October 2019: Infosys: Whistle blower complaint and free cash flows

During the month the price of Infosys, one of our holdings, fell sharply after the whistleblower complaint made to the company’s board of directors and to the SEC became public. The complaint covers a whole host of issues from name calling to questioning the accounting policy of the company. The allegation about irregular accounting practices is a serious issue and therefore needs to be looked into. Moreover as Infosys is listed in the US, it can have potential liability towards its ADR holders if it has indulged in accounting misrepresentation.

The profit and loss account of a company is essentially an opinion, as a whole host of assumptions, including some standardized, and some subjective assumptions, go into producing it. Based on the assumptions one makes, the accounting can be conservative, aggressive to outright fraud. Therefore we like to look at the P&L statement in conjunction with the cash flow statement as cash flow is a reality. Free cash flow is the cash left after meeting all the expenses of the company as well as after paying for capital expenditure and working capital requirements. This is essentially the surplus cash left for the shareholders, and the management can do what they deem fit with it, like paying dividends, doing buybacks, making acquisitions or letting the cash accumulate in the company. Infosys through its history has converted 79% of its profits into free cash flow. In the last two financial years since the current CEO took over, this number has edged up to nearly 90%. Even in the first half of the current year the ratio of free cash flow to earnings is in line with the historical average. Based on these numbers we believe that the allegation of accounting misrepresentation is unlikely to be true.

The allegation that the CEO doesn’t spend his entire time in the corporate office is a matter of much amusement to us, when we consider that this is the company that pioneered the concept of global delivery centers and aspires to do digital transformation for its clients. The profitability of each business deal is a business decision which can be based on several considerations, strategic or tactical and if the allegation that some deals have zero profitability is true, then Infosys won’t be the first firm to do that. As such it is not something that warrants alarm. The other allegation about the extent of disclosure to the board is a subjective matter, particularly when one considers the large number of contracts that a company of Infosys’ size writes every year. So it is not a very clear violation of any law or norm without knowing exactly what information was not disclosed to the board.

Infosys has been through a series of corporate upheavals whether it was the nth promoter becoming the CEO or the very public spat between the erstwhile CEO, some board members and promoters. It would bode well for the company if this current situation doesn’t slide into acrimony. One should remember though, that even when the company went through corporate turmoil in the past, its business still delivered – be it revenue and earnings growth or profitability and cash generation during that period.

We must confess that our above analysis of the situation is based on incomplete information as the matter is still being investigated by the company. However, we draw comfort from the fact that there is no significant change in the cash generation in the company, which would likely have been affected if there was some truth to the allegations being made. We hope to see an early resolution to the issue.