How to Ride Buyback
The US has witnessed a staggering $1.5 trillion worth of buybacks by 370 S&P 500 companies over the last three years. Given the US Federal Reserve’s tightening bias, that boom could be over soon. Buybacks were funded in an ultra-low-interest-rate environment through corporate debt at historically high levels. The hunt for yield has created many arguably risky financial engineering initiatives.
Research demonstrates that buybacks are generally ineffective in longterm value creation, notwithstanding the short-term spikes in stock prices due to optically better earnings per share (EPS). Two key shortcomings relate to timing the buyback and the moral hazard of executive compensation being positive correlated to a financially engineered EPS jump.
So, the key to successful stock repurchase programmes requires a transparent disclosure of the purpose, strategy and thinking behind a buyback programme, as an integral part of the disclosed long-term philosophy for the company’s capital allocation policy. This rarely happens. Investors over time are, thus, unable to judge the success of buybacks relative to the established goals.
The current trigger for the frenetic activity in India has been the Cognizant buyback announcement leading to the desperate need to jump on to the bandwagon. This hurried comparison with Indian IT companies is unwise as there are significant differences. Cognizant doesn’t distribute dividends and its capital allocation policy hinges on buybacks as an active strategy of returning cash.
Its existing stock repurchase program- me of $2 billion announced in 2013 was completed recently. The current $3.4 billion programme includes a component of $1 billion announced in June 2016. Also, it uses debt to partially fund the programme. So, the current announcement is not as radical as it seems.
However, activist investor Elliott Management’s contribution has been to make the programme much more aggressive in terms of the reduced time period of two years in which to accomplish this, the simultaneous push for scaling the business along with increasing profitability by 3.3 percentage points from the 18.7% this quarter, and introducing a dividend distribution of $700 million in its capital allocation policy. While this integrated buyback programme will, indeed, increase its five-year trailing total quarterly shareholder returns (TSR) of 11.75% by 1-2%, the sustainable increase will come only from improving its operating efficiency.
The key to Cognizant’s TSR outperformance over the last five years — 11.75% vs the industry average of 8% — has not been due to buybacks but because of its superlative profitable growth from a revenue of $6 billion in 2011 to $13.5 billion now, versus that of Infosys from $7 billion to $10 billion.
It was here that Infosys lost out during S D Shibulal’s tenure from April 2011 to August 2014. Its priority is now to bridge this yawning gap and Vishal Sikka’s clarion call to reach $20 billion by 2020 should be seen in this light. Organically, Infosys can grow to a maximum of $14 billion, thus leaving $6 billion of acquisitions to bridge the gap.
Infosys needs innovative product and solutions companies for such acquisitions that are only available in the US whose markets are at all-time highs. This should provide a perspective of the ‘huge’ cash hoard being touted. Of course, dilution through follow-on offerings and debt is always a possibility. But the wisdom of returning cash now and tinkering with the capital structure soon thereafter is questionable.
It is the individual motivation of each company in the context of its overall priorities that determines the prudence of attempting a buyback. Tata Sons, being a 73% shareholder of TCS, needed a tax-effective mechanism to use the cash in the aftermath of the Cyrus Mistry affair and would have influenced TCS’ decision.
Given the active market for corporate control in the US, Cognizant had limited options in the face of activist shareholders. In its judgement, this was the best option to reach a ‘standstill agreement’ with Elliot. Infosys is under no such compulsion and must not feel unduly pressured while engaging in its liquidity assessments.
A face-saver for the founders could well be a factor. But then, it shouldn’t be more than a $1-1.25 billion buyback that would be recouped through free cash flows generated within a year. Given that its dividend payout has been significantly increased to 73% of free cash flows from 33% in 2014, this would seem more than reasonable.
The ultimate judgement on this issue lies with the board. And reaching a conclusion is not quite as simple as it is being made out to be.
The writer is a Sloan Fellow, London Business School
No, at least in India, it’s not a mountain