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Don't fix it if it ain't broken
ƒ No drastic internal revamp that jeopardises 25%+ FY12E growth
ƒ Instead shifts to be in line with long-term consulting, IP strategy
ƒ New CEO likely near term, but could the next head be non-Indian?
ƒ Shares close to undervalued zone, FY12 guidance likely catalyst
Hold the course, for now
Much newsprint has recently been
devoted to a possible organisational
restructuring at Infosys. Yet, after our
recent Bangalore visit, we think the
intended changes are not as new, urgent
or drastic as the reports may have led
investors to believe. Instead, we believe
that FY12 could be a 25%+ revenue
growth year, and management may not
resort to measures that could jeopardise
near-term growth opportunities. Some
tweaking is due for later in the year, but
we believe that would be part of a more
drawn out long-term strategic shift.
Strategy roadmap; avoiding employing a million by 2020
The first change could be that of the CEO (as the current CEO may
replace the Chairman who is due to retire in August). We expect further
changes to be in line with Infosys’s strategy to target a revenue mix that
is equally split between: 1) business transformation, 2) strategic global
sourcing and 3) new engagement models. Attaining this mix would need
revenue from transformation and innovation to increase significantly.
From investors’ perspective, the success of the company’s strategy could
address long-term concerns about its headcount-led model. We calculate
that if Infosys has to achieve a 20% CAGR in revenue at current
productivity levels, it may have to employ close to a million in the next 10-
12 years. Such scale could pose challenges of a level yet unthinkable.
Could the longer-term CEO be non-Indian?
As has been widely reported, S.D. Shibulal is a logical choice for CEO,
given the historical pattern of COOs taking on the role. But past CEOs
have given up their posts well before the 60-year age limit, and it is likely
Mr. Shibulal (aged 56) could transition the role to a non-founder CEO in a
couple of years. While there are several strong internal candidates, at the
risk of looking too far out, we would be interested to see if Infosys opts for
a non-Indian CEO. One candidate could be Steve Pratt, head of the
consulting practice and twice voted among the top-25 consultants globally.
Such a choice could fit well with Infosys’s global aspirations and strategy.
How to make money from Infosys shares?
We lower FY12-13E EPS by 2-3%, largely to factor in the 3QFY11 miss.
But we still forecast over 25% 12-month stock return, in line with EPS
growth, and retain BUY. For the analytically inclined: 1) our long-term
“what was” compared to “what should have been” DCF model points to
the stock being close to outright undervalued; and 2) our “guidance gap”
analysis suggests Infosys could at least marginally outperform the index
in FY12, and that the forthcoming FY12 guidance could act as a catalyst.
The Risk Experts
• Our starting point for this page is a recognition of the
macro factors that can have a significant impact on stockprice performance, sometimes independently of bottom-up
factors.
• With our Risk Expert page, we identify the key macro risks
that can impact stock performance.
• This analysis enhances the fundamental work laid out in
the rest of this report, giving investors yet another resource
to use in their decision-making process.
Don’t fix it if it ain’t broken, at least not now
Much newsprint (Times of India, Business Standard, 2 February) has recently been
devoted to a possible organisational restructuring at Infosys. Yet, after our recent visit to
Bangalore, we think the intended changes are not as new, urgent or drastic as the
reports may have led investors to believe. We noted the usual caution from
management on not taking the US/Europe recovery for granted. But behind that
conservativeness, we sensed that FY12 could be a significant growth year (i.e., 25%+
USD revenue growth as per our projections). We therefore believe that it is unlikely that
management will resort to internal measures that could jeopardise near-term growth
opportunities, and that instead any changes could be part of a more drawn out longterm shift.
Recent internal reorganisations by peers have been during times when industry-wide
revenue opportunities have been lacklustre (TCS in early 2008) or when it was
necessary because of company underperformance versus peers (Wipro in 2011).
These situations do not apply to Infosys’s current state – therefore, we think there is
hardly a case for a company-wide restructuring.
Changes should be in line with strategic roadmap
We gather, however, that some internal “tweaking” could happen later in the year,
which is likely to be in line with Infosys’s strategic roadmap for the next three-five years,
and should ultimately lead to more autonomy for unit heads. We believe those tweaks
could happen after September 2011, after the likely appointment of a new CEO, so that
the new structure settles by March 2012 in time for the next fiscal year.
Infosys’s “TOI” strategy – first discussed in an analyst meeting in July 2010, and later
likely ironed out in an internal Strategy and Planning (STRAP) meeting in Mysore last
month – is aimed at achieving a revenue mix that is equally split between: 1) business
transformation (T – transformation), 2) strategic global sourcing (O – operations), and
3) new engagement models (I – innovation). Attaining such a mix would need revenue
from transformation (currently 26% of revenue) and innovation (less than 10% including
product revenue) to increase significantly.
Therefore, we believe the focus will increasingly be on consulting-led deals and on new
pricing models, platforms and cloud computing. Seven themes that the company has
identified are likely to drive the innovation strategy – digital consumers, emerging
economies, sustainable tomorrow, new commerce, healthcare economy, smarter
organisation and, pervasive computing
Implications for long-term investors
From an investor’s perspective, the success of this strategy could address the longterm concerns about the company’s revenue growth and margin prospects (i.e.,
reducing dependence on headcount addition, etc) and, hence, decide the levels at
which long-term valuations could eventually settle.
Many of the intended changes are not new
1) Infosys already runs on a vertical-based structure (and has since 2004) – in line with
the current industry thought that it is the most efficient structure for scale companies. In
addition, after country-head appointments last year, the company has been moving to a
geography-based structure in specialised markets such as Germany, France, Canada
and Australia.
2) Infosys has recently been seeing consulting, system integration and enterprise
solutions as one unit. In fact, it already clubs its revenue from consulting with enterprise
solutions into one horizontal, and the next stage could likely be to better channel the
unit’s focus to win transformational deals. Infosys is already working on over 20 such
transformational programmes for clients.
3) Meanwhile, the innovation unit intends to accelerate its existing efforts in IP creation
(such as iEngage, Flypp), and on platforms (HRO) and non-effort based pricing.
CEO change likely in the near term
The one change that is most likely due is that of the CEO. Chairman Narayana Murthy
is scheduled to retire this August, and we believe current CEO S. Gopalakrishnan is a
front runner to replace him (although external candidates could also be interviewed). As
has been widely reported in the media, the current COO and co-founder S.D. Shibulal
could then become a fairly logical choice for CEO, as that would ensure smooth
leadership transition. This will also be in line with the pattern of the company’s
leadership changes so far, where the COO has gone on to become CEO, and the post
has stayed among the company’s founders.
More interesting could be longer-term leadership choices
More interesting given the TOI strategy is what happens longer term on the leadership
front. Infosys has a 60-year age limit for executive officers and 65-year age limit for
board members. But the past CEOs (Narayana Murthy, Nandan Nilekani, and likely S.
Gopalakrishnan) gave up their posts well before that. Given Mr Shibulal is aged 56, it is
not inconceivable to imagine that his role would be to ensure the company’s strategy
takes off smoothly and then to transition the leadership to a new non-founder CEO a
couple of years later
There are several strong internal candidates for the role including Chandra Shekhar
Kakal, Ashok Vemuri, Subash Dhar, B.G Srinivas, or even Pravin Rao (under whom the
retail vertical has gained strong relevance). While it may be too early to think that far
and much could change over the next couple years, a significant step would be to have
a non-Indian CEO who is also familiar with the company and its culture. One such
candidate could be Steve Pratt, who heads the consulting practice, and would fit well
with Infosys’s global aspirations and consulting goals. Note Mr Pratt has been voted
twice among the top-25 consultants in the world by Consulting magazine (2003, 2005).
Why organisational restructuring could cease to be news
Recent concerns about manpower (attrition, quality of talent, rising wages) have led to
companies questioning their so far successful offshore business model more than ever
before. We calculate that if current productivity levels continue and the large players
have to deliver a 20% CAGR in revenue for the next decade, Infosys, TCS and Wipro
will each need to employ close to a million people within the next 10-12 years.
Expanding headcount could therefore lead to a new level of organisational challenges
over the next few years, and any internal restructuring could cease to be news.
How to make money from Infosys shares?
We reduce our FY12-13 EPS estimates by 2-3%, largely to factor in the 3QFY11 miss.
However, we still look for 25% USD revenue growth in FY12, flattish EBIT margin (on
higher graduate level hiring, stable currency), and thus 25%+ INR EPS growth.
The stock currently trades at 19.9x FY12E EPS, and applying a similar multiple to
FY13E EPS should lead to a 20-25% stock return over the next 12 months, in line with
earnings growth. We derive our TP from a DCF methodology with assumptions as
shown in Exhibit 8. We have reduced our TP from Rs4,000 to Rs3,800, reflecting the
slight downgrade in our earnings assumptions. Key risks to our investment thesis and
TP are: unexpected macro weakness and currency volatility.
For the more analytically inclined, however, we repeat two of our previous analyses to
judge the stock’s potential.
1. What if you had perfect information about cash flows?
Our historical DCF models that compare “what was” with “what should have been” are,
in our view, useful visual aids to identify buy/sell opportunities for the long term.
As part of this exercise, we back-calculate the theoretical historical DCF fair values of
stocks using reported numbers. In other words, these are the prices a stock should
have traded at if investors had perfect information about the company’s future earnings/
cash flows. Clearly, the actual stock prices have been much more volatile than the
theoretical prices (which is a straight line) because of fluctuating earnings estimates
and risk perceptions. Therefore, it is only correct to assume that our current estimates
could also be at risk (both upward and downward), so build in bear and bull cases for
our assumptions.
As readers will notice, the base, bear and bull cases converge at the start of the
analysis (FY02) because we now have close to full information of the past 10 years’
cash flows. But they start to diverge as future information becomes less perfect (FY11
theoretical price is based on 10 years of imperfect data).
At current prices, Infosys looks undervalued, as the stock trades in between our bearcase and base-case price estimates. Such a price usually presents a good buying
opportunity. In fact, given likely above-trend earnings growth in FY12, we would not be
surprised if the stock trades even above our fair value estimate before this year-end
2. “Guidance gap” provides cue to stock out-performance
The gap between Infosys’s initial annual EPS guidance and the prevalent Street EPS
estimate has been a reliable indicator historically of the stock’s performance for the rest
of the year versus the index.
We notice that if the guidance gap is too large (i.e., >10%), the stock tends to underperform in the year (Infosys has gone on to beat its initial EPS guidance by 9-10% on
an average since FY02). Indeed, even in FY06, when the stock returned 44% in
absolute terms, it actually underperformed the index by a massive 30%, suggesting that
any gains made by the stock were a function of overall market ebullience.
Years such as FY05 and FY07 were near-perfect years from an investor’s view point.
These were years when the starting guidance gap was small, and the year was
therefore set up for a “beat and raise” kind of scenario.
In FY11, the guidance gap was large, and Street estimates did not budge through the
year – but the stock has still beaten the index so far. This is because, lately, Infosys
guidance has been seen as overly conservative (coming after successive USD revenue
guidance cuts in FY09), and Street estimates for the next year have been raised with
each guidance raise for the current year.
Looking into FY12, we think Infosys could guide for 18-20% USD growth to start with
(NASSCOM’s industry export growth projection is 16-18%, peer Cognizant’s 2011
growth guidance is 26%) and then raise it through the year to meet our estimate. That
would suggest the initial EPS guidance could be INR137-139, roughly a 7-8% gap (and
below our 10% cut-off) with the current FY12 consensus estimate of INR150. This sets
the stock up for at least a marginal outperformance versus the BSE Sensex in FY12.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Don't fix it if it ain't broken
ƒ No drastic internal revamp that jeopardises 25%+ FY12E growth
ƒ Instead shifts to be in line with long-term consulting, IP strategy
ƒ New CEO likely near term, but could the next head be non-Indian?
ƒ Shares close to undervalued zone, FY12 guidance likely catalyst
Hold the course, for now
Much newsprint has recently been
devoted to a possible organisational
restructuring at Infosys. Yet, after our
recent Bangalore visit, we think the
intended changes are not as new, urgent
or drastic as the reports may have led
investors to believe. Instead, we believe
that FY12 could be a 25%+ revenue
growth year, and management may not
resort to measures that could jeopardise
near-term growth opportunities. Some
tweaking is due for later in the year, but
we believe that would be part of a more
drawn out long-term strategic shift.
Strategy roadmap; avoiding employing a million by 2020
The first change could be that of the CEO (as the current CEO may
replace the Chairman who is due to retire in August). We expect further
changes to be in line with Infosys’s strategy to target a revenue mix that
is equally split between: 1) business transformation, 2) strategic global
sourcing and 3) new engagement models. Attaining this mix would need
revenue from transformation and innovation to increase significantly.
From investors’ perspective, the success of the company’s strategy could
address long-term concerns about its headcount-led model. We calculate
that if Infosys has to achieve a 20% CAGR in revenue at current
productivity levels, it may have to employ close to a million in the next 10-
12 years. Such scale could pose challenges of a level yet unthinkable.
Could the longer-term CEO be non-Indian?
As has been widely reported, S.D. Shibulal is a logical choice for CEO,
given the historical pattern of COOs taking on the role. But past CEOs
have given up their posts well before the 60-year age limit, and it is likely
Mr. Shibulal (aged 56) could transition the role to a non-founder CEO in a
couple of years. While there are several strong internal candidates, at the
risk of looking too far out, we would be interested to see if Infosys opts for
a non-Indian CEO. One candidate could be Steve Pratt, head of the
consulting practice and twice voted among the top-25 consultants globally.
Such a choice could fit well with Infosys’s global aspirations and strategy.
How to make money from Infosys shares?
We lower FY12-13E EPS by 2-3%, largely to factor in the 3QFY11 miss.
But we still forecast over 25% 12-month stock return, in line with EPS
growth, and retain BUY. For the analytically inclined: 1) our long-term
“what was” compared to “what should have been” DCF model points to
the stock being close to outright undervalued; and 2) our “guidance gap”
analysis suggests Infosys could at least marginally outperform the index
in FY12, and that the forthcoming FY12 guidance could act as a catalyst.
The Risk Experts
• Our starting point for this page is a recognition of the
macro factors that can have a significant impact on stockprice performance, sometimes independently of bottom-up
factors.
• With our Risk Expert page, we identify the key macro risks
that can impact stock performance.
• This analysis enhances the fundamental work laid out in
the rest of this report, giving investors yet another resource
to use in their decision-making process.
Don’t fix it if it ain’t broken, at least not now
Much newsprint (Times of India, Business Standard, 2 February) has recently been
devoted to a possible organisational restructuring at Infosys. Yet, after our recent visit to
Bangalore, we think the intended changes are not as new, urgent or drastic as the
reports may have led investors to believe. We noted the usual caution from
management on not taking the US/Europe recovery for granted. But behind that
conservativeness, we sensed that FY12 could be a significant growth year (i.e., 25%+
USD revenue growth as per our projections). We therefore believe that it is unlikely that
management will resort to internal measures that could jeopardise near-term growth
opportunities, and that instead any changes could be part of a more drawn out longterm shift.
Recent internal reorganisations by peers have been during times when industry-wide
revenue opportunities have been lacklustre (TCS in early 2008) or when it was
necessary because of company underperformance versus peers (Wipro in 2011).
These situations do not apply to Infosys’s current state – therefore, we think there is
hardly a case for a company-wide restructuring.
Changes should be in line with strategic roadmap
We gather, however, that some internal “tweaking” could happen later in the year,
which is likely to be in line with Infosys’s strategic roadmap for the next three-five years,
and should ultimately lead to more autonomy for unit heads. We believe those tweaks
could happen after September 2011, after the likely appointment of a new CEO, so that
the new structure settles by March 2012 in time for the next fiscal year.
Infosys’s “TOI” strategy – first discussed in an analyst meeting in July 2010, and later
likely ironed out in an internal Strategy and Planning (STRAP) meeting in Mysore last
month – is aimed at achieving a revenue mix that is equally split between: 1) business
transformation (T – transformation), 2) strategic global sourcing (O – operations), and
3) new engagement models (I – innovation). Attaining such a mix would need revenue
from transformation (currently 26% of revenue) and innovation (less than 10% including
product revenue) to increase significantly.
Therefore, we believe the focus will increasingly be on consulting-led deals and on new
pricing models, platforms and cloud computing. Seven themes that the company has
identified are likely to drive the innovation strategy – digital consumers, emerging
economies, sustainable tomorrow, new commerce, healthcare economy, smarter
organisation and, pervasive computing
Implications for long-term investors
From an investor’s perspective, the success of this strategy could address the longterm concerns about the company’s revenue growth and margin prospects (i.e.,
reducing dependence on headcount addition, etc) and, hence, decide the levels at
which long-term valuations could eventually settle.
Many of the intended changes are not new
1) Infosys already runs on a vertical-based structure (and has since 2004) – in line with
the current industry thought that it is the most efficient structure for scale companies. In
addition, after country-head appointments last year, the company has been moving to a
geography-based structure in specialised markets such as Germany, France, Canada
and Australia.
2) Infosys has recently been seeing consulting, system integration and enterprise
solutions as one unit. In fact, it already clubs its revenue from consulting with enterprise
solutions into one horizontal, and the next stage could likely be to better channel the
unit’s focus to win transformational deals. Infosys is already working on over 20 such
transformational programmes for clients.
3) Meanwhile, the innovation unit intends to accelerate its existing efforts in IP creation
(such as iEngage, Flypp), and on platforms (HRO) and non-effort based pricing.
CEO change likely in the near term
The one change that is most likely due is that of the CEO. Chairman Narayana Murthy
is scheduled to retire this August, and we believe current CEO S. Gopalakrishnan is a
front runner to replace him (although external candidates could also be interviewed). As
has been widely reported in the media, the current COO and co-founder S.D. Shibulal
could then become a fairly logical choice for CEO, as that would ensure smooth
leadership transition. This will also be in line with the pattern of the company’s
leadership changes so far, where the COO has gone on to become CEO, and the post
has stayed among the company’s founders.
More interesting could be longer-term leadership choices
More interesting given the TOI strategy is what happens longer term on the leadership
front. Infosys has a 60-year age limit for executive officers and 65-year age limit for
board members. But the past CEOs (Narayana Murthy, Nandan Nilekani, and likely S.
Gopalakrishnan) gave up their posts well before that. Given Mr Shibulal is aged 56, it is
not inconceivable to imagine that his role would be to ensure the company’s strategy
takes off smoothly and then to transition the leadership to a new non-founder CEO a
couple of years later
There are several strong internal candidates for the role including Chandra Shekhar
Kakal, Ashok Vemuri, Subash Dhar, B.G Srinivas, or even Pravin Rao (under whom the
retail vertical has gained strong relevance). While it may be too early to think that far
and much could change over the next couple years, a significant step would be to have
a non-Indian CEO who is also familiar with the company and its culture. One such
candidate could be Steve Pratt, who heads the consulting practice, and would fit well
with Infosys’s global aspirations and consulting goals. Note Mr Pratt has been voted
twice among the top-25 consultants in the world by Consulting magazine (2003, 2005).
Why organisational restructuring could cease to be news
Recent concerns about manpower (attrition, quality of talent, rising wages) have led to
companies questioning their so far successful offshore business model more than ever
before. We calculate that if current productivity levels continue and the large players
have to deliver a 20% CAGR in revenue for the next decade, Infosys, TCS and Wipro
will each need to employ close to a million people within the next 10-12 years.
Expanding headcount could therefore lead to a new level of organisational challenges
over the next few years, and any internal restructuring could cease to be news.
How to make money from Infosys shares?
We reduce our FY12-13 EPS estimates by 2-3%, largely to factor in the 3QFY11 miss.
However, we still look for 25% USD revenue growth in FY12, flattish EBIT margin (on
higher graduate level hiring, stable currency), and thus 25%+ INR EPS growth.
The stock currently trades at 19.9x FY12E EPS, and applying a similar multiple to
FY13E EPS should lead to a 20-25% stock return over the next 12 months, in line with
earnings growth. We derive our TP from a DCF methodology with assumptions as
shown in Exhibit 8. We have reduced our TP from Rs4,000 to Rs3,800, reflecting the
slight downgrade in our earnings assumptions. Key risks to our investment thesis and
TP are: unexpected macro weakness and currency volatility.
For the more analytically inclined, however, we repeat two of our previous analyses to
judge the stock’s potential.
1. What if you had perfect information about cash flows?
Our historical DCF models that compare “what was” with “what should have been” are,
in our view, useful visual aids to identify buy/sell opportunities for the long term.
As part of this exercise, we back-calculate the theoretical historical DCF fair values of
stocks using reported numbers. In other words, these are the prices a stock should
have traded at if investors had perfect information about the company’s future earnings/
cash flows. Clearly, the actual stock prices have been much more volatile than the
theoretical prices (which is a straight line) because of fluctuating earnings estimates
and risk perceptions. Therefore, it is only correct to assume that our current estimates
could also be at risk (both upward and downward), so build in bear and bull cases for
our assumptions.
As readers will notice, the base, bear and bull cases converge at the start of the
analysis (FY02) because we now have close to full information of the past 10 years’
cash flows. But they start to diverge as future information becomes less perfect (FY11
theoretical price is based on 10 years of imperfect data).
At current prices, Infosys looks undervalued, as the stock trades in between our bearcase and base-case price estimates. Such a price usually presents a good buying
opportunity. In fact, given likely above-trend earnings growth in FY12, we would not be
surprised if the stock trades even above our fair value estimate before this year-end
2. “Guidance gap” provides cue to stock out-performance
The gap between Infosys’s initial annual EPS guidance and the prevalent Street EPS
estimate has been a reliable indicator historically of the stock’s performance for the rest
of the year versus the index.
We notice that if the guidance gap is too large (i.e., >10%), the stock tends to underperform in the year (Infosys has gone on to beat its initial EPS guidance by 9-10% on
an average since FY02). Indeed, even in FY06, when the stock returned 44% in
absolute terms, it actually underperformed the index by a massive 30%, suggesting that
any gains made by the stock were a function of overall market ebullience.
Years such as FY05 and FY07 were near-perfect years from an investor’s view point.
These were years when the starting guidance gap was small, and the year was
therefore set up for a “beat and raise” kind of scenario.
In FY11, the guidance gap was large, and Street estimates did not budge through the
year – but the stock has still beaten the index so far. This is because, lately, Infosys
guidance has been seen as overly conservative (coming after successive USD revenue
guidance cuts in FY09), and Street estimates for the next year have been raised with
each guidance raise for the current year.
Looking into FY12, we think Infosys could guide for 18-20% USD growth to start with
(NASSCOM’s industry export growth projection is 16-18%, peer Cognizant’s 2011
growth guidance is 26%) and then raise it through the year to meet our estimate. That
would suggest the initial EPS guidance could be INR137-139, roughly a 7-8% gap (and
below our 10% cut-off) with the current FY12 consensus estimate of INR150. This sets
the stock up for at least a marginal outperformance versus the BSE Sensex in FY12.
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