Infosys' (INFY) share price has dropped more than 20% since April 13, following the reduced 2013 revenue growth forecast of 8%-10%. Some might wonder if Infosys looks cheap at the current price of $43-45. My discounted cash flow model suggests a fair value range of $45-50. Given so, the current discount does not provide enough margin of safety.
Infosys has benefited from the typical outsourcing business model.
It brings in revenue from US and Europe and provides the service in India to bank on the low labor cost of highly educated Indian labor force. This model allowed it to keep its operating margin around 28%-30% for the past 10 years. On the demand side, companies become more thrift about IT spending during the economy downturn. Rather than building operations in-house, they tend to outsource more. As a result, it has expanded greatly since 2008. According to its annual report, its revenue grew at a CAGR of 10.9% and net income at a CAGR of 8.1% during 2008-2012. Its employee headcount increased from 91,200 in 2008 to 150,000 in 2012.
The growth momentum came to a pause in Q4 2012.
The company suffered delays in contract closure and observed ramp-downs with a number of clients in the financial services industry. As a result, it failed to meet the already downgraded revenue guidance. On top of that, the management lowered the revenue growth guidance in FY2013 to 8%-10%. Infosys reported revenue of $6.99bn and net income of $1.72bn in fiscal year 2012.
DCF model assumptions are set forth below.
All the financial statement figures below are sourced from Morningstar.com Premium content.
- Revenue Growth: Annual revenue growth from 2013 to 2017 is 10%. Perpetual revenue growth rate after 2017 is 5% which translates into annual growth rate of 5.08% in free cash flow after the following parameters are factored in. This is the most controversial projection that I will discuss later in greater details.
- Operating Margin: I assume that it stays at 28.63% (10-year average) between 2013 and 2017 and drops to 27% due to wage increase in India. It is reasonable to believe that in the long term the wage gap between India and developed economies should close up.
- Other Income (Expense): this item on its income statement is mostly investment gains (loss) from its financial assets, including instruments to hedge foreign currency risk (since Infosys receives payments in USD or Euro and pays employees in Rupee, it is subject to foreign currency risk). I estimate an investment gain that is 3.22% of the revenue in 2013-2017 and 1% gain thereafter.
- Effective Tax Rate: I estimate the tax rate to increase by half a percentage point every year from 29% in 2013 to 31% in 2017 and stay at 31% thereafter. Tax breaks for Infosys' STP (Software Technology Park) offices in India have all expired in March 2011. As a result, its effective tax rate jumped from 13.15% in 2008 to 28.80% in 2012. This might seem too conservative but later I will show that flexing the tax rate assumption does not impact the fair value estimate too much.
- Depreciation and Amortization: $194.33 mil (3-year average) every year.
- Capital Expenditure: 5.47% of revenue (5-year average) every year.
- Other Non-cash Items: $-255 mil (3-year average) every year to account for change in working capital, other non-cash items, etc.
- WACC: Morningstar assigns 10% to the cost of equity. Since Infosys carries little long-term debt ($24mil compared to total asset of $7.5bn), WACC is basically the cost of equity.
Fair Value Estimated to be around $45-$50
Assuming revenue grows at 10% in 2013-2017, the fair value is estimated to be $45.70. The table below lists how fair value estimate is changed by change in 5-year revenue growth. "10,11,12,12,12" means revenue grows at 10% in 2013, 11% in 2012 and so forth, which is the more realistic growth pattern featuring the short-term slow-down and recovery afterwards. This scenario values Infosys at $48.33.
5-year Revenue Growth Rate %
Fair Value Estimate
If the tax rate is set to be at 28.8% perpetually, with short-term revenue grows at 10%, the fair value estimate is revised up to $47.52. Therefore, the higher tax rate assumption does not depress the estimate too much.
Tax Rate %
Fair Value Estimate
Increase to 31.5 by 2018, Rv gr@10
Stays at 28.8, Rv gr@10
To conclude, the 5-year growth should range between 10% and 12%, which gives a fair value range of $45-$50. This only provides about $2-$7 margin of safety, which is not enough to compensate for uncertainty around the DCF assumptions. To name a few, operating margin compression due to wage inflation in India and investment loss due to foreign currency movements. Given so, the stock is for sure not a value play at $43. A reasonable entry point will be below $35.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.