Infosys Shares Should Remain Volatile, Hit $65 Mark

Ashish R. Thadhani (Gilford Securities) recently sent a note to clients raising his earning estimates and price target for Infosys Technologies (INFY) and reiterating his 'Buy' recommendation. His note follows:

INFY: Reassuring Execution; Raising Estimates, Target

• Investment Conclusion. After factoring in higher revenue – offset partially by a stronger rupee – we are raising our estimates as follows: fiscal 2007 diluted EPADS to $1.45 on revenue of $3.092 billion (44% YoY growth) from $1.42 on revenue of $3.049 billion; and fiscal 2008 diluted EPADS to $1.75 on revenue of $4.166 billion (35% YoY growth) from $1.70 on revenue of $4.040 billion. We are also introducing a fiscal 2009 diluted EPADS estimate of $2.10 on revenue of $5.415 billion (30% YoY growth). Our estimates imply 34%/24% compound revenue/EPADS growth in calendar 2006-08. Based on prevailing investor sentiment, we are raising our target price from $56 to $65. In 12-months, this would correspond to 30-35x forward diluted EPADS of $2.00.

However, given the ~70% gain since mid-June, current valuation of 34x forward diluted EPADS, potential moderation in QoQ revenue growth and an upcoming wage hike – we also expect greater price volatility.

• 3Q07 Results. Diluted EPADS of $0.38 vs. $0.26 a year ago on revenue of $820.8 million (up 47% YoY) beat our $0.37 estimate on revenue of $797.7 million. Highlights of the quarter included 10% QoQ revenue growth vs. our 7% estimate; timely pricing, product-mix and scale benefits that thwarted 200 bps of currency headwinds; and three recent wins valued at $70-100 million each.

In December, Infosys became the second offshoring company to be inducted into the NASDAQ-100 index – facilitated by three ADS offerings since 2003. Being part of a benchmark index should translate into greater investor demand.

• Description: Founded in 1981, Infosys is a premier technology services vendor. It designs and delivers IT-enabled business solutions that span the entire software lifecycle: consulting, development, maintenance, systems integration and package implementation. In addition, Infosys offers software products to the banking industry, as well as BPO services. Infosys employs a Global Delivery Model that utilizes distributed project management and allows for substantial cost savings. The Company maintains its global sales headquarters in Fremont, CA. Infosys is distinguished by market leadership (largest U.S.-listed exporter of software from India with a $3.3 billion revenue run-rate); growth (3Q07 revenue advanced 47% YoY); and profitability (28% operating margin ranks highest in the industry).

• Takeaways. We credit recent results to a favorable market environment and acceptance of the offshoring value proposition for larger/strategic engagements – supported by a premium brand, comprehensive portfolio of services and scalable manpower infrastructure (the Mysore center is building capacity to train 50,000 employees annually). Infosys has not witnessed any evidence of a slowdown in IT spending: its top-25 clients recorded 12.6% QoQ growth. Offshore salary increases in April are once again expected to average 13-15%. In November, Infosys completed a secondary offering of 30 million ADSs (at $53.50 each) – lifting the count in this category to 108 million, or 19% of the total. Insiders sold 12% of their aggregate holdings valued at $697 million.

• Infosys raised fiscal 2007 basic EPADS guidance to $1.47 on revenue of $3.09 billion (up 44% YoY). This outlook is based on volume-driven revenue growth; stable pricing (2-4% uptick on renewed/new agreements will likely be offset by volume discounts); exclusion of large deals despite an encouraging pipeline; unchanged YoY operating margin; 14-15% YoY offshore salary increase (effective April 2006); and an exchange rate of INR 44.11 per U.S. dollar vs. 44.53 in 3Q07.

• Areas of strength in 3Q07 included the Telecom vertical (72% YoY growth), Package Implementation practice (61%) and European region (58%). BPO revenue advanced 81% YoY to $40.5 million accompanied by a 21% operating margin. Operating income of $234.1 million (28.5% margin) surpassed our estimate of $221.0 million (27.7% margin). The QoQ improvement in operating margin was helped by revenue productivity (80 bps impact), 28% growth in Finacle/product revenue (80 bps) and scale/SG&A efficiencies (50 bps) – despite steep rupee appreciation averaging 3.8% (200 bps). Available productivity levers include scale/SG&A benefits, utilization and ramp-up of the Consulting/China subsidiaries (50 bps drag).

• Hourly price realizations averaged $68.16 for onsite work (up 2% QoQ and 5% YoY) and $25.73 for offshore (up 2% QoQ and 3% YoY). IT Services utilization (excluding trainees) stood at 76.6% vs. 77.6% a year ago. Billed volume rose 37% YoY and 7% QoQ. High-margin offshore revenue contributed 50.8% of the total vs. 49.7% in the September quarter. Global headcount rose 5% QoQ and 40% YoY to 69,432 in December. Attrition deteriorated to 13.5% (LTM) from 10.8% a year ago – and included a 1.3% involuntary component reflecting tougher training standards. Hiring plans call for gross addition of 30,000 employees in fiscal 2007, up from the prior 28,300 figure.

• By industry, Financial Services ranked largest (at 39% of revenue), followed by Telecom (18%), Manufacturing (13%), Retail (11%) and Others (19%). Top-10 clients accounted for 31.0% of revenue, down from 32.9% in the September quarter. Infosys has 67 clients (vs. 61 in September) with LTM revenue of $10+ million, 11 (vs. 12) with $50+ million and two (vs. two) with $100+ million. Infosys added 43 new clients – compared with 45 in the immediately prior period – and exited the quarter with an active roster of 488, up from 476 in the September quarter.

• Infosys generated CFFO of $237 million (or $0.42 per ADS) in the quarter. Proceeds from exercise of options amounted to $30 million. Major outflows included dividend payments ($71 million) and capital spending on infrastructure ($77 million) – the latter is budgeted to climb from $246 million in fiscal 2006 to $350-400 million in fiscal 2007. Infosys exited the quarter with net cash of $1.086 billion, up from $936 million on September 30. Accounts and unbilled receivables improved to 63 DSOs from 64 in September.

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• INFY shares are suitable for aggressive investors. In our opinion, principal risks include the following: 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.

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Comments

[GregCalderone]

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