Infosys: FY09 EPS Guidance Upholds Durability of Model

Excerpts from Gilford Securities analyst Ashish R. Thadhani's recent update to clients on Indian outsourcer Infosys Technologies (INFY):

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Investment Conclusion. Based on a pronounced short-term revenue slowdown – offset partially by higher profitability and a lower tax-rate – we are reducing our estimates as follows: fiscal 2009 diluted EPADS to $2.30 on revenue of $5.045 billion (21% YoY growth) from $2.35 on revenue of $5.430 billion; and fiscal 2010 diluted EPADS to $2.55 on revenue of $6.231 billion (24% YoY growth) from $2.70 on revenue of $6.923 billion. Our estimates imply 23%/13% compound revenue/EPADS growth in calendar 2007-09 – after factoring a one- time jump in the tax-rate due to expiration of prior tax benefits.

Given continued investor concern over the U.S. IT spending environment (60.7% of revenue), we are resetting our target price from $58.50 to $51. In 12-months, this would correspond to 20x forward EPS of $2.55 – a premium to the current depressed valuation (17x). Notwithstanding its cautious stance in a difficult macro environment, Infosys anticipates significant longer-term growth opportunities and also offers a strong platform for customers seeking efficiencies in their IT spend. Infosys remains the second largest U.S.-listed exporter of software from India distinguished by a premium brand, industry- leading profitability and scalable manpower infrastructure.

4Q08 Results. Diluted EPADS of $0.54 vs. $0.45 a year ago on revenue of $1.142 billion beat our $0.53 estimate on revenue of $1.143 billion. Results were held back by an $11 million forex loss (-$0.02 EPADS impact) – offset partially by a $5 million tax reversal (+$0.01). Operating income advanced 39% YoY and exceeded our estimate. Highlights included 32% YoY and 5.3% QoQ organic revenue growth; resilient operating margin (28.8% vs. 27.5% a year ago despite a 400 bps currency headwind); improving employee attrition for the second straight quarter; four $50+ million wins; a special dividend of $0.50 per ADS plus hike in the regular dividend payout to 30% in fiscal 2009 from 20%; and guidance of 18% YoY EPADS growth – ahead of what many investors had come to fear...

Takeaways

• Infosys posted slower growth in the North American (+2.8% QoQ and +29% YoY) and Financial Services segments (-3.0% QoQ and +21% YoY). Management conveyed the following outlook: flat QoQ revenue guidance reflects delayed finalization of new projects by Financial Services and Retail clients in an unsettled macro environment – as opposed to cancellation of any ongoing projects; 76% of Infosys clients expect flat-to-lower IT budgets in 2008 but offshore allocation should continue to rise; Infosys has neither faced pressure for downward price renegotiations, nor has it aggressively pushed clients for higher rates; and the pipeline of $50+ million deals remains healthy but slow decision-making on larger deals cannot be ruled out.
• Infosys introduced fiscal 2009 basic EPADS guidance of $2.31-2.35 (up 17-19% YoY) on revenue of $4.97-5.05 billion (19-21%). This outlook is based on stable pricing; exclusion of ~15 large opportunities in the pipeline; annual salary increases (effective April) averaging 11-13% for offshore staff and 4-5% for onsite (230 bps impact); a 50 bps drop in the operating margin; and exchange rate of INR 40.02 per U.S. dollar vs. 39.41 in January.
• Areas of strength in 4Q08 included the Manufacturing vertical (69% YoY growth), European region (46%) and Consulting & Package Implementation practice (41%). Including the recent Philips acquisition, BPO revenue rose 54% YoY to $69.0 million accompanied by a 13.2% net margin. Operating income of $328.6 million (28.8% margin) surpassed our $318.1 million estimate (27.8% margin). The QoQ gain in operating margin was driven by rupee depreciation (averaging 1% = 50 bps), absence of the California wage settlement (60 bps) and scale/G&A benefits – offset partially by lower utilization. Other levers for countering currency and wage pressures include price realizations, revenue- mix (i.e., higher-margin solutions and event-based pricing), offshore-mix, utilization, Consulting/China subsidiary contributions (transitioning from investment mode) and a variable compensation structure (tied to revenue/margin performance).
• Hourly realizations averaged $73.15 for onsite work (flat QoQ and up 5.5% YoY) and $27.55 for offshore (up 0.5% QoQ and 5.6% YoY). IT Services utilization (excluding trainees) stood at 74.5% vs. 72.5% a year ago. Billed volume rose 26.2% YoY and 4.9% QoQ. Higher-margin offshore revenue contributed 52.5% of the total vs. 52.2% in the December quarter. Global head-count rose 2.9% QoQ and 26.2% YoY to 91,187 in March. Attrition improved to 13.4% (LTM) from 13.7% a year ago. Employee departures are attributed primarily to the pursuit of higher education. Hiring plans call for gross addition of 25K employees in fiscal 2009, down from 33K in fiscal 2008 and 31K in fiscal 2007.
• By industry, Financial Services ranked largest (34% of revenue), followed by Telecom (23%), Manufacturing (16%), Retail (12%) and Others (15%). Top-10 clients accounted for 32.0% of revenue, down from 32.5% in the December quarter. Infosys has 89 clients (vs. 81 in December) with LTM revenue of $10+ million, 18 (vs. 17) with $50+ million and six (vs. four) with $100+ million. Infosys added 40 new clients compared with 47 in the immediately prior period. It exited the quarter with an active roster of 538 – including 113 Fortune-500 clients -- up from 530 in December.
• Infosys generated CFFO of $190 million (or $0.33 per ADS) in the quarter. Major outflows comprised capital expenditures ($109 million) -- budgeted to decline from $374 million in fiscal 2008 to $250-300 million in fiscal 2009 due to completion of the Mysore campus and fewer employee additions. Infosys exited the quarter with net cash of $2.065 billion, up from $2.013 billion on December 31. Accounts and unbilled receivables slipped to 74 DSOs from 66 in December due to timing issues.

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INFY shares are suitable for aggressive investors. In our opinion, principal risks include the following: U.S. slowdown; 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.