Infosys, Share Your Cash!

Well, this isn’t what I’m saying. This is what investors and analysts have been pestering Infosys to do for years now.

The company currently has accumulated almost Rs 151 billion (or US$ 3.2 billion in cash) on its balance sheet. That’s a lot of moolah!

But with ever rising cash balance, even the hounding it has received at the hands of its investors, analysts, and fund managers has risen over the years.

“Why doesn’t Infosys just pay off the excess cash to shareholders as a special dividend?” asks the investor.

“Why doesn’t it go and acquire companies using this cash?” questions the analyst.

“Isn’t holding so much cash a waste given that this asset earns returns of no more than 8% while the company pays a cost of capital of around 14%?” wonders the fund manager holding a large chunk of Infosys’s shares in his portfolio.

Well, we at Safal Niveshak see this as an absurd comparison.

Of course Infosys’s cost of capital is close to 14%, but that is for its operating investments in its business, which has earned over 35% over the past many years.

On the other hand, its cash is invested in near-riskless, liquid investments. The appropriate benchmark to compare this cash is the return Infosys would make on a riskless, liquid investment (like a government bond) and not on its highly profitable operational business.

The 10-year government bond in India is yielding around 8% currently, and that is all Infosys’s cash has to make to break even, not 14% cost of capital that it pays.

It’s like you invest Rs 100 in my business at an interest rate of 14% (this is my cost of capital).

My business is earning Rs 35 every year in profits (so my rate of return on Rs 100 invested is 35%).

Now whatever excess cash I generate from this business, some of it I reinvest in the business to earn 35% return and the rest I invest in safe government bonds that earn me 8%.

In simple terms, I borrow money at 14% and earn 35% when I invest in my business. This is a highly profitable investment for me.

On the other hand, my ‘excess’ cash is earning me 8% in interest from government bonds.

Would you compare this 8% return I make on government bonds with 14% interest I pay you, and thus accuse me of losing money? No!

I would have been a bad businessman if I had borrowed at 14% and invested in a business that was earning, say 10% or any other number lesser than 14%.

But here I’m earning 35% on a capital that is costing me just 14%.

Whatever I earn (8%) on my excess cash generated from this profitable business can’t be compared to any of these figures here. This 8% can only be compared to what I could earn if I invest this excess cash somewhere else.

You’re getting my point, right? It’s the concept of opportunity cost of capital.

In the same way, whatever little Infosys earns on its cash invested in government bonds can only be compared to the return on a similar kind of investment (another bond) and not Infosys’s operational business.

What this discussion means is that, for Infosys, cash is not a good or a bad investment. It is just a neutral one.

Cash isn’t king always
Does Infosys’s example means that all companies should be allowed to hold on to as much cash as they want to?

My answer – No, not at all!

Clearly, some companies accumulate too much cash and their investors would be better off if that cash were returned to them.

As we saw in Infosys’s case, an investor is never hurt by cash being invested in low return, riskless assets (like government bonds).

However, what investors should worry about is what the company may do with the cash:

1. Make bad investments
2. Overpay for acquisitions
3. Just fritter it away

As an investor, I would be happy to see the company earning 8% in government bonds than be invested in projects earning 15%, if the cost of capital for those projects is 20%.

In short, when I look at cash in a business, I am less concerned by how much is there, and more by what the management can do with it. This is especially when the cash is in the hands of companies that have a history of poor investments and bad acquisitions.

I will not be too concerned with cash balances in the hands of companies that are selective in their investments and have earned high returns (like Infosys).

In fact, in a case like Infosys, this debate of ‘how much cash is too much’ to me is a no-brainer.

Do I trust Infosys’s managers with my cash? Yes I do.

Do you trust Infosys’s managers with your cash? It’s purely your call.

By the way, the real question should be if you don’t trust Infosys’s managers with your cash, what other Indian company would you trust with your cash?

Anyways, I see three scenarios relating to cash unfolding for Infosys in the future:

1. Dream scenario
In this scenario, Infosys continues to use its excess cash to grow its business that in turn continues to generate high returns. So, it invests to grow its business and holds on to cash when it does not.

This scenario won’t hurt investors. Of course investors won’t get special dividends, but who needs them when you see the stock price appreciation that comes with rising profits and consistently high return on operational investment?

2. Nightmare scenario
In this scenario, Infosys (like its investors) gives in to the fallacy that its return on cash (around 8%) is too low and decides to take operating investments or acquisitions that generate returns that are higher than 8% but lower than the cost of capital (14%).

This would be devastating for shareholder value. If Infosys goes on an extended buying spree, making expensive acquisitions, I would join investors in pestering it to return cash back.

3. Dividend scenario
In this scenario, Infosys decides to pay out its entire cash of US$ 3.2 billion in dividends. As an investor, I will get a big dividend cheque on which the company would have already deducted a dividend tax (at around 17%, Infosys would have to pay US$ 540 million as divided tax…what a waste!). Also, when the company pays dividend, its stock price will decline by roughly the dividend amount (as investors will have no cash left to value).

In fact, there is a very real chance that a big payout could be viewed by the market as a negative signal of Infosys’s future prospects (“Why is it paying out its entire cash? Does it have no plans to invest to grow its business?”). This could lead to the stock price to drop by more.

Got that?

By the way, if you have any questions related to this discussion, just write to me and I’ll try to do my bit to explain you more.

Now answer this – Are you an investor in Infosys? If yes, how do you want the company to utilize its excess cash? Share your view in comments below or post on our Facebook page.

Disclaimer: I am not an investor in Infosys and this post must not be seen as a recommendation to buy Infosys’s shares. This is just Safal Niveshak’s to educate investors in analyzing a company before buying its stock.

Note: The idea for this post came from an article written by Aswath Damodaran, a leading author on subjects like valuation, corporate finance, and investment management.