India has four Dow Global members. These include Reliance Industries (RS), Tata Steel (OTC:TATLY), Bharti Airtel and Infosys (INFY). In this post I want to cover Infosys which reported earnings earlier today.
Infosys is a core long term holding for any global portfolio. But valuation is an issue; and valuation is something which must always be borne in mind.
Please visit "The Quant Report" and link through to the INFY report for a decade's worth of historic data and the various valuation metrics applied in arriving at below referred indicative out values.
Between the year ended 31 March 2000 and 31 March 2009, INFY has delivered annualized earnings growth of 37.91%. By end March 2010, annualized earnings growth since 31 March 2000, is expected to have fallen to 32.63%. Dividend growth has been even stronger with a dividend growth rate of near 41% annualized expected between the year ended 31 March, 2000 and 31 March 2010. Payout ratio has run at a median rate of 15.17% between the year ended 31 March, 2000 and 31 March 2009 and are expected to rise to just below 20% by end March 2010 – the dividend is safe. The balance sheet is unleveraged and the management is top quality.
PE ratio (Annual Average Price / EPS) for Infosys has run at median levels of 34.7 between the year ended 31 March, 2000 and 31 March 2009. PE 6 (Annual Average Price Divided by Median 6 Year EPS) has run at median levels of 71.32 during the same period. However, the multiples have dropped dramatically in recent years; during the year ended 2009 it was down to 14.72 and for the present fiscal year to date, it is running at 18.
The historic multiples were high and investors must bear in mind that Infosys has grown from $0.12 in earnings to over $2.10; growth at these levels going forward will not be as easy. With lower growth expectations, I would be a mistake to look for median reversion on multiples. Growth has numerous challenges; firstly IT Services is intensely competitive and the competition is intensifying; secondly the financial services, a key user of IT services, has been badly hurt by the implosion of the debt bubble; thirdly outsourcing and off-shoring is and is likely to become more politically unpalatable; finally the telecom sector, another major market for IT services is going through pain of its own in terms of growth expectations.
There is an added problem, India's IT services face high inflation and Rs cost pressure on input costs; at the same time outputs (revenue) are derived from states with lower inflation rates. What this means is margin pressure. Furthermore, with India's demand for capital, demand for Rs is elevated and this leads to an expectation of a strong Rs. Because revenue is dollar denominated, a strong Rs leads to slow top line growth in Rs terms; and that is a great dampener on valuation. Slow top line growth in an era of rising input costs adds even more margin pressure; in addition a strong Rs makes competition in US more challenging.
There is a lot Infosys has done and will do to mitigate these risks; they can be expected to improve productivity and continue making productivity gains; they can move staff closer to customers and hire locally (diversify their input cost base); they can diversify their revenue stream and reduce dependence on US (India is a huge growth market for IT services and gains in Europe are very likely). But the fact remains that there are challenges to growth which lie ahead.
I am working with a base case scenario which will allow INFY to grow earnings at 12% annualized going ahead. The calculated multiple an investor should be willing to pay for 12% long term earnings growth, 16% investor long term return expectation and a P% payout ratio is 16.8. For P% we use the median payout ratios over the last 10 years, or 40% if higher. Based on this the value we can expect by 2014 is $41; the share price trades at near $50 today. If we reduce the investor long term return expectation to 14%, a multiple of 33.6 would apply making for a price target of $82.50. If we reduce the investor long term return expectation to 15%, a multiple of 22.4 would apply making for a price target of $55. In my view, a reasonable valuation range for INFY is $55 to $85 by 2014.
Through this crisis the stock traded at a low of $21; this is 20% over my estimate of 2009 fair value; this strength is indicative of the very high quality of the holding. Because of the stock quality and its place as a core holding for long term investors, I would add positions at $35 and look to accumulate if it falls towards $30. Infosys is not a share I would recommend selling simply because it got expensive; this share is best held for the long term.
Disclosure: Long Infosys.