Infosys: A 2017 Growth Story

| About: Infosys Limited, (INFY)

Summary

Infosys is undervalued compared to its peers.

Growth to come from the emerging markets.

Trump's policy could help improve its performance.

At the beginning of every year, I go for bargain hunting. In this, I screen companies that underperformed their peers in the previous calendar year. Then, I look at the reasons why the companies underperformed and come up with a short or long thesis. This year, my focus turned to Infosys (NASDAQ:INFY), an Indian conglomerate that provides IT services to corporations. Amongst the global peers, INFY was one of the worst performing companies as you can see below:

Peer Companies

1-Year Return (daily)

Infosys

-8.60%

Wipro (NYSE:WIT)

-12.63%

Cognizant Tech Solutions (NASDAQ:CTSH)

1.61%

IBM (NYSE:IBM)

25.75%

Accenture (NYSE:ACN)

17.17%

Oracle (NYSE:ORCL)

11.57%

SAP (NYSE:SAP)

15.25%

As seen, INFY underperformed its peers in the year except for WIT which had its challenges of missing estimates and a decelerating growth in seven years.

Why INFY Underperformed

Two reasons contributed to the underperformance. First, the company suffered from the loss of the $300m contract with the Royal Bank of Scotland (NYSE:RBS) after the bank dropped an earlier plan to launch Williams & Glyn as a standalone bank. 3,000 people lost their jobs as a result. The dropped guidance was a key factor for the underperformance. Second, the company missed on revenue in Q1 and Q2, and reduced its FY17 guidance.

Infosys Client Base

Infosys serves global companies and governments. According to the company, at the end of 2016, it had 1,092 clients, which was a slightly higher number compared to the previous year. The clients are distributed in terms of revenue as shown below:

Source: Infosys Annual Report

Geographically, the following table shows the change in the distribution of clients around the globe. In the table, it is clear that North American and Indian revenues increased marginally while those from Europe and Rest of the World (ROW) decreased.

Source: Infosys

Infosys serves four main industries with Financial Services and Insurance (FSI) having the largest share. The FSI and the Retail, CPG, and Logistics (RCL) seeing marginal increase in revenues, and Energy, Utilities, Communications, and Services (ECS), and Manufacturing and Hi-Tech lagging as shown below:

Source: Infosys

The IT Consulting Market

The IT consulting market growth depends to a large extent on the performance of the economy. In a flourishing economy, companies tend to invest more in IT services. According to a report by IDC, the IT consulting industry will grow by 4.1% through 2017. It attributed this to a number of factors such as a rebounding European Union economy and corporations' shift to the cloud.

In its 2017 technology market outlook, Deloitte noted that companies will accelerate their IT investments in the year with machine learning taking the lead. Strategically, machine learning allows organizations to reduce capex and increase efficiency. Additionally, companies are investing in the digitization of the workplace, cybersecurity, artificial intelligence, and cloud adoption. The manufacturing industry is forecasted to increase, with companies investing heavily on automation. The energy market is also anticipated to grow as oil prices rebound. This will depend on whether oil producers will be faithful in their oil freeze pledge. According to Deloitte, projects worth $620 billion have been deferred through 2020 because of the decline in oil prices. In case of a sustained rebound in oil prices, some of these funds will get to the IT consulting firms. In addition, the World Bank expects the world economy will grow from 2.3% in 2016 to 2.7% in 2017. Most of this growth will come from the emerging and developing markets.

In the United States, investors and most managers have taken the Trump victory positively, with the financial sector having the biggest gain. Investors are pleased with the proposed infrastructure spending, reduction in corporate taxes, and the removal or easing of regulations. Analysts at the World Bank believe that the suggestions by Trump will create a boom in the economy if trade restrictions won't be implemented.

In Europe, the second largest market for Infosys, Brexit was a major issue in 2016. The challenge was how companies would adopt to the "new normal" in Europe. The management said the following about Brexit and its implications on its business:

On Brexit, there are challenges for a company such as Infosys in this uncertainty and yet there is a great opportunity for technology and services in the areas such as integration, interoperability, and transparency that in events such as Brexit here.

The main challenge was in terms of currency volatility, the future growth of the continent, and the future performance of companies in a "broken" Europe. Recent economic data show that the United Kingdom economy is doing well in Europe after the vote. The EU economy has equally been doing well after the vote. I therefore believe companies like Infosys will weather the Brexit storm successfully. In fact, Bloomberg reported that most CEOs would consider moving after Brexit, which would require services of IT consulting firms.

Fundamentals

Infosys has increased its quarterly diluted EPS, revenue, and cash and short-term investments despite the challenges it has faced.

Source: YCharts

However, the firm has substantially slowed down the profit margin from 26.25% in 2012 to the current 20.83%. However, the current profit margin is higher compared to its comparable peers except for Oracle which has a profit margin of 22.49%. The same is true with its trailing 12-month gross profit margin, EBITDA margin, and operating margin. The company also has a better return on equity than most of its comparable peers.

Valuation

A look at the company's valuation shows that it is relatively undervalued compared to its peers. I have compiled a few metrics that show the company is currently undervalued and has a potential to grow:

INFY

WIT

CTSH

IBM

ACN

ORCL

SAP

Market Cap

34.72B

23.80B

34.59B

159.51B

74.78B

160.44B

109.08B

PE Ratio (TTM)

16.38

18.81

22.36

13.69

17.20

18.89

28.19

EV to EBITDA

10.55

10.76

11.16

11.12

11.05

10.17

15.38

Dividend Yield (Forward)

2.47%

0.3%

-

3.34%

2.08%

1.53%

1.48%

Debt to Equity Ratio

-

0.2578

0.0871

2.498

0.0037

1.121

-

Source: Author

Conclusion

Infosys stock has been affected by the lowering of guidance by the management and the recent misses in revenues. The company has also been affected by the increased competition from its larger peers. Indirectly, INFY has been affected by the sluggish growth in the FSE sector because of increased regulations (read Dodd-Frank), low interest rates, and the emerging technologies like peer-to-peer lenders. I believe that these challenges will change in this year as the new administration removes regulations and as the interest rates rise. In addition, the company's services will come to focus as oil prices rise and deferred projects start to be implemented. Finally, the company has the potential to grow in the developing markets. In Kenya, for instance, the company provides banking solutions to Equity Bank, which is the largest bank by customer numbers in the market. The product enables the bank to reach many unbanked people. This is an area where INFY can reciprocate to other banks in the developing world.

As demonstrated in the table above, the company lags behind its peers. Not shown in the table, it trades at a smaller multiple compared to the industry average of 17.9. All eyes will be on the company on Friday when it reports. Wall Street and the Estimize community expect an EPS of $0.23, and revenues of $2,584M and $2,583M, respectively. I believe the company's share price has the potential to go up this year. A DCF calculation places its fair value at $21.08.

Disclosure: I/we 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.

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