After disappointing for eight quarters, Infosys (INFY) surpassed market estimates with better-than-expected results for the third quarter and also raised its full year guidance, contrary to most analysts who were expecting the company to disappoint again.
Infosys posted revenue of $1.911 billion, up 6.3 percent sequentially, up 5.8 percent year-over-year and ahead of the Street estimates at $1.85 billion. Profits were 76 cents a share, ahead of the consensus at 72 cents.
For the full year ending March 2013, the company expects revenue of at least $7.45 billion and profits of $2.97 a share; Street estimates had been for $7.32 billion and $2.95 a share.
A majority of the analysts, including at firms such as Barclays Capital, CLSA, JPMorgan, Nomura and top Indian brokerages, expected Infosys to disappoint as the company headed into the earnings season and lowered their twelve month price targets. Given a string of earnings disappointments, expecting another disappointment was par for the course.
Post the results, Infosys shares were on fire, increasing by a record 17 percent on Friday. It added another 3.5 percent on Monday in India's bourses, closing at a PE multiple of 17. Brokerages, including a few who were previously skeptical, have revised their 12 month price targets to indicate a further 10 percent upside, post the 20 percent increase in the stock price.
The biggest question after the phenomenal burst, in part driven by massive short covering, is whether the results herald a sustainable turnaround that is structural, or are attributable to an improving demand environment, or are due to a combination of several pent-up positive drivers that are not structural.
The largest contributors to the company's revenues like the U.S. region or application, development and maintenance (ADM), which fell 3 percent year-over-year for the first time in 4-5 years, didn't drive the marginal outperformance. The performance was driven by the rest of the business which historically has been relatively volatile.
The company's software (IT Services and Consulting) personnel were around 123,000, while utilization was close to 70 percent throughout the calendar year 2012. The stagnation in the software professionals head-count and utilization levels for the last 4 quarters is concerning particularly when TCS and Cognizant (CTSH) have ramped up.
Infosys management didn't attribute the performance to a stronger demand scenario and acknowledged that new contracts are seeing higher competitive intensity in an environment with limited opportunities. Indian IT services companies are aggressively building order books at any cost and are dropping offshore billing rates to bag big contracts. Infosys will find it challenging to aggressively win new projects without compromising its premium pricing strategy.
Any pick-up in IT spending in 2013 will boost margins and re-rate the company as it is best leveraged given its large bench and exposure to discretionary projects. Utilizations at <70% offer sufficient margin levers for the company in the short term as it is low compared with its historical levels and its competitors. But, CEO Shibulal said early signs indicate flat to declining IT spend in customers' 2013 budget.
Infosys can sustain the higher valuation multiples only after a few more quarters of consistent performance. The recent massive price surge in the absence of clearly demonstrated structural improvements means the stock price can melt again like it did after each earnings announcement in calendar year 2012, in case the IT budgets remain flat in 2013 or the company is unable to increase utilization levels without compromising on pricing.
After the results, a few big brokerages revised the EPS estimates upwards, on average, by 2 percent for FY 2013 and 4 percent for FY 2014. The magnitude of divergence between the new price targets and revised EPS estimates reflect the cluelessness of many analysts whose earnings estimates and price targets were widely off the mark in the last 4-6 quarters. The 17 percent price surge factors in most of the positives and given the uncertainty, limits the upside and increases downside risks.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.