Infosys Technologies: First-Rate Execution in a Daunting Environment

Excerpted from Gilford Securities analyst Ashish R. Thadhani's recent report to clients on Infosys Technologies Ltd. (INFY):

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Founded in 1981, Infosys is a premier technology services vendor. It designs and delivers IT-enabled business solutions that span the entire software lifecycle: consulting, development, maintenance, systems integration and package implementation. Infosys employs a Global Delivery Model that utilizes distributed project management. Infosys is the third largest Indian IT Services company – distinguished by a premium brand, industry-leading profitability and scalable manpower infrastructure. Its global sales headquarters are in Fremont, CA.

Based on slow IT spending in a deepening global economic downturn – and pervasive presence across the troubled Financial Services segment – we are reducing our estimates as follows: fiscal 2009 diluted EPADS to $2.24 on revenue of $4.673 billion (12% YoY growth) from $2.25 on revenue of $4.742 billion; and fiscal 2010 diluted EPADS to $2.05 on revenue of $4.386 billion (6% YoY contraction) from $2.25 on revenue of $4.998 billion. At this time, we are introducing a fiscal 2011 diluted EPS estimate of $2.20 on revenue of $4.927 billion (12% YoY growth). Our current model anticipates no sustained upturn in revenue until the March 2010 quarter.

We are lowering our target price from $35 to $32. In 12-months, this would correspond to 15x forward EPS – a premium to the current valuation (13x).

3Q09 diluted EPADS of $0.58 on revenue of $1.171 billion beat our $0.57 estimate on revenue of $1.186 billion. Revenue was held back by currency volatility (-$57 million impact). On a constant currency basis, revenue increased 14.6% YoY and 1.0% QoQ vs. reported figures of +8.0% YoY and -3.7% QoQ. Results were also distorted by a $41 million currency translation gain (+$0.07 EPADS impact) and $44 million hedging loss (-$0.08) – primarily due to steep rupee depreciation averaging 11.1% QoQ and 25.4% YoY – and a $12 million tax reversal (+$0.02).

Notwithstanding the challenging backdrop, Infosys recorded solid QoQ progress across most operating metrics: volume (+2.0%), utilization (+0.6%), offshore revenue contribution (+1.5%), operating margin (+220 bps), headcount (+2.8%) and attrition (-1.0%). However, pricing fell 1.8% QoQ on a constant currency basis. Further erosion is not being ruled out but Infosys did reaffirm its commitment to keep the operating margin on a firm footing. It has successfully negotiated demands to match lower competitor rates with tradeoffs such as higher volumes and/or non effort-based pricing.

Areas of relative strength included the Financial Services and Retail verticals (+4.1% and +2.9% QoQ on a constant currency basis) and the North American region (+1.5%). Meanwhile, weakness was noticeable across the Manufacturing and Telecom verticals (-3.7% and -3.4%) and Europe (-1.2%).

Operating income of $371.3 million (31.7% margin) surpassed our $347.7 million estimate (29.3% margin). The QoQ improvement in operating margin was driven by rupee depreciation (470 bps) and controlled G&A – mitigated by a larger bench (130 bps), depreciation of European/other currencies vs. the U.S. dollar (100 bps) and lower pricing. Other income included a $7 million break-up fee from Axon Group plc – offset partially by $3 million in transaction-related expenses.

Infosys has not suffered any material project cancellations although decision-making has been impacted by the overall environment and ownership/management changes in the Financial Services segment. Client budgets should be finalized by March and are expected to decline 4-5% YoY. The 2% reduction in fiscal 2009 revenue guidance is explained by unfavorable currency swings and, to a lesser extent, recent pricing pressure. Current guidance assumes stable pricing and exchange rates (INR 48.71 per U.S. dollar) with no QoQ volume growth in 4Q09.

Hiring plans call for gross addition of 27K employees in fiscal 2009 – up from 25K in October – due to higher acceptance of campus and BPO offers plus lateral hiring for specialized skills. In fiscal 2010, Infosys will honor its prior campus commitments, enrich/extend the training program from 16 to 24 weeks and exit the year with a headcount of 110K vs. 104K in fiscal 2009E and 91K in fiscal 2008. In response to client requests, Infosys will maintain a massive bench (~30K employees) capable of responding quickly to future opportunities. Offshore salary increases in April are likely to be muted. We also note that variable compensation – functioned on revenue growth and operating margin – represents up to 30% of total compensation for offshore employees (and 5% of revenue).

During the quarter, Infosys won four transformational engagements. These included Bharti Airtel (delivery of interactive applications to power its Direct-To-Home TV service) and AstraZeneca (expansion of an existing application maintenance relationship). Infosys noted that it is increasingly moving toward outcome-based pricing.

Infosys has not felt any immediate fallout from the Satyam (SAY) scandal. As a matter of principle, it is not proactively targeting Satyam clients but will be responsive, if approached. Infosys believes it is well prepared to address heightened due-diligence scrutiny.

Finally, we commend Infosys for its voluntary disclosure of cash balances held at all financial institutions. Its audit committee independently verifies these amounts as well. Additionally, unlike Wipro (WIT) and Satyam, it did not allocate IPO shares to any clients.

INFY shares are suitable for aggressive investors. In our opinion, principal risks include the following: U.S. slowdown; rising offshore salaries; appreciation of the Indian currency, which would translate into higher expenses incurred in rupees; correction in the Bombay Stock Exchange and/or U.S. markets; political opposition in the U.S.; and geopolitical uncertainty in the Indian subcontinent.

ANALYST CERTIFICATION

I, Ashish Thadhani, certify that all the views expressed in this research report accurately reflect my personal views of the subject companies. I certify that I have not and will not receive compensation with respect to the issuance of this report.

Comments

[ArtfulDodger:]

Mr. Thadhani:

Good report all the way around. Good points on the positive and negative sides of this stock and on the risk.

I like your disclosure statement.

I have had a watch on this company. I'm now putting it higher on my list thanks to your article.

Thank you for your work! Keep it up!

Jan 22 08:27 AM