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3QFY11 results
Infosys’ 3QFY11 numbers were materially short of street expectations.
6%QQ growth in $-revenues and a 2%QQ growth guidance for Mar-11
quarter is completely at odds to the management’s bullish commentary
on order flow through the quarter. That said, 26,000 fresher offers for
2011 and record hiring of laterals in 2010 implies Infosys is preparing for
a big year ahead. With attrition also turning benign, confidence in
managing margin pressures from wage hikes remains high. Miss in
3QFY11 notwithstanding, we see a very good 2011 ahead, but markets
need to see it too and that could take some months. Robust results from
TCS and solid guidance from Cognizant should come in handy. BUY.
Miss on the topline likely driven by select telcos in US
Infosys’ 3QFY11 revenues at US$1,585m fell short of street expectations. We
see the Dec-10 quarter miss and a subdued Mar-11 guidance as mere blips
amid a strong demand environment. While there is much speculation on the
reasons behind this miss, in our view deferral of IT spends by select telecom
clients is the key contributor. Regulatory uncertainty around Net Neutrality
(See Page 3 for more details) resulted in freeze in IT capex/opex by select
telcos in US in Dec-10 quarter. With new rules now in place, we expect some
of this uncertainty to go away driving a fresh IT capex cycle by the telcos.
Planning for a big 2011 continues
Over 26,000 job offers have been made for graduating class of 2011, over
9,300 lateral (experienced) employees have been hired in the last 2 quarters,
and utilisation has been brought down to expand the bench. Does this show a
company planning for just 1-2%QQ growth in the coming quarter, as Infosys’
Mar-11 guidance implies? We think not. Despite headwinds from promotions,
currency appreciation, declining utilisations and third-party hardware costs
(US$9.3m) in an India-based project, Infosys managed margins flattish QQ.
This implies that Infosys’ margin performance has more legs thru 2012.
Sustaining stock returns demands new investments
While stock prospects for 2011 remain sanguine, money making in Infosys
remains dependent on a few connected variables that need continual testing.
Sustaining stock returns demands sustenance of the PE multiple which in turn
would require a high teens earnings growth. As our recently released sector
report, This is I.T. (http://www.clsa.com/member/reports/457605400.pdf)
argues, this would demand expansion of the addressable market to maintain
revenue growth and greater usage of non-linear models to overcome margin
pressures from manpower shortage. Expansion of its executive council to
include younger business leaders has ensured greater debate on new
investments and early success of new ventures such as Flypp will likely drive
further investments in such new areas.
3QFY11 results
For a stock touching new life highs every day, results need to come at the top
end of street expectations, not struggle to meet them. By that yardstick,
Infosys’ Dec quarter report leaves much to be desired. We agree 6%QoQ US$
revenue growth isn’t bad at all (but 7% was expected at the least), and
margins stayed flat (in line, so just ok), and employee hiring was good. But
somewhere, the order flow bullishness from the sector has been lost in
translation when we compare Infosys numbers to what could have been, or
what we reasonably expect from its larger peer TCS on 17th January.
As the summary in Figures 1 & 7 (operating metrics) shows, 3QFY11 results
were a mixed bag on operating parameters. Manufacturing grew 10%QoQ in
$-terms, helped by a late year surge in demand from a vertical that has
inspired more fear than confidence for much of 2010. ERP and product
engineering businesses delivered solid growth as well. However, the troubled
telecom vertical remains a source of worry and likely drove the 3QFY11 miss.
Uncertainty in telecom has also driven a modest Mar-11 revenue guidance, in
our view. A likely ramp-down in the utilities order from Karnataka State also
impacted growth in the energy & utilities vertical.
Regulatory uncertainty in telecom sector in US was a drag
Telecom sector has remained a problem area for Infosys for almost 3 years
now. While underperformance in FY09/10 was driven by the ramp-down in
the key British Telecom account, regulatory uncertainty in US remains the
chief cause of decline in 3QFY11.
What is Net Neutrality?
Net Neutrality is a principle aiming to protect end- users of broadband internet services. The principle
advocates that Internet service providers can not provide differentiated service based on the kinds of
equipment that may be used for last mile connectivity or on the content of the websites being accessed.
Why the spotlight?
In late 2007, Comcast began employing a technology that terminated established communication between
peers on the BitTorrent and Gnutella networks, without informing the users. In early January of 2008, the
issue began to take legal form as the FCC (Federal Communications Commission) called a hearing on
network neutrality to order.
It has its supporters among consumer right groups…..
Websites have stopped being passive storehouses of content. Netflix and Hulu sell access to movies and
premium TV shows just like Comcast. Skype provides phone service just like Verizon. With new interactive
website applications, sites are no competing with services being provided by telecom giants themselves.
Comcast charging an end user extra to access Hulu or Netflix violates anti trust laws.
But also vocal opponents such as AT&T, Comcast and Verizon….
However, unlike websites that are passive content pages, Netflix, Hulu, Skype, etc are bandwidth monsters.
Internet service providers want to charge them for the additional burden these sites put on their network
bandwidth.
Net Neutrality regulation passed in December 2010
Ending a period of uncertainty, on 21 December 2010, the FCC succeeded in passing net-neutrality
regulation. (Though these are widely expected to be challenged in court)
Internet companies must not block websites that offer services that compete with their own.
Internet providers can not play "favourites" by "dividing delivery of Internet content into fast and slow
lanes." (or basically Comcast cannot make Netflix video stream slower than it should.)
Broadband providers can charge more to websites that want faster service for delivery of games, videos or
other services.
Uncertainty around Net Neutrality has resulted in US telcos deferring some of
the planned IT spending. While the FCC (Federal Communications
Commission) has passed net neutrality regulations, these are expected to be
challenged in courts. Infosys remains an important vendor to some of the key
players involved in the net neutrality debate and our checks indicate that
decline in telecom revenues in Dec-10 quarter can be majorly attributed to
this uncertainty. That said, Infosys is seeing a pick-up in wireless
communication sector through 2011 as this uncertainty goes down. In fact,
the new regulations will likely result in a renewed IT capex cycle at these
telcos, which should drive increased services spending.
Slower growth in energy & utilities is not a cause for worry
2.7%QQ growth in energy & utilities was much below company average and a
key driver of revenue underperformance. Infosys had won a Rs3.9bn contract
from the Karnataka Power Transmission Corp under R-APDRP (Restructured -
Accelerated Power Development & Reforms Program) and this had resulted in
the spike in India and Energy & Utility revenues in 1HFY11. Volatile nature of
implementation of this project has resulted in slower growth in the quarter
impacting vertical growth. With Infosys signing key Global500 clients in the
vertical, we remain sanguine on growth prospects.
What makes us confident of 25%+ growth in FY12?
Much of the hiring in 1HCY11 was to back-fill the rising attrition. With attrition
numbers trending down, strong hiring through 2HCY10 and over 26,000 job
offers for the graduating class of 2011 suggests Infosys is preparing for a big
year in 2011.
After a poor quarter in Sep-10, client additions have also picked up in Dec-10
quarter with 40 new clients signing up. 8 of these clients are Fortune 500
clients.
Moreover, we feel that some of the client issues faced by Infosys in Dec-10
quarter are transitory and are unlikely to impede growth prospects in 2011.
Sustaining stock returns demands new investments
Infosys trades at 20.8xFY12 EPS, but 16.8xFY13 EPS. The upside from hereon
is a matter of time, when confidence in the FY12 outlook takes root, and the
FY12 PE multiple can expand. We suspect this will happen over time, though
more gradually now that some scepticism on revenue growth needs to be
overcome. We remain buyers of Infosys on a 12-month view and are
retaining a target price of Rs3,875, which implies about 20x March 2013 EPS.
This is all very well. However, the medium to long-term investment future of
Infosys is dependent on a few connected variables that need testing.
‰ PE multiples will need to sustain for stock returns to continue.
‰ Sustainable PE multiples go hand-in-hand with earnings growth. This
does not necessarily imply a PE-to-growth ratio of 1x – PE/G multiples
can expand to 1.2-1.4x when growth drops off - but a mid-teens
earnings growth is still needed to sustain a high multiple (around 18-20x
for Tier-1 vendors).
‰ For earnings growth to continue, revenue growth should hover around the
18-20% mark and margins should be protected from any precipitous fall.
‰ For revenue growth to sustain around 18-20%, there should be enough
manpower availability or else, nonlinear models need to become bigger.
Infosys has two investment futures, both of which rest on a strong 2011,
unless cataclysmic macroeconomic events intervene. One of the possible
pathways suggests that 2011 will be a flash in the pan - a good year, but
followed by ordinary years that put downward pressure on PE multiples.
Infosys may have another 15-20% upside left, but thereafter, upside wanes
to single digits (for the industry leaders) or even worse. The second future is
a brighter one. Infosys reinvents itself, introduces new services, breaks the
linear equation of revenue-employees and opens new markets. High-teens
earnings growth can continue for longer. Multiples can sustain and roll over
year to year. In five years, Infosys, with a current stock price of Rs3,200, can
be at Rs4,600 in one scenario (good 2011, ordinary thereafter) or head to
Rs7,100 (the ‘reinvention’ scenario)
As a matter of illustration, we shall highlight two scenarios which yield very
different long term trajectories for a Tier-1 stock such as Infosys. As we shall
see, a minor difference in revenue growth (which yields a US$1.5bn revenue
difference between the two scenarios after five years) and a minor increase in
margin erosion (a 200bp gap over five years) can dramatically alter stock
returns, if multiples contract. At Rs3,200, Infosys can head to Rs7,100 in one
five-year scenario, a 17% annual return. In the other, it merely gets to
Rs4,600 in five years, just a 7.5% annual stock return.
For some more time, Infosys could remain torn between its decade-old
culture of conservatism and new-market realities. Thankfully, the expansion
of its executive council to include younger business leaders has at least
ensured greater debate and the success of some new ventures such as Flypp
should be a dramatic opinion changer within the firm. Infosys continues to
reject asset intensity of any sort, and it is highly focused on margins - both
potential hurdles to investments in new areas. On the positive side, once
convinced, Infosys has shown the ability to execute the best. Late to enter
BPO, it was early to sideline voice offerings and focus on processes. Despite
perceived cultural barriers to risk, Infosys has continued to invest in its
FINACLE core banking product, which is now a 5,700 member strong team.
And it has been adding to its SET LABS R&D group as well. We remain
optimistic
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