Infosys: 'Flat World' No Haven from Flattened Valuation

by: Ashish R. Thadhani posted on: July 14, 2008 | about stocks: INFY    
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Excerpts from Gilford Securities analyst Ashish R. Thadhani's recent note to clients on Infosys Technologies Limited (INFY):

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INFY: “Flat World” No Haven from Flattened Valuation – 16x Forward EPS; Maintaining EPS Estimates, Buy Rating

Investment Conclusion. Based on a more cautious revenue outlook – offset by a lower tax-rate – we are adjusting our estimates as follows: fiscal 2009 diluted EPADS remains at $2.30 on revenue of $5.015 billion (20% YoY growth but down slightly from our prior $5.045 billion projection); while fiscal 2010 diluted EPADS also stays unchanged at $2.65 on revenue of $6.143 billion (23% YoY growth and down from $6.231 billion previously). Our estimates imply 22%/14% compound revenue/EPS growth in calendar 2007-09 – after factoring a one-year extension in the “STPI” tax holiday to March 2010.

Recent price weakness can be attributed to renewed investor concern over the U.S. IT spending environment (62.6% of revenue). Nonetheless, we are fine-tuning our target price from $53 to $54. In 12- months, this would correspond to 20x forward EPS of $2.69 – a premium to the current depressed valuation (16x). Notwithstanding an uncertain macro environment, Infosys anticipates significant longer- term growth opportunities as clients increasingly focus on their business and IT efficiency.

1Q09 Results. Diluted EPADS of $0.54 vs. $0.46 a year ago on revenue of $1.155 billion beat our $0.50 estimate on revenue of $1.153 billion. Results included a $10 million net currency translation/hedging gain (+1.7 cent EPADS impact) and $7 million tax reversal (+1.2 cents). Operating income advanced 34% YoY and exceeded our estimate by 6%. Highlights included 24% YoY organic revenue growth, as well as above-average QoQ gains in the North American and Financial Services segments; currency-aided operating margin of 26.7% vs. 24.7% a year ago; three “transformational” wins and a record 49 new client additions; and reaffirmation of fiscal 2009 EPADS guidance, implying 5-6% QoQ revenue growth.

Infosys will hold its annual Analyst Day on August 1 in New York.

• Takeaways. Infosys posted acceptable growth in the North American (+4.2% QoQ and +24% YoY) and Financial Services segments (+2.8% QoQ and +19% YoY). Excluding a sharp 22% QoQ revenue decline at the top client (a European Telecom), Infosys recorded 3.8% growth across its top-10 clients and 3.9% at all others. A noticeable drop in utilization is attributed to recent employee additions vs. any unanticipated demand shortfall.

Management conveyed the following outlook: fiscal 2009 is progressing in line with prior expectations – IT spending decisions have continued to experience delays in a challenging economic environment pending improved sentiment and visibility; however, the Financial Services segment should mirror overall ~20% YoY growth for the year; meanwhile, pricing is expected to remain stable through fiscal 2009 despite sporadic renegotiation requests; and future overage stemming from potential rupee depreciation is likely to be reinvested toward domain expertise and IP creation.

• Infosys provided fiscal 2009 EPADS guidance of $2.32-2.36 (up 14-16% YoY) on revenue of $4.97- 5.05 billion (19-21%). This outlook is based on stable pricing; exclusion of 12-15 large opportunities in the pipeline; annual salary increases (effective April) averaging 11-13% for offshore staff and 4-5% for onsite (220 bps impact); a 50 bps drop in the operating margin; and exchange rate of INR 43.04 per U.S. dollar vs. 40.02 in April.

• Areas of strength in 1Q09 included the Manufacturing vertical (69% YoY growth), European region (27%) and Consulting & Package Implementation practice (27%). Including the recent Philips acquisition, BPO revenue rose 46% YoY to $72.5 million accompanied by an 18% operating margin. Operating income of $308.2 million (26.7% margin) surpassed our $292.1 million estimate (25.3% margin). The QoQ gain in operating margin was driven by rupee depreciation (averaging 5.6% = 250 bps) – offset by scheduled salary hikes (220 bps), seasonal visa expenses (70 bps) and lower utilization (150 bps). 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), a variable compensation structure (tied to revenue/margin performance) and scale/G&A benefits.

• Hourly realizations averaged $73.16 for onsite work (flat QoQ and up 4.0% YoY) and $27.50 for offshore (flat QoQ and up 4.5% YoY). IT Services utilization (excluding trainees) stood at 70.9% vs. 73.9% a year ago. Billed volume rose 18.5% YoY but just 0.5% QoQ. Higher-margin offshore revenue contributed 52.5% of the total vs. 52.5% in the March quarter. Global headcount rose 3.5% QoQ and 24.2% YoY to 94,379 in June. Attrition improved to 13.6% (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, unchanged from April.

• By industry, Financial Services ranked largest (35% of revenue), followed by Telecom (20%), Manufacturing (18%), Retail (12%) and Others (15%). Top-10 clients accounted for 30.1% of revenue, down from 32.0% in the March quarter. Infosys has 91 clients (vs. 89 in March) with LTM revenue of $10+ million, 18 (vs. 18) with $50+ million and six (vs. six) with $100+ million. Infosys added 49 new clients compared with 40 in the immediately prior period. It exited the quarter with an active roster of 567 – including 114 Fortune-500 clients – up from 538 in March.

• Infosys generated CFFO of $331 million (or $0.58 per ADS) in the quarter. Major outflows comprised dividends ($424 million) and capital expenditures ($80 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 $1.912 billion, down from $2.065 billion on March 31. Accounts and unbilled receivables improved slightly to 73 DSOs from 74 in March.

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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.

ANALYST CERTIFICATION

I, Ashish Thadhani, certify that all the views expressed in this research report accurately reflect my personal views of the subject companies. I certify that I have not and will not receive compensation with respect to the issuance of this report.

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