I have been holding a negative view on the Infosys (INFY) stock for some time now. The Indian IT Services Industry is showing slowing growth due to a number of macro factors. Some companies are managing the transition better while others are still stuck in the glory days of the past. Infosys which used to be the leader in the IT services space earlier, has become its most prominent laggard. The company generates high margins despite its services being no better than other Indian IT companies like Wipro (WIT), Cognizant (CTSH), TCS and HCL Technologies. IBM (IBM) and Accenture (ACN) have ramped up their Indian operations with thousands of low cost employees. This has allowed them to whittle down the first-mover advantage that INFY enjoyed. Now the U.S. multinational corporations can offer the same services for almost the same price as Infosys. It does not make sense for Infosys to have the same valuation multiple as other faster growing companies. The recent earnings have proved me right with the INFY stock tanking by more than 20% after reporting its FQ413 earnings today.
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 priced 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 U.K.-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 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, has never become an end to end solution provider like IBM or Accenture . While Infosys has failed to move up the value chain, IBM has effectively copied the INFY model by increasing offshoring 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 the global economy sputters then Infosys will be negatively affected as global corporations cut their discretionary IT spends. Infosys gets more of its revenues from U.S. 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%
What went wrong with the FQ413 earnings
- Horrible 2013 revenue guidance - Infosys predicted a revenue growth of just 6-10% for 2013 which was much lower than what investors were expecting. The growth rate is also much lower than what India's leading IT industry body NASSCOM has been forecasting (12-14% growth). INFY also failed to give an earnings guidance.
- Bad Global macro acts as a tailwind - Infosys management talked about the adverse economic environment affecting operations. Most Indian IT service companies generate most of their revenue from the U.S. and European markets. These economies are experiencing a growth slowdown which is affecting the IT purchase decisions. The currency markets have also been volatile which has made currency management increasingly difficult for companies like Infosys.
- New strategy is yet to show any traction - "Infosys 3.0" is the management's new strategy to focus on more software and platforms. This has failed to show any traction amongst customers. Infosys has failed to differentiate itself compared to other Indian outsourcers. The company has already lost a huge amount of market share to rivals due to its premium pricing strategy. The management has committed to set aside $100 million for the new strategy.
The Indian economy is going through a very rough patch right now with both investment and consumption declining. The GDP growth is slowing as corruption and governance issues take centre stage. Infosys gets most its revenues from export markets, has been performing badly in the last couple of years. While CTSH, TCS and HCL have kept growing in high double digits, Infosys has been stuck in a rut. The company is also no longer the employer of choice amongst Indian engineering graduates. The top management does not seem to have much of a clue on what to do right now. The company will have to completely reinvent itself to adapt to the changed environment. I would advise investors to look at Cognizant if they want to gain an exposure to the $100 billion Indian IT Services market.