Infosys - Buy The Dip And Profit From Sikka's Speed Of Execution

| About: Infosys Limited, (INFY)
This article is now exclusive for PRO subscribers.

Summary

Infosys is going through a multi-year transformation, and Narayamurthy's return to Infosys has "shaken up the boat".

Operating margins are stabilizing but at lower levels, driven by increased utilization and focus on productivity. Management's focus on "platform-based solutions" is likely to be a slow burn strategy that will yield results in the next 12-18 months.

The leadership of Dr. Vishal Sikka brings a valuable "outside-in" perspective of working with a non-linear, product-led company like SAP, and is likely to help Infosys wring out a lot more juice out of its existing platforms and products.

The market is factoring in an anaemic growth, but with the economy thawing in Europe and picking up steam in the USA, growth in FY 16 would be at least 300-400 bps up from FY 15.

At the current market price, the company makes for a low-risk buy with a 30%-40% upside over 12 months. Every pullback gives one of the opportunity to accumulate more.

Infosys, a $32 Bn success story in IT services from India, has been going through a leadership transition over the last three years, which has resulted in the company losing its leadership position (in terms of size and growth) to other nimbler rivals like TCS, Cognizant, and also getting snapped at the heels by HCL Technologies and Wipro.

This prompted the company's legendary founder, N.R. Narayanamurthy, to come back and shake the boat a little boat and appoint a new captain (Dr. Vishal Sikka). On that note, NRNM (and his son) have left. The street still does not find enough evidence about whether there is a structural permanent change if growth YoY can rise above double digits. The company has guided for a 7%-9% growth in FY 2015.

The best investments are those into great companies with temporary, fixable problems. Margins have been steady primarily driven by utilization, which has risen a full 800 bps last fiscal. One of the biggest challenges for Infosys has been employee attrition - for a long time, Infosys used to be the "Microsoft" of India. With a lot of start-ups mushrooming and younger, nimbler companies coming up, Infosys no longer has the same charm, especially for mid-to-senior level folks.

I decided to deep dive further by speaking to mid-rung employees and also with its sales employees in the USA (close to customers). You can read the transcript from Q1, FY'15 (Qtr ending June '15) here.

Having always had an "investigative kind" of mentality, I believe a lot more in collecting relevant data points that confirm or negate my hypotheses - feedback from customers, employees, ex-employees is paramount, and this is a summary of what I discovered:

  • Focus on productivity: Across the spectrum, every one of the employees I spoke talked about how their KRAs have got tightened and there is a lot more pressure to deliver. Proof is the fact that with a 0.8% growth in employees, revenue growth in Q1 was 2.2%. This is a trend that will continue, although at a slower pace. I do believe that Infosys will drop another 100-200 bps in EBITDA as it tries to move Q-o-Q growth to 4%-5% from the 2%-3% that it is right now.
  • Lots of fat trimmed across layers, especially in the middle: At least one of the employees talked about how a lot of "employees". While no one wants to take names specifically, it is understood that about 15-16 Sr. VPs and above were not able to increase traction substantially, and hence, chose to leave the kitchen rather than take the heat.

  • Slow increase in momentum: Shibulal, the outgoing CEO of Infosys, talked about a slow increase in momentum. With NRNM at the helm and shepherding the tough part of the restructuring, and now a new leader at the helm, there is a slow but rapid shift in momentum.
  • Employee-friendly policies: Infosys has put in place a clear calendar for appraisal, sharpened KRAs and made linkage between KRAs and promotions/bonuses transparent to make sure that people get the message. There was a lot of heartburn about professionals not being able to rise to the top, but with the appointment of an outsider, Dr. Vishal Sikka, a lot of two-downs who see themselves arising to the top in 4-5 years now believe that they have a fair chance.
  • Improved transparency: In the last 18 months, there has been a lot more emphasis on town hall meetings and communicating frequently, there is a "tighter" knitting between senior management and junior employees. Of course, this is likely to lead to a little more attrition in the short run.

So, what's the deal here? Reading between the lines in the annual report, the big takeaway is that Infosys wants to improve its platform-based offerings that actually assist its customers with their business transformation (for e.g., say develop an integrated cloud-based module that allows for omni-channel retailing. That needs synchronization of customer data across stores, e-tail websites, loyalty programs and also managing e-mail, B2C and B2B logistics etc.). These, by their very nature, are a lot more uncertain and iterative than traditional B2B RFP-led "projects". Given that, I do expect that this will start showing results by Q4, FY'15. NRN, too, when he took over the helm, pointed at these changes getting completed in another 36 months.

For the record, LTV won in the last twelve months and was $2.4 Bn, up from $2 Bn (TTM) in September '13. These take about 18-30 months, on average, to run-off into revenue. My sense is that Infosys will grow at 7%-8% in FY '15 and would move up to a 9%-10% in FY '16 on the back of improved backlog.

Valuation:

INFY is a fountain that spins cash and has a giant cash hoard. Of the $32 Bn in market cap, about $4.5 Bn is cash. Given Infosys' prudent capital allocation, I do not expect it to ever waste away this money by doing any non-accretive M&A. That leaves a value of about $27 Bn to the core business.

The business generated about $2.0 Bn of cash last year, and is on track to generate $2.3 Bn of OCF after all WC changes. That gives it an OCF yield of about 8% (capex is less than $0.4 Bn).

Summary:
At the current market price of $54.23, I see an asymmetric upside-downside equation. The downside gets cushioned to a large extent by the 2% dividend yield + near $5 Bn in cash + $1.5 Bn of FCF (post dividends) in FY '15. So, it's hard for me to see the market cap go below $29 Bn or so even in the worst case (stock price of $46-$47). On the upside, at a conservative $10.3 Bn in FY '16 topline and a PAT of about $2.4 Bn, applying a multiple of 15-16 x FY '16, the CMP comes to about $34-36 Bn, an upside of 20%-30% from the current levels.

All the optionality of:

  1. a new leader with a product mindset (Dr. Vishal Sikka comes from SAP - which has a lot more "non-linearity" built into its business model). I do expect Infosys to monetize its products and platforms a lot more aggressively, moving ever so away from its Systems Integrator mindset.
  2. potential better performance from the existing set-up
  3. improvement in deal and revenue pipeline
  4. any revenue-enhancing acquisitions (given the $5 Bn cash kitty)

- comes as an upside. That being the case, this represents a low-risk bet with a moderate, nearly guaranteed upside, especially if one is investing in dollars. I would urge investors to buy the stock at the current levels and keep adding on any pullback. This could be a 15%-20% anchor in any moderate-risk investor's portfolio.

Remember the new CEO's name means "money" in the local dialect!

Disclosure: The author is long INFY. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.