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Infosys: Solid Quarter And Good Prospects For 2020, With Investigation Overhang Somewhat Mitigated

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About: Infosys Limited (INFY)
by: Alexander Veytsman
Alexander Veytsman
Long/short equity, hedge fund manager
Summary

There were mixed quarter results, but overall investors chose to focus on the positives.

Digital came in particularly strong and there are solid prospect for consulting and outsourcing segments.

The investigation overhang has been somewhat mitigated, but we expect more noise to continue.

In this article, we review INFY's latest earnings, commenting on the company's recent improvements, as well as the steps forward for 2020. Recall, INFY is the Indian company that focuses on business consulting, information technology and outsourcing services. Infosys competes with Wipro, Tata, Cognizant, and Accenture, among other players. IT Services is a very fragmented space, which makes it very difficult to analyze. Therefore, any data points that emerge after earnings results are helpful to gain further insights about the company and the industry as a whole. Please see our most recent Article on INFY. In the present article, we are upping our price target and reaffirming our Bullish thesis.

Valuation

We value Infosys in the peer group that includes many players from the fragment IT services space (which specifically focuses on outsourcing and consulting): Accenture, Cognizant, Sapient, IBM, Capgemini, Globant, EPAM, Wipro, and Tata Consultancy, among others. We find that on 2020 earnings the PE multiple of 18x remains appropriate and fairly conservative. When applied against our 2020 EPS estimate of $0.65 (up from $0.62), we get the target price of $12 (up from $11). We maintain our Bullish thesis.

Key Takeaways From the Recent Quarter

Positive spin on the ongoing controversy: We will start with non-financial matters, since this is the most obvious elephant in the room. The company resolutely stated that they have conducted an internal audit-related investigation that found no improprieties in their financial statements. It is unclear to us, if this overhang will go away, since there are still many questions unanswered about the financials; furthermore, the methodology of the investigation itself could be called into question since the company had a say in selecting the actual audit committee and the period they studied was largely limited to 2018-19. At present, it appears to us that INFY has scored a win in this controversy, but we don't know if more information/investigative materials will emerge in the near future. We also haven't heard much from the SEC. Hence, the company is not out of the woods just yet.

Mixed quarter results: The company delivered an EPS of 15 cents, beating the Street by a penny. The revenue grew 8.4% Y/Y to $3.24 billion, beating consensus by $20 MM. While on the surface we see mixed results, neither the top line beat, nor the bottom line miss were truly meaningful. Hence, investors zoomed right past them, focusing instead on positive color of the investigation.

Strong digital performance: Digital segment grew 40% Y/Y during the quarter, with the annual run rate now at $5 billion. Further, it is our understanding that going forward, the company will target 40-45% of total revenues toward the digital segment. The strong digital trend is in line with the focus of both consulting and outsourcing companies, albeit Infosys is a clear leader when it comes to the Indian competition.

Consulting expectations remain solid, in line with the overall Indian demand: We are estimating 9.5% Y/Y growth for Infosys during calendar 2020, driven mainly by the European clients. We are cognizant of the fact that there were pockets of softness coming out of Europe in 2019, mainly around financial services clients. However, as the economic outlook improves and with Great Britain and Germany narrowly missing two quarters of negative GDP growth in 2019, which officially define recession, we believe that economic sentiment has improved for many large-cap companies.

Outsourcing softer, but may see further tailwinds in late 2020: It is true that demand for outsourcing, especially BPO (business process outsourcing) is on a secular decline. However, we also believe that some pickup in non-BPO outsourcing is likely by August-September of this year.

Dividend remains strong: We believe that the company may further up its dividend in 2020, which would take the yield closer to 2.5%, a very high bar for the IT Services companies.

Risks to Our Thesis

Cyber risks: We cannot overemphasize the danger of cyber risks, particularly for non-US players, such as INFY, where security systems are often exposed. In our view, this is the number one threat, even beyond macro concerns.

Macro risks: Consulting business is almost entirely dependent on strong economy, which makes the risk of economic downturn especially relevant. However, the upside is that during rough economic times there are better outsourcing opportunities.

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.