Seeking Alpha
Recommended for you:
Profile| Send Message|
( followers)  

In May 2012, I estimated that Infosys (NYSE:INFY) had a fair value between $45 and $50. As seen in Chart 1, the stock traded between $38 and $50 until mid-January, when a happy surprise on Q3 F2013 earnings sent the stock to $52 per share during after hours on 1/11/2013. Since then, the stock price has never dropped below $50. At the current level, INFY appears to be fairly valued, according to my updated DCF model. However, with its price above $50 and the stock market near its all-time high in history, this cyclical stock carries great downside risk and therefore, should be avoided in the near term.

Chart 1. Stock Performance of INFY since 5/15/2012

(click to enlarge)

I believe the market optimism in INFY will be short-lived because I don't find many positive changes in the fundamentals that are substantial and structural. This article does a good job reviewing the Q3 F2012 results in great detail. In addition to what has been mentioned in that article, here are three other reasons why Infosys is not poised for a turnaround yet.

1. Infosys' premium pricing continues to struggle, but management does not plan to cut price substantially.

Weak IT spending and the commoditization of traditional ADM services during recent years makes it hard for INFY to charge premium prices. Since 2009, there has been a strong trend of vendor consolidation among customers and a shift in client focus from maximizing values to reducing costs. This particularly hurts Infosys, as it is arguably the most rigid among Indian IT firms on pricing. As reflected in Table 1, Infosys grows its top line much more slowly than most of its industry peers, except Wipro (NYSE:WIT). INFY still maintains its advantage on operating margin over other competitors, except Tata Consultancy (TCS.BO). I believe that Infosys' margin contraction over the past few quarters is mostly due to market competition as opposed to any management decision to strategically cut prices. My read from the Q3 F2013 transcript is that, although INFY has softened its stand on pricing, the management team is not planning to fundamentally change its premium pricing strategy.

Table 1. Revenue Growth and Operating Margin

Quarterly y-o-y revenue growth

2011-09

2011-12

2012-03

2012-06

2012-09

2012-12

Latest Quarter Revenue in $mil

INFY

16.71%

13.94%

10.55%

4.85%

2.92%

5.81%

$1,911

WIT*

15.69%

12.03%

9.65%

7.62%

4.63%

4.76%

$1,577

CTSH

31.55%

26.93%

24.80%

20.88%

18.18%

-

$1,892

NSE: TCS*

26%

20.60%

20.00%

13.10%

13.00%

14%

$2,948

NSE: HCL*

21.90%

18.70%

17.10%

12.10%

11.10%

13.00%

$1,154

Operating Margin

INFY

28.06%

31.01%

29.81%

27.91%

26.27%

25.69%

WIT

16.52%

17.45%

17.26%

17.86%

17.47%

17.77%

CTSH

18.30%

18.51%

18.59%

18.50%

18.76%

-

NSE: TCS*

27%

29.20%

-

27.50%

26.80%

27.30%

NSE: HCL*

17.10%

18.50%

18.40%

22.00%

22.20%

22.60%

Comment: All revenues are based on U.S. dollars. INFY's and Cognizant Technology Solutions' (NASDAQ:CTSH) quarterly revenue growth and operating margin are sourced from Morningstar.com. WIT revenues here refer to its IT services revenues, which are reported in its analyst data sheet. TCS and HCL Technologies data is sourced from their investor sites here and here. HCL margin in the table is, in fact, EBITDA margin, as HCL does not report operating margin in its press release.

S.D. Shibulal, CEO of Infosys, detailed the company's growth strategy in his response to Jesse Hulsing from Pacific Crest Securities on the earnings call. In short, the strategy has two focuses: to expand its consulting and system integration business, where price premiums are easier to maintain, and to achieve non-linear growth in all product lines.

2. It could take a few years for Infosys to achieve non-linear growth.

The Indian IT industry has long been known to operate on a linear growth model, where revenue per employee is constant. Simply speaking, to grow revenue in the linear growth business model means to hire more programmers to write more codes. INFY wants to achieve non-linear growth in its products and platform business by offering more value-added services. But such transformation could take years, as suggested by this article. Currently, INFY's revenue growth still strongly correlates with headcount growth, as suggested in Table 2.

Table 2. Revenue Growth and Headcount Growth

Item

F2009

F2010

F2011

F2012

2012-12

Total Headcount

104,850

113,796

130,820

149,994

155,629

Headcount Growth

14.98%

8.53%

14.96%

14.66%

3.76%

Revenue Growth

11.66%

3.02%

25.75%

15.78%

5.80%

3. Infosys does not appear to look for large acquisitions that are much needed to grow its consulting business.

Customers of consulting and system integration business are less price sensitive. Therefore, it is easier for Infosys to maintain pricing premiums in such areas. INFY's acquisition of Lodestone in September 2012 is a key step it took to move up the value chain. This type of deal is good, but INFY needs to do more acquisitions like this to really strengthen its consulting business. Its competitors have moved early on this, and INFY would need to move fast to catch the last train, as argued by Indian School of Business Assistant Professor of Strategy Raveendra Chittoor in his article. Bloomberg's interview with INFY's CEO on 1/24/2013 does reveal that Infosys is looking for firms to acquire. However, my understanding of the CEO's tone is that INFY is shopping for smaller firms in the products and platform business for public services in the U.S., and staff integration and culture fit are important. All of these make me think that large-scale overseas acquisitions are not likely to happen in the near future.

Updated Models

My model in May 2012 was based on an annual revenue growth rate of 10% between 2013 and 2017, and a 5% perpetual yearly growth rate on long-term FCF post-2017. Operating margin was assumed to stay at 28.63% over the next five years. Tax rates were predicted to increase by half a percentage point every year from 29% in 2013 to 31% in 2017, and stay at 31% thereafter.

I have rebuilt my model with a revised outlook on revenue growth, margins and tax rates. Below are my key model assumptions. Long-term cash flow growth is kept at 5%. Details about other model inputs and justifications about my assumptions can be found here. For cross-check, in the base scenario, INFY's EBIT margin decreases from 32.23% in the first nine months of F2013 to 29.82% in 2017, and its net margin decreases from 23.46% to 21.47% in 2017.

Table 3. Key Model Assumptions

Revenue growth

First 9 months in F 2013

2013

2014

2015

2016

2017

Base

4.34%

5.80%

6.00%

7.00%

9.00%

12.00%

Bull

5.80%

7.80%

9.80%

11.80%

13.80%

Bear

5.80%

4.00%

3.00%

3.00%

3.00%

Operating Margin

2013

2014

2015

2016

2017

Base

26.59%

27.00%

26.50%

26.00%

25.50%

25.00%

Bull

27.00%

27.00%

27.00%

27.00%

27.00%

Bear

27.00%

26.00%

25.00%

24.00%

23.00%

Effective tax rate

27.22%

28.00%

28.00%

28.00%

28.00%

28.00%

EBIT margin (base case)

32.23%

31.82%

31.32%

30.82%

30.32%

29.82%

Net margin (base case)

23.46%

22.91%

22.55%

22.19%

21.83%

21.47%

FCFF over revenue (base case)

19.23%

18.13%

16.57%

15.30%

14.25%

13.39%

FCFF over net income (base case)

81.97%

79.16%

73.39%

68.76%

65.22%

62.78%

I decided to use a cost of equity of 10.5% as opposed to 10% in the previous model because the stock market is riskier now than in May 2012. The S&P 500 and Dow Jones are trading near their all-time highs from October 2007, despite recent signs of a stagnant economy and weakening company fundamentals. The Fed decided to continue QE and keep interest rates at current levels after a two-day FOMC meeting ending on 1/30/2013. Its latest FOMC statement noted a slowdown in economic growth around year-end, as the fourth quarter GDP dropped by an annual rate of 0.1 percent, the worst performance since Q2 2009. Chart 2 shows that earnings and revenue growth rates of S&P 500 companies have come to a halt over the past two quarters. The disconnect between Fed-policy-driven optimism and the realities of the economy convince me that downside risk outweighs upside potential in the near term. Infosys, as a typical cyclical stock, could be hit very hard in a market pullback.

Chart 2. S&P 500 Earnings & Revenue Growth

(click to enlarge)

Source: Earnings, Revenue, & Valuations: S&P 500 Sectors. Updated as of January 30, 2013. Yardeni.com

Conclusion

My model projects the fair value to be around $55 a share in the base case scenario. The $3 discount based on the current price of $52 does not offer much margin of safety. Furthermore, considering a possible 10%-15% pullback in the near term, I would recommend avoiding this cyclical stock, as it carries too much downside risk at the moment.

Scenario

Bull case

Base case

Bear case

Fair value estimate per share

65.67

54.82

40.06

Terminal P/E

12.57

11.99

10.98

Terminal P/CFO

14.34

13.92

13.31

Terminal P/S

2.88

2.57

2.20

Upside Potential/Downside Risk

26.09%

5.26%

-23.08%

Source: Infosys Is Fairly Valued, But Has Greater Downside Risk