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Software: Can debt help?

Dec 24, 2007

In our past many articles on the software sector, we have written about the appreciating rupee’s impact on companies’ profitability, talks of a possible slowdown in the US tech spending and the companies’ aggressiveness on moving up the value chain, thereby dealing with the cost side pressures and at the same time, penetrating into the domains of global IT incumbents. In all these discussions, there has been little talk on the companies’ financial strength as most of these (companies) are known to be strong cash generators. But, would some amount of debt also help these companies shore up their global ambitions as also improve their intrinsic value? In this article, we will focus on the impact that some amount of debt can have on these companies businesses and balance sheets. Yes you heard it right! Debt with an IT company may sound like a cricket bat in the hands of Tiger Woods!

IT biggies have always been debt free. Infosys, in particular, has not taken any debt in the past 7 years. TCS, Wipro and Satyam have marginal debt on their books, though their debt to equity ratio is less than 0.1 times with average interest coverage ratios of 260 times, 65 times and 95 times respectively. While zero or near-zero debt might seen as a strong point in favour of these companies, the fact that this (zero debt) unnecessarily suppresses their intrinsic value is a fact that is never taken into consideration. How? Simply, the intrinsic value of a company is the value of its long-term (say, 10 years) cash flows discounted (by the cost of capital) to the present value. Now, while cost of equity for these companies is around 14%, the cost at which they can raise some debt can be easily around 7% to 8%. But how much debt should they take, or at how much of debt can they maintain their balance sheet strength?

The legendary investor, Benjamin Graham’s ‘margin of safety’ principle has it that a company with an interest coverage ratio (PBIT/Interest payment) of 4 times is considered safe. So, taking the case of Infosys and using its profit before interest and tax of around Rs 47 bn (on a trailing 12-months basis), it has the ability to pay annual interest of around Rs 12 bn (Rs 47 bn divided by Rs 12 bn will be around 4 times interest coverage). Now assuming the Infosys can avail of debt at an interest rate of 7%, the debt it can take to pay interest of Rs 12 bn will be around Rs 170 bn (Rs 12 bn divided by 7%). It will then have a debt to equity of 1.2 times (current equity is Rs 130 bn). Its average cost of capital will thus decline from 14% to 10%, which will shore up the company’s intrinsic value. While this seems a quantum leap from a zero debt to equity ratio, investors would do well to note that a debt of Rs 170 bn does not seem so large when seen in context of the company’s cash generating ability. As a matter of fact, the company generates operating cash flow of around Rs 50 bn annually, which, even after assuming the interest payment on debt, will make it comfortable for the company to repay debt in a short span of time.

Assuming the company can put to use this entire amount taken up as debt, its enterprise value (EV) will also increase. Our rough calculations show that the EV shall increase by around 10% from the current levels.

The financial leverage (debt to equity ratio) acceptable to the stock markets is primarily dependant on the stability of the industry the companies are working in. More stable the industry the higher would be the acceptable financial leverage and vice versa. Also the amount of debt, which can be raised, will vary from company to company and it will depend on the interest coverage ratio the companies the comfortable with.

Apart from this financial engineering and the consequent benefits of the same on the company’s value, the debt raise can be used to finance a global acquisition, even a large one, which can prove to be the ultimate way these companies can add value to their business. The Indian IT companies were not required to take any debt on their books mainly because they used to focus on organic growth. However, with the overall macro environment going against them and there being a need to scale up faster and fill up domain competencies, an inorganic growth route can become an equally important tool. And for that, some amount of debt can help!

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