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• The Infosys 4QFY11 report card is a difficult one. Revenue guidance miss
in a good environment is difficult to digest. Sequential volume decline (Q/Q)
in a period of industry upturn is unexpected. The unfortunate result of that is
that Infosys has missed the low end of its revenue guidance band restated for
constant currency. The patchy performance was broad-based with almost all
verticals showing tepid Q/Q growth. Although 4Q is seasonally weak, the
weakness was sharper than expected. However, US$ revenue growth guidance
of 18-20% for FY12 tracks expectations, pointing to healthy industry demand.
• The biggest concern is whether there is sufficient coherence and
configuration of management to drive this company to leadership; the issue
seems largely internal and company-specific. As we stated in our Mar 4 note
(“Still a few wrinkles to iron out; some are new and some are old; reiterate
Neutral”), Infosys is going through structural issues. Senior executive
empowerment is laudable, but multiple responsibilities for business heads
might be causing under-performance in some areas. Our finding is that at
least one of the responsibility areas has under-performed peers, and multiple
responsibilities might have something to do with this, e.g. retail vertical has
performed in line with peers, but infra management, managed by the same
person, has significantly underperformed. We believe the company needs to
address these issues, stem attrition, and turn its attention to clients.
• Where does the Infosys stock go from here? ~10% decline in the stock price
(India-listed shares) on Apr 15 might suggest some value but we caution against
the value-trap argument. Downward earnings revisions would result in lower
valuation multiples, which might cause the stock to settle at Rs2800-Rs3,300,
below our original Rs3,000-Rs3,500 estimate, over the next six months. We
caution investors against buying the stock just because it might be cheaper
than its five-year (full-cycle) median valuations. Going by historical multiples
has limitations if companies structurally change, for better or for worse.
• Management comments on an FY12 margin decline of up to 300bp to
explain tepid Rs. EPS guidance growth is rather conservative, but we are
less confident now about FY12 margins. The explanation ignores the positives
of leverage in the business model with revenue growth of 20%+, and pricing
tailwinds in FY12, and the negative of likely higher S&M investments.
• FY12 downgrades likely; stay Neutral. We reduce FY12E EPS by 5%, and
expect consensus downgrades to reflect the weak 4Q FY11 and moderate
margin pressures in FY12 (vs FY11). We still prefer TCS and Wipro, both OW.
Points worth noting
Management restructuring should be swift, decisive and
seamless
Infosys is undergoing management restructuring to keep up with the times. The
short-comings of the executive council structure have been discussed in our report
“Still a few wrinkles to iron out; some are new and some are old; reiterate Neutral”
(dated March 4, 2011), where-in we concluded that over-empowerment of business
leaders in large companies handling significant portfolios is undesirable. Today
Infosys has adopted a leaner structure wherein it is organizing itself into five main
verticals including (a) BFSI, (b) Energy, Telecom and Services, (c) Retail, Logistics
and Life Sciences, (d) Manufacturing, and (e) Public Services and Healthcare. There
would be alignment of larger horizontals such as package implementation and
infrastructure management into these verticals. The leaders for these vertical have not
been announced, and it is quite possible that we may see some existing members of
the executive council make way for new members.
From the investors’ perspective, it is desirable that such matters are settled
expeditiously and seamlessly as pre-occupation with such matters can take toll on the
customer engagement process, client satisfaction scores and containment of attrition
at the middle management level and rank-and-file staff.
Notably, Mr. Mohandas Pai, the company’s first non-founder employee director, and
Mr. K. Dinesh, co-founder of the company, have stepped down from the board of
Infosys and announced their resignation from the company effective June 2011.
Multiple responsibilities for management may be
contributing to relative under-performance in several areas
We observed that in several cases where members of the executive council
management have multiple responsibilities, one or two of portfolios has tended to
suffer.
For example, in CY10, 1) Infosys’s telecom revenue growth under-performed TCS’s;
2) Infosys’s market share in large, strategic deals was lower than TCS’s, while the
BFSI vertical managed by the same person outperformed that of TCS; 3) the
performance of Infosys’s retail vertical is comparable to that of TCS, but Infosys’s
high-growth infrastructure management has performed well below that of peers such
as TCS/HCLT. Thus, it is possible that the multiple responsibilities could be
affecting the functioning of one or two portfolios under their charge.
The second drawback we see with this kind of over-empowerment is that by making
several bucks stop with a manager, a manager can subsidize and explain away a poor
or lagging performance in one area with better performance from a strongperforming
one. That's a poor logic, in our view, because every business should stand
on its own which has a better chance of being so when the buck for this is wholly
stops with one individual and he is responsible for no other thing.
Finally, with companies such as TCS/Infosys as big as they are already, are
individual business segments/units not large enough to warrant full-time, undivided
leadership? Can business unit heads handle this kind of breadth in larger companies?
Perhaps, it is best to vest responsibility exclusively as TCS/Cognizant tends to
do.
Interest income likely to contribute more than 17% of FY12
EPS
Adjust the P/E multiple accordingly as core EPS growth is revised downwards
Infosys core EPS was about Rs105 in FY11, and we expect an increase of ~17% in
FY12 to Rs.122, which is meaningfully below the total EPS growth expectation of
22%. The residual earnings growth is contributed by higher interest income. Infosys
has cash balances in excess of $3.7 billion and we expect deposit yield to be 9.0% for
FY12, resulting in Rs.23 of EPS, growing ~70% from FY11. We had highlighted this
in detail in our note dated April 11, 2011 (“Non-operating factors crucially influence
Infosys' EPS growth in FY12E; accordingly, adjust the P/E multiple”), pointing that
if the source of Infosys’ EPS growth were due to factors unrelated to the core
business and accrues from below the operating line items, we believe the investors
should be cognizant of this in setting the FY12 P/E multiple for the company.
Conservative commentary on margins for FY12
Management commentary on margin decline in FY12 of up to 300 bps to
explain tepid INR EPS guidance growth rather conservative but we remain less
confident than before about the margin performance in FY12 than we were
previously. Infosys’ 300 bps decline in margins assumes hiring of 45,000 resources
at 75% utilization (utilization assumptions likely conservative if revenue growth
exceeds guidance). Infosys allows for 100 bps Y/Y decline for lower utilization in
FY12, which we believe will not materialize. Another 100 bps Y/Y decline is
provided for due to the stronger Rupee (versus USD) as of March 31, 2011 (at which
level Infosys has assumed the Rs EPS guidance). The balance 100 bps decline
accrues from wages and salary hikes offset by pyramid (entry-level employees). This
explanation is not all clear for it ignores on the positive side - (a) the leverage in the
business model with revenue growth of 20%+, (b) pricing tailwind going into FY12
and on the negative side higher S&M investments that Infosys will likely need to still
make in line with its aspiration to be a higher-end player.
Table 3: Decomposition of Infosys margin guidance
Factor Impact
FY11 Margins 29.4%
Positives
Employee Pyramid 200 bps
Negatives
Wages 300 bps
Currency 100 bps
Utilization 100 bps
FY12 Margin Guidance 26.4%
Source: Company reports
Valuation
Our Sep-11 price target of Rs3,300 is based on a one-year forward multiple of 20.5 –
this is at the median end of the last three years’ historical trading multiple range and
we believe that P/E multiples are unlikely to expand further.
We have been positive on sector fundamentals and believe that Indian IT companies
would continue to benefit from robust CY2011 IT budgets and the business
environment for IT Services in BFSI, manufacturing and other emerging verticals
continues to be strong. However, we believe this is adequately reflected in valuations,
with consensus already expecting 25%+ growth in FY12E (which would get revised
slightly downwards). We see limited absolute share price upside from current levels
in the next 6-9 months, but would be buyers on meaningful declines given the strong
fundamentals and healthy business environment.
Negative risks to our price target: Further rupee appreciation against the US$ and
continued supply side pressures (higher attrition or wage hikes).
Positive risks to our price target. Better pricing and volume growth relative to
expectations and a faster-than-expected recovery in the US provide upside risk to our
FY12 EPS and hence, price target.
Looking at 5 years’ (full cycle) median multiple might not be relevant as the
company has changed structurally. We caution investors against the argument
that the stock is a BUY because it seems cheaper than its five-year (full-cycle)
median forward P/E multiple. Going by historical multiples has limitations if
companies structurally change, for better or for worse. (refer to figure 5). Infosys’
missing revenue guidance for the quarter in a good environment might cause some
level of de-rating which could bear down on the stock (in addition to the earnings
impact alone).
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
• The Infosys 4QFY11 report card is a difficult one. Revenue guidance miss
in a good environment is difficult to digest. Sequential volume decline (Q/Q)
in a period of industry upturn is unexpected. The unfortunate result of that is
that Infosys has missed the low end of its revenue guidance band restated for
constant currency. The patchy performance was broad-based with almost all
verticals showing tepid Q/Q growth. Although 4Q is seasonally weak, the
weakness was sharper than expected. However, US$ revenue growth guidance
of 18-20% for FY12 tracks expectations, pointing to healthy industry demand.
• The biggest concern is whether there is sufficient coherence and
configuration of management to drive this company to leadership; the issue
seems largely internal and company-specific. As we stated in our Mar 4 note
(“Still a few wrinkles to iron out; some are new and some are old; reiterate
Neutral”), Infosys is going through structural issues. Senior executive
empowerment is laudable, but multiple responsibilities for business heads
might be causing under-performance in some areas. Our finding is that at
least one of the responsibility areas has under-performed peers, and multiple
responsibilities might have something to do with this, e.g. retail vertical has
performed in line with peers, but infra management, managed by the same
person, has significantly underperformed. We believe the company needs to
address these issues, stem attrition, and turn its attention to clients.
• Where does the Infosys stock go from here? ~10% decline in the stock price
(India-listed shares) on Apr 15 might suggest some value but we caution against
the value-trap argument. Downward earnings revisions would result in lower
valuation multiples, which might cause the stock to settle at Rs2800-Rs3,300,
below our original Rs3,000-Rs3,500 estimate, over the next six months. We
caution investors against buying the stock just because it might be cheaper
than its five-year (full-cycle) median valuations. Going by historical multiples
has limitations if companies structurally change, for better or for worse.
• Management comments on an FY12 margin decline of up to 300bp to
explain tepid Rs. EPS guidance growth is rather conservative, but we are
less confident now about FY12 margins. The explanation ignores the positives
of leverage in the business model with revenue growth of 20%+, and pricing
tailwinds in FY12, and the negative of likely higher S&M investments.
• FY12 downgrades likely; stay Neutral. We reduce FY12E EPS by 5%, and
expect consensus downgrades to reflect the weak 4Q FY11 and moderate
margin pressures in FY12 (vs FY11). We still prefer TCS and Wipro, both OW.
Points worth noting
Management restructuring should be swift, decisive and
seamless
Infosys is undergoing management restructuring to keep up with the times. The
short-comings of the executive council structure have been discussed in our report
“Still a few wrinkles to iron out; some are new and some are old; reiterate Neutral”
(dated March 4, 2011), where-in we concluded that over-empowerment of business
leaders in large companies handling significant portfolios is undesirable. Today
Infosys has adopted a leaner structure wherein it is organizing itself into five main
verticals including (a) BFSI, (b) Energy, Telecom and Services, (c) Retail, Logistics
and Life Sciences, (d) Manufacturing, and (e) Public Services and Healthcare. There
would be alignment of larger horizontals such as package implementation and
infrastructure management into these verticals. The leaders for these vertical have not
been announced, and it is quite possible that we may see some existing members of
the executive council make way for new members.
From the investors’ perspective, it is desirable that such matters are settled
expeditiously and seamlessly as pre-occupation with such matters can take toll on the
customer engagement process, client satisfaction scores and containment of attrition
at the middle management level and rank-and-file staff.
Notably, Mr. Mohandas Pai, the company’s first non-founder employee director, and
Mr. K. Dinesh, co-founder of the company, have stepped down from the board of
Infosys and announced their resignation from the company effective June 2011.
Multiple responsibilities for management may be
contributing to relative under-performance in several areas
We observed that in several cases where members of the executive council
management have multiple responsibilities, one or two of portfolios has tended to
suffer.
For example, in CY10, 1) Infosys’s telecom revenue growth under-performed TCS’s;
2) Infosys’s market share in large, strategic deals was lower than TCS’s, while the
BFSI vertical managed by the same person outperformed that of TCS; 3) the
performance of Infosys’s retail vertical is comparable to that of TCS, but Infosys’s
high-growth infrastructure management has performed well below that of peers such
as TCS/HCLT. Thus, it is possible that the multiple responsibilities could be
affecting the functioning of one or two portfolios under their charge.
The second drawback we see with this kind of over-empowerment is that by making
several bucks stop with a manager, a manager can subsidize and explain away a poor
or lagging performance in one area with better performance from a strongperforming
one. That's a poor logic, in our view, because every business should stand
on its own which has a better chance of being so when the buck for this is wholly
stops with one individual and he is responsible for no other thing.
Finally, with companies such as TCS/Infosys as big as they are already, are
individual business segments/units not large enough to warrant full-time, undivided
leadership? Can business unit heads handle this kind of breadth in larger companies?
Perhaps, it is best to vest responsibility exclusively as TCS/Cognizant tends to
do.
Interest income likely to contribute more than 17% of FY12
EPS
Adjust the P/E multiple accordingly as core EPS growth is revised downwards
Infosys core EPS was about Rs105 in FY11, and we expect an increase of ~17% in
FY12 to Rs.122, which is meaningfully below the total EPS growth expectation of
22%. The residual earnings growth is contributed by higher interest income. Infosys
has cash balances in excess of $3.7 billion and we expect deposit yield to be 9.0% for
FY12, resulting in Rs.23 of EPS, growing ~70% from FY11. We had highlighted this
in detail in our note dated April 11, 2011 (“Non-operating factors crucially influence
Infosys' EPS growth in FY12E; accordingly, adjust the P/E multiple”), pointing that
if the source of Infosys’ EPS growth were due to factors unrelated to the core
business and accrues from below the operating line items, we believe the investors
should be cognizant of this in setting the FY12 P/E multiple for the company.
Conservative commentary on margins for FY12
Management commentary on margin decline in FY12 of up to 300 bps to
explain tepid INR EPS guidance growth rather conservative but we remain less
confident than before about the margin performance in FY12 than we were
previously. Infosys’ 300 bps decline in margins assumes hiring of 45,000 resources
at 75% utilization (utilization assumptions likely conservative if revenue growth
exceeds guidance). Infosys allows for 100 bps Y/Y decline for lower utilization in
FY12, which we believe will not materialize. Another 100 bps Y/Y decline is
provided for due to the stronger Rupee (versus USD) as of March 31, 2011 (at which
level Infosys has assumed the Rs EPS guidance). The balance 100 bps decline
accrues from wages and salary hikes offset by pyramid (entry-level employees). This
explanation is not all clear for it ignores on the positive side - (a) the leverage in the
business model with revenue growth of 20%+, (b) pricing tailwind going into FY12
and on the negative side higher S&M investments that Infosys will likely need to still
make in line with its aspiration to be a higher-end player.
Table 3: Decomposition of Infosys margin guidance
Factor Impact
FY11 Margins 29.4%
Positives
Employee Pyramid 200 bps
Negatives
Wages 300 bps
Currency 100 bps
Utilization 100 bps
FY12 Margin Guidance 26.4%
Source: Company reports
Valuation
Our Sep-11 price target of Rs3,300 is based on a one-year forward multiple of 20.5 –
this is at the median end of the last three years’ historical trading multiple range and
we believe that P/E multiples are unlikely to expand further.
We have been positive on sector fundamentals and believe that Indian IT companies
would continue to benefit from robust CY2011 IT budgets and the business
environment for IT Services in BFSI, manufacturing and other emerging verticals
continues to be strong. However, we believe this is adequately reflected in valuations,
with consensus already expecting 25%+ growth in FY12E (which would get revised
slightly downwards). We see limited absolute share price upside from current levels
in the next 6-9 months, but would be buyers on meaningful declines given the strong
fundamentals and healthy business environment.
Negative risks to our price target: Further rupee appreciation against the US$ and
continued supply side pressures (higher attrition or wage hikes).
Positive risks to our price target. Better pricing and volume growth relative to
expectations and a faster-than-expected recovery in the US provide upside risk to our
FY12 EPS and hence, price target.
Looking at 5 years’ (full cycle) median multiple might not be relevant as the
company has changed structurally. We caution investors against the argument
that the stock is a BUY because it seems cheaper than its five-year (full-cycle)
median forward P/E multiple. Going by historical multiples has limitations if
companies structurally change, for better or for worse. (refer to figure 5). Infosys’
missing revenue guidance for the quarter in a good environment might cause some
level of de-rating which could bear down on the stock (in addition to the earnings
impact alone).
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