Infosys Earnings Preview: Expect a Comfortable Earnings Beat

Includes: CTSH, INFY, WIT
by: Naveen Selvaraj

Infosys (NASDAQ:INFY) quarterly results (due on 13th April - tomorrow) are an eagerly anticipated event for analysts tracking IT services, and Indian IT services companies in particular. The March quarter results are especially critical in setting expectations for the next fiscal year.

Here are my revenue and EPS estimates :

1. On revenues, Infosys will exceed the top-end of its guidance by ~$30M or 2-3% above the top-end of guidance with revenues of $1.27-28B.

2. On EPS, the beat will be huge - by at least 8 cents for the Mar10 quarter with EPS-Basic of 63-65 cents.

Infosys is well known for being quite conservative in its estimates and that is evident in its guidance given for the Mar10 quarter. Infosys has guided for a ~10.5-11.5% YOY growth in revenues to $1.24-$1.25B for the Mar10 quarter. EPS guidance is 56 cents, flat on a YOY basis. Analyst estimates as per Yahoo Finance are also pretty close to the company's guidance. Consensus revenue estimate is $1.26B while EPS estimate is 0.57, 1 cent above company guidance.

Read on as I try to construct my case for a good earnings result from INFY which will be well above consensus estimates and company guidance:

INFY - Revenue, EPS Vs Guidance

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Source: Gridstone Research

INFY: Revenue, EPS Sequential Growth

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Source: Gridstone Research

INFY: Revenue, EPS YOY Growth

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Source: Gridstone Research

EPS Estimate Is Downright Conservative As Revenues Grow (Positive)

At the mid-point of its revenue guidance - $1.245B, Infosys will have $125M more in revenues in Mar10 compared to the Mar09 quarter. For a company with a net margin of ~27%, that should add ~$33M to the bottom line. Since its share count has been nearly flat in the last year at ~570M shares, this incremental net income should add at least 6 cents to the EPS while INFY has actually guided for flat EPS at 56 cents. So even at the company guided top-line figures, the EPS guidance is very conservative. This is supported by its EPS performance in the last six quarters - All six have beat earnings and the last two quarters have seen a huge upside (6-9 cents) over company guidance.

Currency Fluctuations Will Boost Revenue Marginally (Positive)

The incremental revenues ($125M) mentioned above are based on INFY's conservative guidance. But revenues could get a minor boost from the currency fluctuations in the last quarter. Besides the US dollar, the three major currencies in which INFY derives revenues are Euro (6.6% of Revs in Dec09 qtr), UK Pound (8.4%) and Australian Dollar (6.3%). This 20% of revenues will be impacted by currency fluctuations. The Australian dollar has appreciated by 2.3% in the Mar10 quarter while the Euro and UK Pound have depreciated by ~5-6% against the dollar. So there could be ~3-4% net positive impact on this 20% of revenues, which translates to a ~1% positive impact on a total revenue basis or ~$12-13M of incremental revenues. So on a net basis, this should add at least ~$12M to the top-line and 2 cents to the EPS, all other factors being constant.

Organic Revenue Growth: Client Additions, Increased Revenue Per Client Will Help

INFY had guided for a 0.1-1% revenue growth in the Dec09 quarter but revenues actually grew 6.7%. INFY attributes this positive surprise to a 12% growth at its top 10 clients. Here's the management comment from the Dec09 earnings call:

...We ended ... this quarter with $1.232 billion of revenues, which was 6.7% growth. Most of the growth came from top 10 clients that grew by 12.2%. Non-top 10 grew by 4.8%. Overall, we obtained a growth of 6.7%.."

A little bit of peer-level data is also pretty handy here. Compared to the Sep08 quarter (before the donwturn), both INFY and Wipro (NYSE:WIT) had lesser active clients as of Dec09. Though both INFY and WIT have been adding 20-30 clients per quarter, the active client base has come down as they have lost more clients (i.e. net client addition is negative). So INFY grew revenues in the last two quarters despite a flat client base which indicates more revenue per customer and especially more revenues per customer from the top 10.

Net Client Additions Could Turn Positive - Peer Comparison

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Source: Gridstone Research

Only Cognizant (NASDAQ:CTSH) has managed to increase its client base and that's reflelcted in the company's industry-leading topline growth. That's pretty visible when we compare the revenues and revenue growth of these three firms over the same period. Cognizant has been well ahead of the pack in 2009 but both INFY and Wipro are catching up as the macro situation improves. So why is it that Cognizant outperformed the other two during the downturn? My guess is that Cognizant is more dependent on annuity-based revenues (App. maintenance etc) and its increasing client base also helped in the revenue growth.

Revenue and Revenue Growth - INFY Vs WIPRO Vs Cognizant

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Source: Gridstone Research

As confidence returns to companies across all sectors, IT spending (specifically offshoring services and discretionary spending projects) should pick up across the board and that will help INFY increase its client base and also increase its revenue per customer as clients go in for increased offshoring. I would bet on the active client base showing its first net increase in the Mar10 quarter (since the Sep08 quarter).

Based on the client base numbers, I calculated INFY's revenue per client to have gradually increased from a low of $1.9M per client per quarter in the Mar09 quarter to $2.2M per client per quarter in the Dec09 quarter. With the expected increase in client base and more revenue per client, I would expect that this would add incremental revenues of at least $10-15M in the Mar10 quarter. So this could translate to a 2-3 cent positive impact on EPS too.

Currency Impact On Margins
and Operating Income(Negative)

Nearly 54% of INFY's revenues is through offshore services, so at the cost of revenue level, at least 54% of costs are offshore. A large part of INFY's capex also goes to offshore centers and therefore the INR (Indian Rupee) - US Dollar rate has a big impact on margins as seen from management comments in the Dec09 call:

"...The operating margin have slightly gone up, it has gone up from 30.3% last quarter to 31.1% this quarter. We had an impact because of the currency. The average rate of Rupee/Dollar last quarter was 48.39, this quarter it is 46.62. So, there was an appreciation of 3.7%, which impacted the margin by 1.8%, ;pricing increased by 1.1% in reported dollars. In terms of constant currency, it is 0.2%. Most of the pricing have shown down to margins. Utilization has gone up by 1% that had impacted positively the margin by around 0.6, and we had an intangible write-off, which negatively impacted the margin by 0.3%, and we have reduction in other costs, which contributed profitably by 1.6. So, net-net, we have seen increase in operating margins during the quarter..."

So the margins could be impacted by ~150-200 bps due to rupee appreciation of ~3.5% in the Mar10 quarter. Assuming there is no positive effect from cost reductions / optimizations, the margins can drop from 31.1% to ~29%. From the calculations above, I had conservatively estimated incremental revenues over and above guidance to be ~$25M (~$12M from currency and $13M from organic volume growth). This gives a base revenue expectation of $1.27B and at an operating margin of 29% (down 200 bps qoq), the operating income will be ~$370M. So this is the worst case estimate for operating income as I have not assumed any positive impact on margins due to pricing, volume, better mix etc.

Non-Operating Income Boost From Higher Cash Balances

Cash and investments is $3.1B while it was ~$2.1B in Mar09 when it yielded $52M in income that quarter. Infosys has reduced its cash holdings since then and put most of it in liquid mutual funds which means that the yield % should go up in the Mar10 quarter. Finance income therefore should be at least ~$65-75M for the Mar10 quarter.

Since Infosys has had net hedging gains in the last two quarters, I conservatively assume that there would be zero benefit / loss from hedging, which gives a total non-operating income of $70M at the mid-point of estimate. PBT should then be $440M (370+70) and with a tax provision of $93M (tax rate of 21.5% as per company's guidance), net income could be $347M (net margin of 27.3%) giving an EPS of 61 cents. For zero-debt companies like INFY, the non-operating income will increase substantially over the next year as yields increase. The cash holdings will also be something that the company will think about - cash dividends or a large acquisition.

In summary, the conservative EPS estimate from my side is 61 cents and I'm pretty confident that it would come in the 62-64 cents range while revenues could come in at $1.27-1.28B for the Mar10 quarter.

INFY 2011 Fiscal Guidance Will Indicate Comfort Level On Offshore Spending

While INFY's 2011 guidance will again be conservative, a double digit growth in revenue guidance will conform to investor expectations of a return to normalcy. However, seeing INFY's track record in giving guidance at the beginning of each fiscal period (very conservative initial guidance with gradual increase in fiscal guidance as quarters roll forward), they are not going to be very bullish on top-line growth unless client budgets, as of April 2010, show a YOY increase over 2009.

Also, the ~$3.1 B in cash reserves is something that INFY could well act upon in 2011. If there are no big ticket acquisitions in the pipeline (likely case), a good chunk of the cash could be returned as cash dividends. A stock dividend is unlikely as that will not solve the ballooning cash reserves problem. INFY has a total expense run-rate of $600-700M per quarter and 2.5 times that should be an ample cushion for a zero-debt and cash flow positive (~$300M FCF per quarter) firm.

Disclosure: Long INFY