Infosys Technologies (INFY) successfully pioneered the offshore Indian IT services model which has now become a $100 billion industry. The company managed to grow at a faster rate than its competitors while keeping premium pricing and high margins. The company was looked upon as a bell whether of the Indian IT industry despite bigger competitors like TCS. However, in the last few years, Infosys has faltered as it could not keep up with the growth rates of smaller competitors like Cognizant (CTSH) and HCL Technologies. Even its main rival TCS has performed much better than Infosys, which has meant that INFY stock has languished compared to the other IT services companies. Only Wipro (WIT) has performed as badly as Infosys in terms of growth and earnings. Infosys has also suffered from a number of top management changes and high employee attrition due to wage freezes earlier. The company seems to have finally woken up to its problems and is now trying to be more aggressive about growth, by lowering prices. Earlier Infosys used to follow a premium pricing model compared to its competitors to maintain margins. However, that strategy has proven disastrous in the last few years as growth has slumped taking margins down as well.
Why we are not positive about Infosys
- With lower pricing, margins will come under pressure - The company has decided that it will lower pricing in order to win big IT outsourcing deals, as it has been bleeding market share to more nimble and lower pricing competitors. This means that the company's earnings will face headwinds of margin compression in the future.
- Current Top Management is not great - Infosys top management has seemed slow and sleepy compared to its competitors. Top management seemed complacent, with the CEOs being only appointed from the founder group.
- Lack of aggression - This can be seen both in case of organic and inorganic growth opportunities. It has allowed smaller competitors like HCL to steal business and acquisitions right from under its nose. HCL Technologies outbid Infosys for UK based software service provider Axon Technologies. The company has also lost out to competitors in winning new deals.
- Employee Morale and Wage Freeze - Infosys faced a lot of employee angst, after it froze salary increases earlier last year. This means an effective wage cut since India which has seen double digit price inflation in the last few years. Infosys was later forced to revise its policy as attrition started to increase.
- Failed to become an End to End Solution Provider - INFY like other Indian IT companies have never become an end to end solution provider like IBM (IBM) or Accenture (ACN). While Infosys has failed to move up the value chain, IBM has effectively copied the INFY model by increasing off shoring to India. So even though IBM's revenues have "plateaud" at $100 billion a year, its margins have kept going up as expensive Western employees were replaced by much cheaper Indian ones. INFY has mostly remained an IT manpower provider, rather than an IT solutions firm. The company has tried in the past to become a major consulting firm like the Big 4, IBM etc. but we have yet to see much traction. The company has lost business as it can't provide the higher end services needed to justify its premium pricing.
- Global Economic slowdown is negative for IT services - The slowing global economy is having a detrimental effect on IT spending as companies become cautious on discretionary spending. If global economy sputters then Infosys will be negatively affected as global corporations cut their discretionary IT spends. Infosys gets more of its revenues from US and Europe, two economies which are not going to grow too strongly in the coming years.
- Stock Valuation catches up with Peers after 20% stock burst - Infosys stock is currently trading at ~$53 which is just 10% below its 52 week high of $60. The company's valuation is not cheap with P/S of 4.2x and P/B of 4.4x. The forward P/E of ~17x is also comparable to other IT companies like Wipro. The company is not a big dividend player with a yield of 1.23%
Infosys - Upside Risks
- Recent Earnings showed some signs of stability - The sentiment towards INFY stock has been very negative in the last year due to its slow growth. So when the company reported a beat and raise quarter, the stock went up by ~20%. The company reported revenues of $1.91 billion (up ~6% year on year) and EPS of 76c, which beat Street Estimates by ~5%. The company forecasts FY 2013 revenues of $7.45 billion and EPS of $2.95.
- Higher Margins than the Industry - Infosys has managed to maintain much higher margins than the rest of the Indian industry with GM in the 40% range, Operating Margin in the ~30% range and Net Margins of 25%. This is almost 10% higher than Cognizant. However, the downside of the high margins has been a lower growth rate. We are not sure whether these high margins are sustainable.
- Solid Balance Sheet - Infosys is a cash rich company with ~$2.7 billion in cash and almost no debt. However, the company has always kept high levels of cash on its B/S, which has not gone down well with investors who felt that the company should either use it or return it to investors.
As we have said before, INFY stock has jumped almost 20% in the last month after the company reported a good set of quarter results. However over a longer period (5 years), INFY has heavily underperformed companies like TCS and CTSH. Even over the last 12 months INFY performance has been quite lackluster as compared to HCL Technologies.
Infosys faced both macro risks as well as high competitive risks from the likes of Cognizant, HCL and TCS which are eating its market share. The recent surge in the stock price has destroyed the margin of safety in buying the stock. We don't think Infosys is a good investment as it was forced to lower prices to play with the competition. The valuation for Infosys is now level with faster growing competitors like CTSH and TCS. The company does not have any killer product or service which will boost its growth over the competition. The high growth days of low cost off shoring are over for the Indian IT industry which is entering the stage of maturity. Infosys brand does not command the premium over other Indian IT companies as it did before. At best, we see Infosys performing at par with the rest of the major Indian IT service providers. For this reason we would advise investors to switch to other technology companies.