India IT Services:Capital allocation driving stocks,or the other way round

Cash conversion has improved for top Indian IT companies in the past 10yearsdespite competition and pricing pressure. OCF/EBITDA averaged 82% in FY17forthe top four versus a 74% 10-year average. Moreover, slowing growth has reducedneed for capital expenditure, leading to FCF/EBITDA of c 71% in FY17, versus a 58%average in the past 10years. No mystery why buyback announcements are frequentnow (from all companies) as investor pressure rises for a higher payout.

    Cash allocation in FY17: In FY17, the top four IT companies generated c USD9bn inOCF, with about 14% devoted to capex (versus a c 20% 10-year average); around 69%to dividends/buybacks, including TCS’s USD2.5bn buyback, effective in Q1(vs 43%);11% to M&A (vs 8%); and 6% as cash accruals (vs 34%). The top four companies inthe past 10years have generated c USD57bn in OCF.

    What buybacks offer, more than just near-term downside protection. Mostcompanies have increased dividends or buybacks to utilise cash. Dividends aregreat, and buybacks are good as well, but why not just increase investment in thebusiness, which can create much higher long term value? First, buybacks are hardlyearnings accretive in India; but, more importantly, a similar investment (USD1-2bn) inR&D can provide better long-term value for all stakeholders. The industry structure ischanging, and growth in digital, agile, dev-ops, cloud, etc needs more investmentfrom Indian companies. Companies such as Wipro and TechM have gone the M&Aroute, but with limited success. This warrants a robust organic framework forinvestment in new technologies, intellectual property, and brands (perhaps creatingsubsidiaries under different brands would be a good idea as well