How Infosys' cash policy has impacted shareholder value

In an interesting report, analysts at Motilal Oswal have put together the impact of Infosys’ cash policy on key financial metrics, such as return on equity, which play an important role in impacting shareholder value.

But before that, here’s a quick word on how various companies approach the issue of cash.

Many companies – mostly young, fast-growing ones -- do not declare dividends. This is because they want to invest profits in growing their operations and they believe shareholders are better off with this policy, instead of receiving cash and investing it in lesser-yielding opportunities elsewhere (more investments in the company’s business will lead to higher profits and, thereby better relative stock price appreciation over the long term).

Then there are mature businesses that have accumulated cash over the years but which do not see too many business opportunities to invest – either within the business or outside, by way of acquisitions – that would provide better returns than what their shareholders could get elsewhere. Such companies choose to declare part of their yearly profits as cash dividends.

Over the years, though, Infosys has chosen to neither invest its cash in major opportunities nor has it paid out much of it through dividends. As a result, in the past seven years between fiscal years 2007 and 2014, its cash has increased nearly 4.5 times from Rs 5,871 to Rs 25,950 crore.

Worse, a significant slowdown in its business over the past few years – vis-à-vis peers – has resulted in its stock price growing a mere 8.7 percent annually over the past five years, leading even its chief financial officer to recently admit the company had in the least failed to do “a good job of articulating its capital allocation plan for many years”.

In the report, Motilal analysts outlined how its low dividend payout policy -- 34 percent of its profits over the past 10 years -- has impacted return on equity (RoE).

They added that had the firm’s dividend payouts been higher, say, at 60 percent, its RoE (a key metric analysts use to determine share price) would have improved from 24 percent in fiscal year 2014 to 33 percent.

Return on equity is calculated by dividing yearly profit after tax by total shareholders equity (assets minus liabilities), and serves as an indicator how well a company is using its assets to create profits. Higher dividends result in fewer retained earnings being added to the balance sheet and boost RoE (by reducing shareholder equity, the denominator in the formula).

“As a result of continuous accumulation of cash as a percentage of the balance sheet size, Infosys’ RoE has continuously eroded over the years, and is down from 43 percent in FY05 to 24.9 percent in FY14,” analysts wrote, pointing out that cash as a percentage of balance sheet over the same period has increased from 52 percent to 64 percent.

Interestingly, while Infosys’ reported 24.9 percent RoE trails that of larger rival TCS’ at 40 percent, taking cash out of the balance sheet equation shows an entirely different picture.

“If we look at the operating RoE, Infosys stands at 54 percent in FY14, beating TCS’ at 52 percent,” analysts pointed out. Operating RoE is calculated by putting operating profits in the numerator and operating equity (total assets – cash) in the denominator.

In other words: 36 percent of Infosys’ equity earns 54 percent returns while the remaining 64 percent (cash component) earns what cash earns – single digits!

Thankfully, after new CEO Vishal Sikka took over the helm in August last year, not only has Infosys pledged it would outline its capital allocation strategy better, it has also said it would utilize capital better by pursuing an aggressive acquisition strategy.

Over the past 10 years, Infosys has spent 4.5 percent of its operating cash flow on acquisitions compared to 6.8 percent to 18.2 percent for peers Accenture, Cognizant, TCS and Wipro, the report pointed out.

But Motilal analysts believe that even in face of a more aggressive acquisition strategy (if it increases M&A spend to the 9.7 percent followed by Accenture), there would still be room to increase dividend payout.

The brokerage also says that with the strategy Sikka has outlined for the firm, it should close the valuation gap with TCS (the market values Infosys at 19 times trailing earnings compared to 25 times for its rival) in future. It has a price target of Rs 2,500 per share on the stock, implying a 27 percent upside from current levels.