Wipro (WIT) is a good company. For some reason it has never quite caught investor interest in the way that Infosys (INFY) has. Azim Premji is a formidable leader; he has a great track record and is well respected in India. On stewardship quality WIT is INFY's equal; but on valuation WIT is the winner. Access The Quant Report here for data based on which below commentary is based.
WIT has low levels of operating risk. Between 31 March 2000 (fiscal 2000) and 31 March 2009, the company has delivered annualized earnings growth of 31.7%; the dividend has grown an annualized rate of 62.7%. Including estimates for the year ended 31 March 2010, the annualized growth rates are 29.6% and 61.4% for earnings and dividends respectively. The six year median earnings levels between the year ended 31 March 2005 and 2009 has grown at 28.7% annualized and growth in six year median earnings at the end of 31 March 2010 is expected to clock in at 27.6%.
WIT is cyclical and strongly influenced by the economic cycle - the annual rate of earnings growth (year on year) was huge during fiscals 2005 (57.9%) and 2007 (38.5%); during fiscals 2006/08/09/10, growth has been subdued at 23.7%, 12.3%, 19.4% and 12.8% respectively. Its cyclical nature will create good entry opportunities and good exit opportunities as it dances to the song of the economic cycle. Normally the IT sector will tend to outperform off bear market bottoms about 6 to 12 months before a typical recession end. After the recession ends, IT will normally under-perform for 18 months or so before returning to an outperform phase.
We are presently headed for a period when IT can be expected to under-perform. Within the IT sector; IT consulting services and communication (networking equipment) services can be expected to perform well ahead of the broad IT sector. For WIT, this could mean a period of holding a core position bought earlier in the cycle and should the stock under-perform, slowly adding speculative (short term) positions to benefit from further out-performance later in the economic cycle.
Future Growth Potential
All told, I believe Wipro has put in a solid long term performance; do note that the slowest year on year growth was 12.3%. As regards the future, I believe WIT can return to 20% year on year growth, however, in the aftermath of the crisis, a stronger Rs, increased competition resulting in margin pressure and slower demand growth might lead to slower growth. In my view 12% as a long term rate over the next several years is achievable with little to no risk.
Growth does not just happen; it takes effort and hard work – and the cost of this effort can be seen in historic financials. WIT has increased operating cash flow at rates of 24.7% between fiscal 2000 and 2009. During the same period investing cash flows have grown at 33.9%; and yes estimated free cash flow too has grown at about 15.7%. In my view, the payout from investment in growth will show in forward years.
Creation & Return of shareholder value
The growth in earnings and core long term earnings potential has been phenomenal for WIT. Dividend growth has been delivered at exceptionally high rates. Payout ratio has run at median levels of 18% to 20%; this level of payout is fully acceptable when you consider the need for investment in future growth. All in all WIT has done a great job in value creation and return.
What is disappointing is that a long term investor, who purchased shares at annual average prices during fiscal 2000 and diligently re-invested dividends in shares, would have made an annualized return of just 5.6%. Sadly, this is more a cause of bubble valuations early in the decade than any deeply distressed valuation today. This is a perfect example of why I tend to avoid Rs/$ cost average investing strategies; my strategy is and always will be to buy value; even deep value.
Growth requires investment and investment needs cash. A company’s capital structure indicates how the cash is raised. What part of it is equity, what part of it is debt and what part of it is hybrid (debt with characteristics of equity or vice versa).
The Modigliani-Miller theorem says that the value of a levered company is equal to the value of an unlevered company plus the marginal rate of tax multiplied by the market value of debt. Simply put, if a company borrows money as part of its capital structure, it will be worth more than if it finances its capital structure 100% equity.
The rational is simple, when you borrow, you pay interest; this is tax deductible. The dividend on equity is not. Thus the market value of a levered company must be higher. In numbers it works like this; if you buy an asset for 100 and expect it to generate 10 (14.29 pre-tax) in post tax cash flow in perpetuity, and the cost of equity is 8%, the future value of cash flows is 125; this is your market value. This assumes a tax rate of 30%.
Now if you have a tax rate of 30% and you borrow 30 at 10% and use 70 from equity costing 8% the picture changes. You now have post tax cash flow in perpetuity of 7.9 (14.29 pre tax cash flow, minus 3 in interest charges and minus 3.39 in tax). At an 8% cost of equity, this is worth 98.75. And the debt is worth 30 (3 in perpetual interest cash flow with a 10% cost of debt); so the total worth is 128.75 compared with 125 previously. For the equity holder, in an unlevered company 100 is worth 125 (Market Value to Book Value of 1.25); in a levered company 70 is worth 98.75 (Market Value to Book Value of 1.41). So you can see that leverage is an important tool to create shareholder value.
The problem with the words of wisdom of Messrs Modigliani & Miller is that their wisdom is often not understood or misused. In the real world, debt holders want their money back; your operating cash flows need to be sufficient to pay back both the interest and principal. You can replace debt by borrowing as you pay down debt, but the cost of debt changes as the economy transitions through its cycle. In addition, during times when the yield curve is inverted and risk aversion is at high levels, access to debt might be very constrained.
At the same time, earnings and operating cash are volatile over the course of an economic cycle. This acceptance of volatility is one reason why equity investors demand a higher return expectation compared with debt providers; volatility implies risk and risk demands a return premium. Debt is a two edged sword. Using debt enhances shareholder value, but using too much debt can cause future dilutive events which will destroy shareholder value.
WIT has a strong unleveraged balance sheet; net of cash and cash equivalents at end of fiscal 2009 the company was unleveraged. In my view, there is potential to add leverage and acquire growth. In the unlikely event that M&A activity is not on WIT’s mind, adding leverage to a 20% of debt plus equity level is fairly safe even in the present climate; it can enhance shareholder value. The funds raised could be returned via dividends, buybacks or a combination of the two.
In my view, the economy has recently entered an early phase of expansion. While the expansion might be less robust than bull predict and the next contraction may be harsher than the bears expect remains to be seen. What I do see is an expansion commencing, and one that is good for at least six months. The signs for reversal will be watched for, but personally, I expect signs of trouble to emerge no earlier than 2012; of course I could be wrong.
WIT is considered a large cap in India which is its principal market of trade; this adds a touch of defense. WIT is a cyclical stock; the earnings volatility adds a level of risk. This brings me to valuation risk, which is high for long term buy and hold investors but possibly low for speculators. Financial risk is low as a result of a strong balance sheet. But keep a watchful eye on news flows and M&A activity; the strength of a balance sheet can quickly change and since Indian companies do not include balance sheets in their quarterly reporting, investors do not always have good visibility on leverage until the year end.
This brings me to valuation risk.
Wipro trades at near Rs 600 per share. In my view, fair value of the share is near Rs 300. Let’s be clear, my fair value calculation is based on an adjusted version of Gordon’s Dividend Growth Model. I use 6 year median EPS as a base long term earnings. I use a notional payout ratio of 40% as reflecting the notional dividend; if the actual payout is lower, it’s not a problem because the lower payout will drive future growth higher than growth rates assumed in my calculation. The future notional dividend flows together with growth in notional dividends at a rate equaling the forward nominal GDP growth expectations (12% for India), are discounted back to today at rates equaling a slight premium the long term return (16% for India) on the main market of trade. This discounted value is fair value; fair value is a level where markets rarely trade; but when they do, it is time for long term investors to consider buying.
The share price is marginally above forward fair value expectation (Rs 500) projected out to 2014. So I cannot call WIT a buy on valuation for long term investors.
However, persons who trade can take speculative positions for the upside potential left in this economic cycle. In my view, over the course of economic cycle, the stock has a potential price target of Rs 1,500. Over 12 months, the gain potential is in my view to Rs 900 levels; keep in mind that while IT can be expected to under-perform, IT services can benefit coming out of the crisis. In addition WIT’s recent quarterly report was both strong on performance and outlook.
In US WIT is trading at $17.36 in US and Rs 595 in India. With the Rs at near 47 to $1; the ADR trades at a big premium to India. The premium is abnormal even when considering other Indian ADR’s listed in US. I have little conviction in this premium as I believe it would have disappeared in a blink by arbitrageurs; yet WIT has maintained a high premium for several years.
Disclosure: Long indirect positions in WIT, with intent to add small speculative positions at Rs 560.