Infosys, Sell-off overdone; Reiterate OP:: Macquarie Research,

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Infosys Technologies
Sell-off overdone; Reiterate OP
Event
 Infosys stock corrected 10% post 4Q results announced on Friday morning.
Volume decline in 4Q and FY12 guidance of 300bp margin decline were the
culprits for the severe stock reaction, in our view. We stick to our positive
investment bias based on a strong demand outlook. Even so, we have cut our
earnings by 5% for FY12 and 3% for FY13 to recognise limited room to
manage margins against FX headwinds and company’s comfort utilisation
level.  Reiterate OP.
Impact
 Demand enthusiasm not reflected in EPS guidance. Infosys top
management reiterated on the earnings call that FY12 should be a normal
year and they are confident of their 18-20% revenue growth outlook. We
believe the EPS guidance of Rs128 is not reflecting the positive demand
scenario. A case in point: the strong hiring guidance put forward by the
company – 45K gross employee addition vs. 43K employee addition in FY11.
 Margin guidance factoring in the negatives but positives not counted.
The 300bps decline in operating margins is made up of three moving parts:
2% INR appreciation (100bps),
Utilization remaining at ~78% with 45K employee adds (120bps), and
Wage hike and regular investment in business (80bps).
The outlook does not factor in any pricing improvement through FY12 and
management agrees that any upside to revenue target would mean upward
bias to margins.

 Pricing holds the key to FY12 performance. Successive decline in offshore
pricing from 3QFY09 to 2QFY11 implies that offshore pricing in 4Q FY11 is
still 7% below the pre GFC level. While we do not expect the pricing to hit that
level anytime soon, a return to normal budgetary cycles and robust demand
gives us reason to be optimistic on this front. For detailed analysis on different
margin levers and our take on them, please see Figure 1.
Earnings and target price revision
 Our revised FY12 and FY13 EPS is Rs143 (down 5%) and Rs178 (down 3%)
respectively. Our new DCF-based TP is Rs3,650 (Rs3,750 earlier).
Price catalyst
 12-month price target: Rs3,650.00 based on a DCF methodology.
 Catalyst: Large deal wins and uptick in discretionary spend
Action and recommendation
 Retain OP. We remain comfortable with our above-consensus 29% US$
revenue growth forecast in FY12E. The sequential volume decline and margin
outlook were dampeners but we think the stock has been over-penalised.


Steeping through the margin mystery
 Where do we differ from the company?  In our analysis in Figure 1 below we have steeped
through the different assumptions that we have taken for different margin levers that are there in
the business and what is our take on them. The key differential in our assumption vs. the company
guidance is on the pricing.
 How have we re-aligned our estimates post the quarter? The key change in our estimates
follows from a less sanguine view on margins post 4Q results. We have cut our margin estimates
by ~150bp for FY12 and FY13, resulting in reduced earnings.  A detailed table on New vs. Old
estimates is present in Figure 2.
 What is the confidence in the reset base? Optimistic demand scenario and Infosys’ ability to
execute in such an environment are the cornerstone of our OP rating. Despite the 4Q miss and
muted profitability guidance, our confidence in these remains undiluted. The biggest risk to our
thesis is the pricing improvement that we have assumed in our model. Given the comments in US
tech results and macro data points, we do not think our volume growth assumption of 23.6% (flat
vs. last year) is at risk



Valuation: DCF-derived target price of Rs3,650 implies FY12E PER of 25x
 Our target price for Infosys is based on a three-stage DCF model. We have factored in a 15% FCF
CAGR over a seven-year period (FY14-21) for the second stage of our DCF. Our terminal growth
assumption is 5% and we have used a WACC of 12.5%
 We expect strong volume growth and margin execution to drive the stock close to our target price.
At FY3/12E EPS estimates, the stock is currently valued at 21x FY3/12 earnings. At our target
price, the stock would trade at 25x one year forward PER, in line with previous up-cycles.


4Q key highlights: (A) Pricing on the uptrend improves continues inspite
of volume disappointment
 Pricing improvement helps the company to fight margin pressure. Infosys reported offshore
constant currency pricing improvement for 4Q at 3.2% (vs 1.4% in 3Q). This is the second
successive quarterly improvement after eight successive quarters of negative growth (Figure 6).
 We believe a pricing uptick is the key margin lever that will potentially play out in FY12 for Tier 1
players. However, for this quarter, seasonal weakness due to the slow ramp-up from customers
saw Infosys slip on volume performance (-1.4% QoQ vs +3.1% in the last quarter, as seen in
Figure 5).


4Q key highlights: (B) Mixed bag Vertical performance
 Manufacturing growth steady, BFSI, Telecom disappoints. Manufacturing registered healthy
constant currency growth of 5% in 4Q. Even so, BFSI revenues dipped in the quarter, posting -
0.7% QoQ decline. Telecom continued its decline with a -4.8% growth in the quarter. The
management signalled that the weakness in this vertical would continue into FY12.


 4Q results was below our and street's estimates. The company reported US$ revenues of
US$1,602m (up 1.1% QoQ vs our est. of 4.8%). In INR terms, the company reported revenues of
Rs72.5bn (up 2% QoQ and 22% YoY), EBITDA margin of 32% and EPS of Rs31.82. The 3% miss
in our profit estimate was driven by lower utilization and dip in volumes.
 Full-year FY11 results detail. The company achieved US$6bn (up 25.8% YoY) in FY11
revenues and EPS of Rs119.40
 FY12 EPS guidance the biggest disappointment. The revenue growth outlook of 18-20% meets
our guidance expectation of (20-22%) and is ahead of street expectations of 17-19%. The
company has guided for FY12 EPS of Rs126-128, significantly below the current street EPS
estimate of Rs150. 1Q FY12 guidance is for US$1,643m to US$1,659m (implying 3.5% QoQ
growth at the high end).
 Attrition dips but continues to remain high, Infosys reported LTM attrition of 17%, down 50bps
from 17.5% reported last quarter. Gross Hiring came in at 8,930 for the quarter (Vs 11,607 in 3Q)
taking the total headcount to 130,820.



 Offshore pricing moves up but volumes dip. Constant currency pricing improvement reported
for 4Q was Onsite at 0.4% (vs. 0.2% in 3Q), Offshore at 3.2% (vs. 1.4% in 3Q) and Blended at
2.1% (vs. 0.5% in 3Q). The improvement in offshore pricing should help the company to manage
margins despite a decent uptick in offshore salaries in FY12. Infosys registered blended volume
decline of -1.4% QoQ (-2% in Offshore and -0.2% in Onshore) after registering 3.1% sequential
growth in volume last quarter. We understand the seasonal factors at work but were disappointed
with anaemic growth.
 Manufacturing emerges stronger, BFSI sluggish. Infosys reported constant currency growth of
5% for Manufacturing (vs. 9% in 3Q) and of -0.7% for the BFSI vertical (vs 7.1% in 3Q)
respectively.



1Q FY12 and FY12 revenue guidance analysis
 Infosys has guided to FY12 consolidated revenues of US$7.1bn-US$7.3bn, implying a US$18%-
20% revenue growth. This was in line with our and street expectations of growth guidance of
~20%.
 The revenue guidance for 1QFY12 is US$1.6bn-US$1.7bn, high end of guidance implies a 3.6%
sequential growth. To meet the top end of its full year revenue guidance Infosys would need to
grow at CQGR of 5%.

Stepping through the upgrade cycle: Mapping the past
 Infosys has a history of consistently raising its guidance through the years. We tabulate the
guidance trend and actual performance by the company for the last four years (see Fig 11). We
expect FY3/11E to be no different from the past years and expect the company to report its
guidance in the coming quarters.

Hiring guidance to increase in successive quarters
 FY3/12E hiring target highest since FY07.  Infosys has a hiring target for gross addition of
45,000 for FY3/12. This is the highest guidance since FY3/07 by the management. When we
compare the guidance given in 4Q results and the actual year-end hiring number, there is always
a sizable upside. We believe this should further indicate the strength of the deal pipeline with the
company (see Fig 12).