Concerns underlying stock buyback

In a recent development, Cognizant Technologies agreed to institute a share buyback programme in response to demands made by an activist hedge fund Elliot Management. In a media interview, TV Mohandas Pai, former CFO of Infosys, made a fresh demand to institute a large buyback programme at Infosys. There is speculation in the press that certain large shareholders of Infosys are not pleased with the company’s acquisition of Israeli software company Panaya and are angling for a large buyback programme.

To understand this sudden clamour for share buyback, it is pertinent to consider the theoretical motivations that influence such decisions and the capital allocation process.

It is relevant in three contexts. The first is the presence of tax arbitrage opportunities where the programme delivers a higher value to shareholders compared to a dividend distribution. In India, a 15 per cent tax is levied on companies distributing the dividend. In addition, the recipients have to pay 10 per cent more if dividend income exceeds ₹10 lakh in a year.

In contrast, there is no tax on long-term capital gains. These differences in the treatment of income under various heads result in a tax arbitrage opportunity that favours share buyback compared to dividend distribution. Even when share buyback is preferable to dividend distribution, it does nothing to the intrinsic value of the firm. The price for each share increases as the number of outstanding shares reduces, but the total value of firm remains constant.

The second context in which share buyback program becomes important iswhere the management wants to signal to the marketplace that the firm’s shares are undervalued. Managements typically repurchase shares when the firm has high free cash-flow. An additional signal embedded in buyback announcements is management witnessing limited investment opportunities and expecting slow growth in its extant business.

The third context in which companies are forced to repurchase shares relates to negating the effects of expensive or unsuitable acquisitions. These investments are expected to reduce the overall future value of the firm and shareholders prefer that management reduces cash available on hand by repurchasing shares.

The demand for repurchase is a result of a combination of these factors. IT firms in India are faced with the prospect of slow future growth and are sitting on a large pile of cash. Nasscom has reduced the industry’s growth target for FY17 to an 8-10 per cent range from a 10-12 per cent range forecast earlier. IT firms also face hurdles from the new immigration stance adopted by the US, their largest market.

The biggest shareholders of these firms appear reluctant to trust the incumbent management with significant investment decisions. They seem to be suddenly aware of conflicts involved in a principal-agent relationship. Boards and management, with only a small stake in ownership, can have interests diverging from those of large shareholders. Specifically, managements may be tempted into ‘empire building’ that increases executives’ compensation and prestige but at the risk of the profitability and the value of the firm. Large cash holdings lead to riskier investments.

In the current situation, the boards of cash-rich companies have to make a critical decision. Buyback programmes are not without value and often help to discipline the capital allocation process. But boards need to appreciate that the short-term solution of instituting a buyback programme does not address the larger problem of slow business growth. A mechanical outcome in form of higher earnings per share will dissipate over time if business growth remains muted.

Boards need to spend time and efforts with management in deciding an optimal capital allocation that aligns with the strategy.

The writer is the founder and managing partner of Quadrature Capital

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