Infosys: 40% Upside Driven By Successful Turnaround

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About: Infosys Limited, Inc. (INFY)
by: Anuj Dhawan
Summary

3Q19 results seem to be giving early indications of the company’s plans gaining traction.

Infosys’ increasing interest in Asia points towards the management focus on diversifying the company’s revenue concentration.

The company’s willingness to invest and turn around deals gone sour further points towards depth in management ability.

Leveraging the momentum in digital, Infosys appears on track for a re-rating in P/E.

If the company can sustain its growth trajectory, over the next 12-18 months, the stock can return ~40%.

Infosys (INFY) has been climbing out of a chasm of investor perception. Over the last 18 months, the company has been making significant strides in getting back to its ways of beating guidance. The results of the last few quarters and momentum in deals won point towards INFY on a sustainable growth trajectory. Absent management issues, the company’s stock looks undervalued.

3Q19 Results

Other than the usual suspects (European weakness in financial services, weakness in communication and life sciences), INFY’s 3Q19 results were quite strong. The company’s ability to capture an increasing proportion of client budgets on digital spending appears to have helped.

Source: INFY Financial Model. Note: The INFY Financial Model has been developed by the author using SEC filings, the company's investor disclosures and competitor analysis.

On the back of the momentum seen, the company also increased its revenue guidance from 6-8% growth in constant currency to 8.5-9% growth in constant currency while maintaining its operating margin guidance of 22% to 24% for the full year.

The intriguing part about INFY’s guidance was the company maintaining the operating margin guidance despite Digital seems to be driving growth (+5% q/q, 33% y/y) – Digital is known to have gross margins a couple of points higher than the rest of the business.

[Abhishek Bhandari from Macquarie] When the 9 months margin has been 23.4%, we have let the full year guidance unchanged at 22 to 24. That leaves a very wide range for the fourth quarter

[Joseph Foresi from Cantor Fitzgerald] People have tried to ask you about margins long-term, probably about six or seven different ways on this call. Why don't you seem to give long-term outlooks on margins or next year's outlook on margins.

Source: 3Q19 Earnings Call

Evidently, the market senses INFY’s conservativism despite things starting to look up. While for most companies, this kind of conservativism can be construed as an indication of a lack of financial control or worse, mismanagement. However, for INFY, this is actually good news – the company seems to be going back to its ways of under-promising while aiming towards outdoing market expectations.

Although the issues of the last few years had taken the edge out of INFY’s guidance beating ways, the company’s three-year plan instituted last year seems to be nicely taking shape.

Expanding scope: New and old

Japanese entry

In December 2018, INFY announced the acquisition of 81% stake in Hitachi Procurement Service (NYSE:HPS). HPS is the global procurement arm of the Hitachi Group. The balance of the 19% will be jointly held by Hitachi, Panasonic and Pasona (a local Japanese staffing firm). As the management noted:

the idea is directly expand this into -- indirect procurement into the larger Hitachi organization across the world, then to Panasonic

Source: 3Q19 Earnings Call

The Japanese deal comes on heels of the deal with Temasek in September and more importantly can help INFY consolidate its position in Asia. Since Japan is the largest IT market outside of the US, not only does a presence in Japan help diversify INFY’s dependence on US revenues but also further growth in its digital business with a focus on procurement.

Skava & Panaya

INFY reported that the company could no longer sell off these assets by end of March 2019. Additionally, the company plans “to repurpose Skava’s business and refocus Panaya’s suite of products”.

INFY had acquired Skava and Panaya in 2015, for an aggregate value of $320 million. While Skava was acquired to leverage its digital experience solutions for the retail industry, Panaya’s automation technology for large scale enterprise software management was aimed at building further differentiation in INFY’s service lines.

In 2018, INFY had set out to sell Skava and Panaya due to lack of meaningful contributions from the two companies. While these assets were on the block for a while, INFY taking them back in the company’s fold signals that the management has a plan to make them work despite them not meaningfully contributing to the financials. Furthermore, despite the effort and money involved in the financing of these turnarounds the company has been able to raise revenue guidance and hold the expectations steady on the margin front.

In the past, these assets had created a major upheaval for the company. If the management has finally decided to digest them, it would be reasonable to assume that a company of INFY’s reputation will not be taking on any further risks.

Growth in Digital

INFY’s digital offerings seem to have helped grow the company’s deal size with the momentum in large deal TCV sustainably picking up.

Source: INFY Financial Model

Evidently, INFY seems to have got the pulse of digital right and seems to be intensely focused on executing it right:

  • The company has been hiring digital specialists at a rapid rate and alongside been looking at large accounts where these folks can be deployed to increase the amount of work coming through.

Additionally, INFY has been expanding sales capacity and re-skilling employees to deliver greater value.

In terms of how satisfied I am, of course, we've seen the performance is strong and I'm never really fully satisfied because there is always more to do. And we want to make sure that we keep our focus on that to make sure we have larger and larger deals both on core services and on digital.

Source: 3Q19 Earnings Call

Source: INFY Financial Model

The management’s insistence on Digital generating higher margins than the core IT business clearly demonstrates that INFY’s digital go-to-market strategy seems to be resonating with customers.

Outlook

The company seems to be following up on its three-year plan rigorously, with 9M19 revenues up 7.4% and an upward revision to the revenue guidance.

Source: INFY Financial Model

As per the company’s 3-year plan, F2019 was expected to be the year of stabilization followed by incremental momentum and acceleration in F2020 and F2021, respectively.

Source: INFY AGM

In the context of the company’s performance this year across revenues and deal wins, it appears that INFY seems to be on track if not ahead of schedule. Coupled with the momentum in digital and growth from newer initiatives, in line with earlier commentary, INFY’s revenue and PAT estimates are as follows:

Source: INFY Financial Model

Over the last few years, INFY's P/E had fallen due to issues in Europe and a spate of management exits.

Chart
Data by YCharts

The company's return to growth is likely to stem the executive exodus while helping the stock's multiple expand. Applying a range of P/E between 20-30x, potential return from the INFY stock over the next 12-18 months could be as follows:

Source: INFY Financial Model

While the potential for macro headwinds to derail growth are well understood, the company’s focus towards investing in its high margin digital business is likely to stand out. Minus the management volatility, INFY’s time tested brand is unlikely to disappoint on the company’s commitments.

Note: All historical financials have been sourced from the company's SEC filings and investor presentations

Disclosure: I am/we are long INFY. 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.