Infosys: Traumatized Environment Affords Rare Buying Opportunity

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

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Investment Conclusion. Based on slower decision-making due to the ongoing global financial crisis and lower interest income – offset partially by a currency-aided margin tailwind – we are reducing our estimates as follows: fiscal 2009 diluted EPADS to $2.25 on revenue of $4.742 billion (14% YoY growth) from $2.30 on revenue of $5.015 billion; and fiscal 2010 diluted EPADS to $2.25 on revenue of $4.998 billion (5% YoY growth) from $2.65 on revenue of $6.143 billion. Our model conservatively assumes no QoQ revenue growth for the next three quarters. Longer term, we believe that Infosys should deliver ~20% YoY revenue growth in fiscal 2011 and beyond. To reflect prevailing sentiment, we are also revising our target price from $54 to $35. In 12-months, this would correspond to 15x forward EPS – a premium to the current depressed valuation. These deep cuts enable us to accentuate 1) an upward bias to our estimates; and 2) compelling valuation of only 11x forward EPS. Upon return of more normal market conditions, Infosys anticipates substantial work that will address post M&A integration, risk management, regulatory compliance and urgent cost restructuring initiatives in the Financial Services segment.

2Q09 Results. Diluted EPADS of $0.56 vs. $0.48 a year ago on revenue of $1.216 billion beat our $0.54 estimate on revenue of $1.218 billion. Revenue was held back by unfavorable currency swings (-$21 million impact). Results included a $28 million net currency translation/hedging loss (-4.2 cent EPADS impact). Operating income advanced 28% YoY and exceeded our estimate by 12%. Highlights included 19% YoY and 5.3% QoQ revenue growth; currency-aided operating margin of 29.5% vs. 27.5% a year ago; five transformational wins; unchanged hiring plan; a 30% jump in the annualized dividend to INR 17.25 per ADS; and fiscal 2009 guidance necessitating only a 2% reduction to our EPS estimate. Separately, Infosys announced that it will not raise its original ₤407 million offer for Axon Group plc made on August 25, thereby ceding the SAP consulting outfit to rival HCL.

• Takeaways. Management noted that global clients continue to entrust Infosys with the critical responsibility of transforming their underlying technology and operational platforms. Revenue rose 7.1% QoQ on a constant currency basis and was driven by non top-10 clients. Infosys recorded solid QoQ movement across key operating metrics: volume (+6.5%), utilization (+1.9%), operating margin (+280 bps), headcount (+6.3%), employee attrition (-0.8%) and DSOs (-4). Not surprisingly, YoY and QoQ growth in the North American and Financial Services segments lagged the overall performance. Meanwhile, the top client (a European Telecom) – down 22% QoQ in 1Q09 – was stable.

  Management conveyed the following outlook: Infosys has not suffered any material adverse impact to its business through September, i.e., project cancellations or pricing renegotiations; nonetheless, the 6% reduction in fiscal 2009 revenue guidance represents a prudent stance to allow for slower business velocity and ramp-ups in the present unsettled environment (3%), as well as the impact of recent currency volatility on reported revenue (3%); and importantly, Infosys expressed high confidence in its ability to maintain the operating margin given a flexible cost model and disciplined pricing approach.

• Infosys trimmed fiscal 2009 EPADS guidance to $2.24 (up 10% YoY) on revenue of $4.72-4.81 billion (13-15%). This outlook assumes stable pricing; exclusion of 12 large opportunities in the pipeline; annual salary increases (effective April 2008) averaging 11-13% for offshore staff and 4-5% for onsite (220 bps impact); an unchanged operating margin (vs. a 50 bps decline previously); and exchange rate of INR 46.97 per U.S. dollar vs. 43.04 in July.
• Areas of strength in 2Q09 included the Manufacturing vertical (71% YoY growth), Consulting & Package Implementation practice (28%) and European region (22%). Including the recent Philips acquisition, BPO revenue rose 38% YoY to $72.5 million accompanied by a 15% net margin. Operating income of $359.1 million (29.5% margin) surpassed our $320.9 million estimate (26.3% margin). The QoQ gain in operating margin was driven by rupee depreciation (averaging 6.0% = 250 bps), as well as the reduced impact of salary hikes (160 bps) and seasonal visa expenses (80 bps). Other levers for countering currency and wage pressures include 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 $73.63 for onsite work (up 0.6% QoQ and 1.7% YoY) and $27.52 for offshore (up 0.1% QoQ and 1.9% YoY). IT Services utilization (excluding trainees) stood at 72.8% vs. 78.4% a year ago. Billed volume rose 17.3% YoY and 6.5% QoQ. Higher-margin offshore revenue contributed 52.7% of the total vs. 52.5% in the June quarter. Global headcount rose 6.3% QoQ and 24.6% YoY to 100,306 in September. Attrition improved to 12.8% (LTM) from 14.2% 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 July.
• By industry, Financial Services ranked largest (33% of revenue), followed by Manufacturing (20%), Telecom (19%), Retail (12%) and Others (15%). Top-10 clients accounted for 28.0% of revenue, down from 30.1% in the June quarter. Infosys has 94 clients (vs. 91 in June) with LTM revenue of $10+ million, 20 (vs. 18) with $50+ million and five (vs. six) with $100+ million. Infosys added 40 new clients compared with 49 in the immediately prior period. It exited the quarter with an active roster of 586 – including ~100 Fortune-500 clients – up from 567 in June.
• Infosys generated CFFO of $387 million (or $0.68 per ADS) in the quarter. Major outflows comprised capital expenditures ($84 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 $1.840 billion, down from $1.912 billion on June 30. Accounts and unbilled receivables improved to 69 DSOs from 73 in June.

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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.

Comments

[Thomas Victor:]

Ashish thanks for the detailed analysis.

You mention "principal risks include the following: U.S. slowdown".

I'm itching to buy INFY but my fear is that the whole world,not just the US is entering a slowdown and we might have a recession for years and years from now. So might be better to wait.

Still, Infosys is doing a great job as usual and in a recession more firms might turn to Infosys to cut cost and still maintain quality. I'm surprised how they have managed to stay so good inspite of having tripled or quadrupled their workforce from a few years ago.

Not getting the AXON acquisition was a bit disappointing. AXON is making a mistake going with HCL for the sake of a a few percentage points in price.

Today 10/15 INFY is back down to $25 - if it ever gets back to it's last Friday low of $22 I won't be able to resist.

2008 Oct 15 05:37 PM