Struggling Infosys Attempts To Acquire Growth

| About: Infosys Limited, (INFY)

Infosys (NASDAQ:INFY), India's second largest software exporter, is expanding into management consultancy by acquiring the Switzerland based Lodestone Holding AG, that has 750 consultants and 200 clients, for $349 million. The outsourcing giant which was once India's largest IT company is struggling due to declining sales, falling stock, dwindling market share, changing CEOs and growing resentment among shareholders. Shareholders have often openly criticized senior management for its risk-averse approach. Its large stockpile of cash reserves finally raised enough eyebrows that it had to be deployed. Sam Mahtani, an Infosys shareholder with UK based F&C Asset Management had earlier called for the company to either distribute the cash as dividends or use it for M&A.

The Bangalore-based IT company is facing increasing competition from Tata Consultancy Services (TCS) and IBM (NYSE:IBM). By the end of June, the company had successfully touched the 30% mark of income from consultancy, now it is looking to go beyond that. IBM, in particular, has gotten very aggressive building a very strong full service network in India offering more than just the back-office infrastructure but the software and hardware to run it all. And it speaks to the problems companies like Infosys have when they won't move quickly to innovate.

Even after the Lodestone deal, Infosys's biggest; the company will still have plenty of cash. Some will be doled back out to recently-suffering shareholders while the rest will be used for M&A. Infosys had $3.7 billion in cash and short term investments in its latest half yearly report, far more than TCS's $1.7 billion. It has been looking for a European M&A target for the last ten years but have finally gotten their prize. By the end of October, Infosys will close on the deal raising their SAP (NYSE:SAP) consultants by more than 750 people which should push SAP consultancy revenues up near $1 billion annually.

Lodestone is expecting to earn about $270 million in the current fiscal year, with about half coming from Switzerland and 23% from Germany. IT companies around the world have been moving into management consultancy due to its higher margins and increasing demand and Infosys looks to be about a year behind the curve. The acquisition will expand Infosys's customer base to include some Fortune-500 companies BMW, and Deutsche Telekom, Europe's largest telecom company. Infosys will have an opportunity to provide IT services as well to Lodestone's high profile customers.

It has also faced some difficulties with finding the right new CEO from its seven founders while the current M.D. and chief S.D. Shibula, who is also a founder and fourth CEO to serve his company, has focused on restructuring to tackle the challenges. A lack of firm leadership has contributed to shareholders' unease and demands for action. It has been historically reluctant of doing M&A, preferring to rely on organic growth. But, to shift business models and company focus will require acquiring expertise and a client base if it wants to stave off increasing competition from IBM and TCS.

Infosys is also aiming to earn 40% of its revenues from Europe in the current year as opposed to 22% earned last year; the Lodestone acquisition is part of that strategy. It has targeted France and Germany as its greatest opportunities since the two countries spent more than $178 billion last year on IT goods and services combined.

For the quarter ending June 30th, Infosys had reported falling revenues by 1% sequentially as net earnings dropped from $463 million to $416 million. However, on a YoY basis, the revenues were up 4.8%. TCS also posted its financials the same day which showed it increasing revenues 3% sequentially and 13% annually. The relative gap in performance between the two companies is having an effect on Infosys retaining the best staff. What once was the equivalent of getting a job at IBM in the 1970's now no longer carries the same halo effect for young workers. Staffing problems have moved up to the senior management level as Shaji Farooq the head of financial services joined its competitor Wipro earlier in the year.

Infosys's primary markets are the U.S and Europe. The prolonged economic crisis has translated into falling sales. Falling revenue is almost always associated with declining market share but in Infosys's case, it is declining even faster because its biggest customers, such as Bank of America (NYSE:BAC) and UBS are trimming their IT expenditures due to financial issues. Most of the U.S. and European banks have had to excise large portions of their staffs as their core lending businesses have stagnated. For those with vibrant, if shady, trading and investment banking arms the situation is different. Citigroup and JPMorgan Chase (NYSE:JPM) have retained their level of IT spending.

The net effect of the latest round of QE will be to continue rolling the entire banking system in the U.S. and Europe into the majors while stripping the regional banks of their good assets, whether that will translate into more IT spending for Infosys or not is hard to predict. Many of the layoffs announced came in spite of QE1 and QE2. JPMorgan, in particular, should thrive in this new environment as will B. of A. since it will be their MBS's the Fed will be monetizing.

The management insists that the fall in stock is only temporary and with their current strategy of expansion in Europe and shift into consultancy, Infosys is looking to be back on track to growth sooner rather than later. Execution and integration of new acquisitions are rarely smooth and for a company that has grown from within itself from the ground up, incorporating a European company with its different culture may be easier said than done.

Infosys is a long way from getting back to an organic growth path and will have to move quickly into the growing markets in Southeast Asia to find their next way forward. The irony should not be lost on anyone that the company which made its fortune outsourcing IT services to the West is now finding itself being outflanked on its home turf by one of the very companies it was founded to support. Both are trading at similar multiples (~15), throwing off similar yields (~1.6%) and Return on Assets (31+ %) but until Infosys proves they can successfully shift into this new business and start growing margins, the stock looks like a value trap.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.