multiplier expected over a three-year window; if it is beyond that, then, the capital is squandered.
The second part of the capital allocation is about acquisitions. There are questions in the market around the price for the earlier one and the strategic rationale. We will let the markets judge that. It is not clear whether there has been any successful acquisitions in the IT service industry in the past 10 years. HP’s acquisition of EDS, an unmitigated disaster, comes to mind.
Finally, most institutions set a target for reserves and return the balance to shareholders by way of buyback. It would also be prudent for Infosys to return 30-35% annually to shareholders, after 40% for an annual dividend, and this can only enhance the EPS. When you are growing earnings at 7-9% annually, investors expect 10-13% EPS growth, and you are generating 20-plus percent cash, the rationale is obvious. This is without compromising growth or capital needs of the business, especially when there is $5.2 billion sitting on the balance-sheet!
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And if boards do not see the logic, it would be fair for investors to demand a restructuring of the board, just as Elliot Capital did. Not doing this would mean not discharging the fiduciary duty cast on the boards and institutional investors to enhance shareholder value. Sitting quiet, accepting stories blindly is no solution for institutional investors! Elliot Capital had the right approach and Indian institutional investors need to more fully accept their responsibility.
Setting emotions aside, the question in the minds of many is not the competence of the board or the management —but is centred more on an orchestrated capital allocation programme that shareholders and markets can respond to, and the fiscal governance by the board around that. Not doing a good capital allocation based on data, hanging on to surplus cash for no other reason than a misplaced idea of self-importance is a big corporate governance issue. Fobbing off shareholders who send detailed proposals with data for the Board to consider buy-backs, giving illogical reasons to hang on to excess cash shows non-application of mind, and worse, disrespect for shareholders.
Pai is chairman, Aarin Capital, and Chityala is chairman, EIP Fund, Vedas Group. Views are personal.