Infosys: Growth May Resume in December Quarter

Excerpts from Gilford Securities analyst Ashish R. Thadhani's recent note to clients on Infosys (INFY):

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After Soft Landing, QoQ Growth May Resume in Dec. Quarter

Based on near-term uncertainty over client IT spending, pricing pressure and continued hiring to support long-term growth – plus conservative expectation of a drawn out recovery – we are reducing our estimates: fiscal 2010 diluted EPADS to $1.95 on revenue of $4.335 billion (-7% YoY) from $2.05 on $4.386 billion; and fiscal 2011 diluted EPADS to $2.00 – including a one-time jump in the tax-rate – on $4.823 billion (+11% YoY) from $2.20 on $4.927 billion. To reflect improving investor sentiment, we are raising our target price from $32 to $35. In 12-months, this would correspond to 15-20x forward EPS – a premium to the current valuation (14x).

4Q09 diluted EPADS of $0.56 on revenue of $1.121 billion met our $0.56 estimate on $1.130 billion. Revenue was held back by currency volatility (-$13 million impact). On a constant currency basis, revenue increased 5.9% YoY but fell 3.2% QoQ vs. reported figures of -1.8% YoY and -4.3% QoQ. Results included a $3.0 million tax reversal (less than +$0.01 EPADS impact). Infosys raised the annualized dividend by 36% to INR 23.50 (or $0.46) per ADS.

Not surprisingly, Infosys recorded QoQ slippage across various operating metrics: volume (-1.4%), pricing (-2.1% on a constant currency basis), utilization (-0.6%) and operating margin (-250 bps). However, it also posted QoQ gains in headcount (+1.7% reflecting high acceptance of campus offers), attrition (-0.7%), new clients (+7) and net cash (+$177 million under IFRS). Areas of relative strength included the RoW region (+5.0% QoQ on a constant currency basis) and Retail vertical (+3.5%). Meanwhile, weakness was pronounced across the Financial Services vertical (-9.0% QoQ) and Europe (-5.3% driven by the U.K.). Operating income of $330.0 million (29.4% margin) missed our $342.8 million estimate (30.3% margin). The QoQ decline in operating margin is explained by lower pricing (-150 bps impact) and reinvestment of currency gains in new markets/solutions and sales personnel to shore up future growth.

Fiscal 2010 revenue guidance assumes flat to a 3% YoY decline on a constant currency basis. Infosys anticipates a 300 bps deterioration in the operating margin due to price erosion (5.7% YoY = -350 bps impact) and lower utilization (net headcount is expected to increase by 8K in spite of the revenue reduction = -400 bps), mitigated by rupee depreciation (9.0% YoY = +450 bps). While the environment remains challenging, Infosys believes that it can hold pricing at 4Q09 levels since a majority of renegotiations have concluded. While results of some banks suggest signs of stabilization, Infosys has not factored any meaningful recovery into its outlook. According to a March 2009 survey of the company’s top-135 clients (83% of revenue), 69% of respondents expect a double-digit cut in their overall IT budget this year – while a similar number stated that spending on offshore initiatives could decline.

Hiring plans call for gross addition of 18K employees in fiscal 2010 – down from 28K in fiscal 2009 – comprising 16K fresh graduates, 1K lateral hires with specialized skills plus 1K onsite staff. Infosys will honor its prior campus commitments, extend the training program by 50% to almost six months, maintain a massive bench (~30K employees) in preparation for an eventual recovery and exit the year with a headcount of 113K vs. 105K in fiscal 2009. It will forego annual salary increases in April. Increments have ranged between 3-7% for onsite staff and 11-15% for offshore in recent years.

Recent results demonstrate that Infosys has managed a turbulent environment with exceptional dexterity. Infosys has not suffered any material project cancellations or client departures. However, it has not been able to fully replenish completed projects. Sales cycles have lengthened from six to nine months and deal sizes have contracted due to scope reductions and inclusion of multiple vendors as a means to extract better terms. Still, quarterly revenue should trough “only” 10-15% below the September 2008 peak while the operating margin is unlikely to breach 25% during the current downturn. Infosys has indicated that several clients are seeking its (maintenance) services to optimize their cost structure. The Energy & Utilities and Healthcare verticals appear to offer the best opportunities. It also noted an increasing focus on new engagement models that should enhance client value and Infosys profitability, e.g., solution-based offerings, SaaS, platform BPO and others.

Political considerations (proposed tax and visa legislation) have not impacted the business so far. To overcome potential visa restrictions, Infosys can step-up onsite hiring, expand its near-shore presence in Canada and Mexico and/or shift more work to offshore locations.

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.

Disclosure: 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.

In the normal course of business, Gilford Securities seeks to perform investment banking and other services for various companies and to receive compensation in connection with such services. As such, Gilford Securities intends to seek compensation for investment banking services from the subject company in the next three months.

Comments

[Alan Young:]

4Q 09 already reported? It isn't clear when their fiscal year starts and ends.

Apr 20 01:33 AM