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Infosys Technologies Neutral
INFY.BO, INFO IN
Five current concerns that are biting the Infosys
shareholder- how well justified are they?
Concern 1: Does Infosys still boast the same caliber of management as before?
Investors wonder whether the current Infosys management is of the same
pedigree as that led by industry icons such as Messrs. NRN Murthy and Nandan
Nilekani. We think this view is somewhat unfair noting that the Infosys of today
faces far stiffer competition than the Infosys of 2000-08 with the resurgence of
TCS, growing to scale of Cognizant and offshore aggression of Accenture.
Concern 2: Is the Infosys business model “stuck in the middle”? What is its
primary articulation? TCS has supreme positioning in total (end-to-end)
outsourcing. Accenture has the pole position in consulting and sole-sourced
business, Cognizant has a ‘growth’ positioning. HCLT, coming from nowhere,
has shown the needed flexibility/adaptability to be relevant in the growth stakes.
What is the Infosys model premised on that stands out? Also, with TCS
overtaking Infosys on EBIT margins and given Infosys’ none-too-impressive
recent track record on margins, what does Infosys 3.0 (its latest avatar) mean
for Infosys’ margins going ahead? We debate this concern at length.
Concern 3: Is Infosys losing ambition? Infosys’ own pronouncements seem to
suggest that their performance should be satisfactorily viewed versus the
guidance issued – a far cry from the practices of the old which accustomed
(indeed, almost spoiled) investors to significant guidance beat.
Concern 4: Not flexible enough on pricing, engagement structures or, on
leveraging the mighty balance sheet. This might have been true of Infosys in the
past which held the company back but we believe that the four primary go-tomarket
verticals today have substantially more autonomy than before in
deciding on such matters. There are no sacred cows today including pricing.
Concern 5: People or process? Is Infosys getting too fixated with
processes/systems rather than focusing on the profile/satisfaction of its people?
Infosys has boasted air-tight processes/systems through its evolution to where it
stands today. However, these do not always help as consequences of iRACE
reveal to us. However, in Infosys’ defense, we see some positive change here.
To conclude, some of the above concerns that investors have are legitimate
which we have identified in our prior research. Others may not be. We explain
where Infosys is changing and where we believe it might need to rethink. We
retain our Neutral rating on the stock continuing to prefer TCS (OW).
As discussed in our cover page, we highlight five capital concerns that strike
investors (besides the perennial, stubborn complaint about non-productive use of
ever-accumulating cash). We provide our view where applicable.
Concern 1: Does Infosys still boast the same caliber of
management as before?
Given the continuous erosion in perception of investors regarding Infosys over the
past 2 years, it becomes logical for investors to ask whether the caliber of the Infosys
management is as excellent as before. Investors hark back to the days of Infosys
when industry icons such as Messrs. Narayana Murthy and Nandan Nilekani led the
company through periods of sustained tizzy growth. Our view is slightly different –
the competitive intensity has increased significantly post 2007 and clients’
propensity to adopt multi-vendor sourcing has equalized the game between 5-6
relevant vendors in the space.
Competitive intensity has perked up with implications for Infosys’ pricing
premium. In the last four years in particular (2007-11), MNCs have matured in
competitive intensity. Cognizant comes of scale while Accenture has made inroads
into India and low-cost GDN model and offensively pushing the offshore
proposition. Closer to home, TCS, a company that Infosys has had the better off
during the pre-downturn years, is performing to its potential fully harnessing its
strengths. IBM has occasionally been a threat but invariably it crops up as a
formidable competitor in markets that entail localization and are characterized by
heterogeneity. In short, competitive intensity has flared up - not necessarily seen in
the number of players (this is still just a handful) but in the depth of competition
offered by the handful.
The upshot is that with clients increasingly pursuing multi-vendor strategies the
notion of pricing premium (so cherished by Infosys) in the industry is an
outdated one. As discussed in our note, “Winning a sustainable pricing premium is
a difficult proposition” (dated August 3rd, 2010) the ability to improve pricing today
depends more on the macro-environment than any, individualized intrinsic ability.
Firms’ pricing behavior may be determined less by their own, individual ability to
favorably influence pricing but more by industry dynamics (such as favorable vendor
supply – outsourcing demand equation). In such a scenario, realization (pricing)
increases accruing to a player are likely to be in step with what peers manage in a
healthy environment. In other words, billing rates/pricing is incrementally getting
equalized among the Big 4 (Infosys, TCS, Wipro and Cognizant) with Accenture and
IBM bringing more credibility to the process. We think that tier-1 players can drive
1-2% increase in pricing in a favorable environment with little/no likelihood of any
benefiting outlier emerging.
Hence, the bias on driving industry leading revenue/profit growth may shift to
volumes rather than pricing. This is a departure from the past when Infosys drew on a
combination of both volume growth and meaningful price rises to drive performance.
Therefore, to attribute Infosys relatively subdued performance since 2008 to
dilution of management caliber is unjustified. The rules of the game that were in
Infosys’ favor shifted away from what prevailed under the leadership of hallowed
leaders such as Messrs.NRN Murthy and Nandan Nilekani to a more competitive
game characterized by increasing depth from competition, multi-vendor sourcing,
dissipation of pricing premium etc. If one could fault Infosys, it is that management
could have responded nimbler to the changing rules of the game.
Table 1: Pricing determinants - Past and Present - rising competition renders the advantage of pricing premium transient
No. Factor in determining pricing Comment and Conclusion
1 Demonstrated or demonstrable domain or
technology leadership
Today, this is undifferentiated among the Big 3 (TCS, Infosys and
Wipro).
2
Contract signed at what stage in the evolution
of the IT industry, company (e.g. Infosys
signing the British Telecom contract at
healthy pricing and BT strongly ramping up
through FY06-08).
Such differences will narrow going forward. Right place at the
right time and at the right price will be arbitraged away as
competitive intelligence picks up and multi-vendor situations
increasingly emerge.
3 Multi-vendor situations
Clients increasingly diversify across service providers to reduce
vendor dependency. It will be difficult for a service-provider to
have an unfettered run on a single account if capability exists
elsewhere. Multi-vendor situations bring honesty to pricing. We
gather that increasingly fewer and fewer large accounts are
exclusive to a vendor and margins thereof in such accounts stem
more from volumes and economies of scale rather than pricing.
4 Contribution of value-added service lines
such as enterprise solutions
Among the Big 3, Infosys enjoyed a pricing premium as it was
early in investing and reaping fruits in higher-value enterprise
solutions. However, over time, peers have built strength in highervalue
service lines, thus diminishing the premium.
5 Areas of value/specialization within a client
Certain premiums could depend on special knowledge of
technology, geography, domain, or the client’s portfolio, within
the pie distributed (e.g. business process optimization and
integration); such areas of specialization constitute a small
percentage of revenues.
6 Specific expertise in unique/less-penetrated
verticals such as healthcare
For example, Cognizant’s expertise in healthcare is likely to
protect its pricing in a non-commoditized vertical.
7
Aberrations in reported quarterly pricing due
to (over) staffing/abnormal incidents of
project starts
When companies are overstaffed relative to business needs, they
occasionally feel tempted to deploy extra effort (more than
needed) to keep bench more utilized. This inflates volumes and
depresses reported realization. But the reported realization
(pricing) decline is not real as this is purely induced as a result of
overstaffing which duly corrects itself in due course.
Also, in a quarter marked by abnormal peaks in project starts
onsite, realizations (onsite) suffer if revenue does not synchronize
with effort expended in transitions/starts (e.g. Wipro in 1QFY11
on onsite pricing). Again, this is a temporary factor.
8 Balance sheet, governance, relationship,
brand and trust
For the Tier-1 vendors, this is a hygiene factor as all three rank
high on this parameter.
Source: J.P. Morgan.
Concern 2: Is the Infosys business model “stuck in the
middle”? What is its primary articulation?
Over the years, Infosys has a constructed a business model that allowed industryleading
profitability combined with growth. One of the bright spots of the Infosys
business model was its early identification of higher-margin enterprise solutions as a
mainstream opportunity and investments made therein. However, down the road as
TCS substantially catches up on margins while keeping a step ahead of growth,
Cognizant leads on growth, Accenture pushes system integration and consulting
offshore & HCLT becomes a force to reckon with in select quarters, investors ask,
“What is distinctive about Infosys’ business model? What does it stand for? What is
the manifestation in financial numbers given that it does not seem to be seen in
growth and/or margins?”
Infosys 3.0 is Infosys’ answer to this relevant question. The company has chosen
elements of best practices of its competitors (which we do not interpret as lacking
originality). Sample the following:
1. Infosys hopes to emulate Accenture’s positioning in consulting and its
people investments made thus far are testament to that.
2. Its positioning in “bread-and-butter” service lines that constitute over 75%
of the addressable market such as infra management, testing, BPO, system
integration is relatively weak vis-à-vis TCS and as we have pointed out
repeatedly, this is where TCS has stolen an absolute march. Infosys now has
business operations heads embedded in each of the four major verticals
solely concerned with developing Infosys’ value propositions in such
segments (see table 1).
3. Infosys 3.0 is completely verticalized by delivery (not just at the front-end)
and in this respect has taken a leaf out of Cognizant’s book towards the aim
of specialization and achieving client-centricity
4. Its IP-driven initiatives (BPO platforms, proprietary offerings on a pay-asyou-
go model) are a step in the new direction that its peers too are taking.
This is tried and untested for the industry as a whole.
To sum up, Infosys 3.0 is not unique by itself as it combines best practices by others
while attempting to distinguish itself IP-driven non-linearity. This is not necessarily
negative provided Infosys suitably customizes the various elements to its own
strengths.
What about margins? Will the new business model settle for lower but
sustainable margins and/or ROIC? We believe so. The new normal on margins
and/or ROIC may be a lower normal and this should be evident by 4QFY12, in our
view. Dissipation of pricing premium that we discussed under Concern 1 is one
factor that contributes to this. Market-share gains especially in “bread-and-butter”
offerings make take precedence in the new Infosys model. We welcome this as stuck
in a strategic bind between pricing and volumes post-downturn , Infosys, in our view,
veered too strongly towards protecting pricing, with the result that volume growth
suffered. Trading off against volumes is not necessarily the best course of action if
75-80% of volumes are obtained from “bread and butter” segments. Volumes also
offer relative scalability and predictability to the business model. (see box below).
Pricing or volume - which is a truer underlying indicator of sustaining health in
Indian IT?
Expanding volumes at increasing price points is the ideal scenario – likely in a bullcase
scenario for Indian IT. But pricing improvements that are mix-led may not
sustain going forward unless mix continues to enrich. Mix-led pricing behavior in a
quarter can be erratic and cannot be relied upon to as a trend as it depends on which
part of the business portfolio grows ahead of company average. In one quarter, the
discretionary aspect(s) of the business portfolio may grow ahead of the defensive
portfolio yielding higher overall price point (aggregate level). But this can reverse
quickly in the following quarter if ADM and plain vanilla service lines (BPO, IMS)
lead the incremental ramp up. Pricing is not a true barometer of predictability of
business momentum if it is primarily (a) mix-driven or (b) skewed by pronounced
shift towards onsite from offshore.
Concern 3: Has the legendary Beat and raise philosophy
towards guidance has changed favoring a norm of “perform
within limits of guidance”?
There is increasingly an uncomfortable change in how Infosys views its own
performance versus guidance gap has shrunk to as to be virtually non-existent. The
legendary beat is a thing of the past. Infosys’ performance versus guidance equation
of late increasingly resembles Wipro (see figure 2). This begs the question – what is
the management trying to commit through its guidance today? Is it a bar that it
expects to easily leap over (as in the past) or should investors interpret this to be the
most likely outcome? If the latter, then investors will likely price their expectations
into the stock accordingly.
There is another softer aspect of ambition and aspiration to this – Is the Infosys
management of today content with just issuing guidance and perform in line with it?
Is there a sense of complacency within Infosys today that it is happy to beat industry
averages and meet its guidance as opposed to keeping its proud tradition of industry
leadership and significant guidance beat alive? In our view, Infosys is best placed to
answer these questions.
Concern 4: Not flexible enough on pricing, engagement
structures or, leveraging the balance sheet
The changing nature of demand from clients entails adjustments that
vendors have to make. TCS, we understand, has sophisticated risk analytics
team across verticals to assess the level of risk in large programs which
involve differentiated contract structuring. Some of Cognizant’s top pharma
relationships are completely outcome-based (>USD 100 million clients).
HCLT has shown willingness to onboard employees from client
organizations. TCS also leads the industry in promising annual productivity
improvements to clients, and does not shy away from making its pay-off
linked to SLA and productivity.
Too much of back-and-forth. At Infosys, whenever such adjustments were
to be made, we gather that at times, negotiations would run back and forth
between the individual go-to-market industry units and a centralized
council. That might have slowed down decision-making in the past. No
longer as we gather as the four go-to-market industry units (verticals) have
been conferred substantial autonomy in crafting engagement structures,
deciding pricing subject to overall, broader corporate goals. We believe that
this has empowered Infosys’ account managers in their decision-making.
More seriously is the question of Infosys’ willingness to leverage its mighty
and pristine balance sheet to drive earnings growth. At ROIC (ex-cash)
exceeding 50%, Infosys can and should trade its balance sheet in favor of
earnings growth. Partner-led/data-centre-based strategies that help enhance
the earnings growth profile leveraging the cushion offered by a rich ROIC
aids valuation and investor returns (see box).
The right trade-off between growth and Return on invested capital (ROIC)
depends on where the firm is with respect to the ROIC curve. Our valuation
framework suggests that valuations are a rather weak function of ROIC if ROIC is
already above a comfortable threshold benchmark (~ 30-35%). If Infosys drops its
ROIC by 10% from the current levels of ~55% in the quest of greater earnings
growth, then that benefits investors. Cognizant, the fastest growing company among
the Big 4 in Indian IT, operates at a comfortable ROIC of 34%, a level that allows
them to drive leading growth without affecting investor returns. It would have been a
different matter if this growth comes at a much lower ROIC.
Developing growth strategies judiciously drawing on ROIC need not
compromise margins as TCS has admirably shown. It’s not a growth versus
margin debate but a growth versus ROIC debate. This is because ROIC is not
only a function of margins and profitability but also of how firms manage their
balance sheet. If vendors concede concessions to clients that entail initial investments
(data-centers for example), or back-loaded cash flows or relaxed payment terms, all
of these is likely to impact the balance sheet. There is benefit in doing this to drive
earnings growth if firm’s existing ROIC is already high. HCLT faces the opposite
imperative – it needs to pursue ROIC-improvement strategies more than earnings
growth to drive a better outcome for investors.
The big message: There is great option value embedded in favor of growth that
Indian IT firms (most notably Infosys) have in current ROIC/operating margins.
Above all, it is a mindset change that Infosys will have to conquer given the
latitude/room that it has (in our view, Infosys can afford to loosen up given its bestin-
class ~55% ROIC). For example, an acquisition strategy that dilutes return metrics
over the long term within an acceptable band, but propels trajectory of earnings
growth to a higher level (by even 3-4% per year) is beneficial for shareholders in the
long run. Tweaking the perfect balance sheet in favor of incrementally better
operating metrics and return ratios yields diminishing returns beyond a point as
our analysis concludes. There is great option value embedded in favor of growth
that Indian IT firms (most notably Infosys) have in current ROIC/operating margins.
Above all, it is a mindset change that Infosys will have to conquer given the
latitude/room that it has (in our view, Infosys can afford to loosen up given its bestin-
class ~55% ROIC). For example, an acquisition strategy that dilutes return metrics
over the long term within an acceptable band, but propels trajectory of earnings
growth to a higher level (by even 3-4% per year) is beneficial for shareholders in the
long run. Tweaking the perfect balance sheet in favor of incrementally better
operating metrics and return ratios yields diminishing returns beyond a point as
our analysis concludes.
Concern 5: People or process? Is Infosys getting too
fixated with processes/systems rather than focusing on the
profile/satisfaction of people it hires?
Infosys has led the industry in establishing processes and systems. Its processes
are so tight that if technical personnel were unbilled, the project manager and his
seniors could get to know of that on a very regular basis; project profitability was
calculated for every project on a periodic basis based on effort accrual. Also, the
sales pipeline predictive mechanism (CRM) at Infosys was so precise and
sophisticated that senior engagement managers and top management could see on a
dynamic basis pipelines of those sales/account management folks whose prospective
pipeline was not filling as fast as their confirmed order pipeline was getting executed
(or depleted). Also, on a dynamic basis, Infosys management could see the deviation
of both the individual and overall pipeline from Infosys’ desired revenue mix.
Our question is: How does all that help if top management, senior officers and
account managers managing P&Ls do not generate enough demand out there in the
market-place? With the benefit of hindsight, processes and systems will raise red
flags but only top management can address the red flags when they see them or better
still pre-empt them altogether in the first place.
So, has Infosys underinvested in profiles of people who can create demand? We
believe that this has been the case till FY10with Infosys waiting out the downturn
hunkering down. However, per capita salary costs suggest that this underinvestment
is now reversed (starting FY11). Infosys’ per capita onsite costs are the highest in the
industry and more important has shown an increasing trend (see figure 3). To some
extent, this has had an impact on Infosys’ margins.
Also, this indicates that today, Infosys is investing more in profiles of professionals
who are domain experts, consultants, account managers – those who can create
demand (volume generation) at higher billing rates (onsite) as opposed to technical
(engineering) resources who would not normally command such per capita wages.
We believe that indicators of success of making such people investments must be
consistent volume growth at above-average billing rates. We await results.
And finally the common concern on hoarding cash: This has been a historic (and
persistent) concern of investors and therefore, we have not discussed this at length
preferring to focus on the more recent investor misgivings. Our view is simply this –
Infosys generates well over USD 1 billion of free cash flow today – this is only likely
to increase with size. So, over the next 3-4 years, cumulative free cash flow
generation would be upwards of USD 5 billion. Acquisitions are hardly likely to
need a good proportion of this (particularly for Infosys given its conservativeness on
this score).
No linkage between going ex-growth and increasing cash pay-out. Also, we
believe that by increasing dividend pay-out, reinstating special dividends, or
initiating buy-backs, Infosys is not sending out signals of moderating growth (as it
believes) but really that it generates more cash that it needs for its operational and
investment needs (a reality of profitable, well-run companies). It also signals wise
capital allocation.
Can Infosys surprise on the upside in 2QFY12?
It seems inconceivable that Infosys would want to continue to operate at utilization at
or below 73% for a protracted period despite its statements on this. Given this and
also Infosys’ employee hiring target of 12,000 (gross) in 2QFY12, we believe that
Infosys could be preparing for a much stronger 2QFY11 (seasonally its strongest
quarter) than what its guidance (3.5%-5.0% Q/Q revenue growth) suggests. So, we
would not rule out a significant upside to Infosys’ own guidance for 2QFY12.
Investment view
Some investor concerns that we have highlighted in this report are legitimate. Infosys
is diligently at work to address some of them. A good entry-point for a 15%+ upside
from the Infosys stock would be at Rs 2,700-2,800. We stay Neutral on Infosys and
continue to prefer TCS (OW). We believe that stocks of both TCS (OW) and Wipro
(OW) should return more to the investor than Infosys (Neutral).
Appendix – Our 3 specific concerns on
Infosys getting addressed
Organizational structure – better now for improved results
than before
As discussed in our March 3rd report, “Still a few wrinkles to iron out; some are new
and some are old; reiterate Neutral”, one of the factors that have held Infosys back,
in our view, is the overconcentration of responsibility in few hands in the name of
empowerment. This can prove burdensome in large companies.
What we found particularly uncomfortable at Infosys is dual ownership of verticals
and horizontals (service-lines) by an individual. Breadth of responsibility that
senior managers handle in roles versus depth in managing dedicated P&Ls
exceeding USD 1bn. Breadth is inappropriate in larger companies. Managing a
vertical (P&L) is quite different in its dynamics from managing a horizontal or
service-line (important KRAs for service heads relate to cost & productivity
management, solution and Centre of Excellence development as opposed to P&L).
We like split in leadership of verticals and horizontals (seen in Infosys 3.0) which
was not there in the prior Infosys structure. That said, Infosys 3.0 is now more
vertically concentrated with energy & utilities rolled into telecom, healthcare rolled
into retail & logistics.
(For greater details on this subject refer to our report " Importance of organization
structure & accountability mapping in Indian IT grows with size; mastering tradeoffs
the name of the game” dated May 16th, 2011).
Traction in “bread and butter” offerings should not suffer
because of high-value positioning aspiration
Infosys has articulated its intent to achieve credible positioning in consulting,
enterprise solutions & system integration. This is partly reflected in the rising per
capita onsite costs as consulting/system integration professionals are expensive
resources (see figure 5). This is good but we caution that this could come at the
expense of traction in “bread-and-butter” offerings such as testing, BPO, inframanagement
and ADM.
As we have repeatedly emphasized, “bread-and-butter” offerings are essential to
the full-services model, which we believe that TCS has managed much better than
Infosys. After all, over 75% of the addressable market for IT-Services lies in the
“bread-and-butter” offerings encompassing ADM, BPO, testing, infra management
and application integration. This dominance of TCS is particularly seen in infra
management, a service line that Infosys has barely grown in the last 12-months. We
regard this as underperformance given the significant and sustainable offshorization
of infra management.
Priority for bread-and-butter offerings recognized in Infosys 3.0. Today Infosys
3.0 envisages separate, dedicated leadership for business operations (or what we call
“bread-and-butter” offerings) in each of the four primary go-to-market verticals. At
the corporate level, responsibility for business operations lies with Mr.
Chandrasekhar Kakal – who earlier did a fine job as head of enterprise solutions –
powering Infosys to leadership in this segment. We are hopeful.
Optimizing the Hunters versus Farmers balance – too much
focus traditionally on farmers (mining)
Infosys is on par with TCS (despite 40% lower revenue base of Infosys) when it
comes to cultivating USD 50 mn+ and USD 100 mn+ accounts (see figure 6) but
typically these accounts grow slower than company-average once they cross such
critical thresholds. Thus, when top-20 accounts saturate, it becomes essential to rev
up growth from elsewhere. However, Infosys derives significantly lower revenues
from new clients in a year than TCS (significantly lower than HCLT as well, a
smaller company).
The new accounts hunted today will be accounts to farm tomorrow. As a rule of
thumb, the 3-4% revenues from new accounts in a year typically grows to 15% in 3
years – accounts bagged over a 4-year period could cumulatively contribute about
30-35% of incremental revenues by year-5. Traditionally, Infosys has leaned on
account farming - thus managing the balance is critical.
We believe that Infosys is conscious of this and hence, this might be changing with
the appointment to the Head of Sales role of Mr. Basab Pradhan – an old Infosys
hand. Basab, in our view, will drive new account penetration, new market penetration
more aggressively than Infosys has been able to demonstrate in the pas
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Infosys Technologies Neutral
INFY.BO, INFO IN
Five current concerns that are biting the Infosys
shareholder- how well justified are they?
Concern 1: Does Infosys still boast the same caliber of management as before?
Investors wonder whether the current Infosys management is of the same
pedigree as that led by industry icons such as Messrs. NRN Murthy and Nandan
Nilekani. We think this view is somewhat unfair noting that the Infosys of today
faces far stiffer competition than the Infosys of 2000-08 with the resurgence of
TCS, growing to scale of Cognizant and offshore aggression of Accenture.
Concern 2: Is the Infosys business model “stuck in the middle”? What is its
primary articulation? TCS has supreme positioning in total (end-to-end)
outsourcing. Accenture has the pole position in consulting and sole-sourced
business, Cognizant has a ‘growth’ positioning. HCLT, coming from nowhere,
has shown the needed flexibility/adaptability to be relevant in the growth stakes.
What is the Infosys model premised on that stands out? Also, with TCS
overtaking Infosys on EBIT margins and given Infosys’ none-too-impressive
recent track record on margins, what does Infosys 3.0 (its latest avatar) mean
for Infosys’ margins going ahead? We debate this concern at length.
Concern 3: Is Infosys losing ambition? Infosys’ own pronouncements seem to
suggest that their performance should be satisfactorily viewed versus the
guidance issued – a far cry from the practices of the old which accustomed
(indeed, almost spoiled) investors to significant guidance beat.
Concern 4: Not flexible enough on pricing, engagement structures or, on
leveraging the mighty balance sheet. This might have been true of Infosys in the
past which held the company back but we believe that the four primary go-tomarket
verticals today have substantially more autonomy than before in
deciding on such matters. There are no sacred cows today including pricing.
Concern 5: People or process? Is Infosys getting too fixated with
processes/systems rather than focusing on the profile/satisfaction of its people?
Infosys has boasted air-tight processes/systems through its evolution to where it
stands today. However, these do not always help as consequences of iRACE
reveal to us. However, in Infosys’ defense, we see some positive change here.
To conclude, some of the above concerns that investors have are legitimate
which we have identified in our prior research. Others may not be. We explain
where Infosys is changing and where we believe it might need to rethink. We
retain our Neutral rating on the stock continuing to prefer TCS (OW).
As discussed in our cover page, we highlight five capital concerns that strike
investors (besides the perennial, stubborn complaint about non-productive use of
ever-accumulating cash). We provide our view where applicable.
Concern 1: Does Infosys still boast the same caliber of
management as before?
Given the continuous erosion in perception of investors regarding Infosys over the
past 2 years, it becomes logical for investors to ask whether the caliber of the Infosys
management is as excellent as before. Investors hark back to the days of Infosys
when industry icons such as Messrs. Narayana Murthy and Nandan Nilekani led the
company through periods of sustained tizzy growth. Our view is slightly different –
the competitive intensity has increased significantly post 2007 and clients’
propensity to adopt multi-vendor sourcing has equalized the game between 5-6
relevant vendors in the space.
Competitive intensity has perked up with implications for Infosys’ pricing
premium. In the last four years in particular (2007-11), MNCs have matured in
competitive intensity. Cognizant comes of scale while Accenture has made inroads
into India and low-cost GDN model and offensively pushing the offshore
proposition. Closer to home, TCS, a company that Infosys has had the better off
during the pre-downturn years, is performing to its potential fully harnessing its
strengths. IBM has occasionally been a threat but invariably it crops up as a
formidable competitor in markets that entail localization and are characterized by
heterogeneity. In short, competitive intensity has flared up - not necessarily seen in
the number of players (this is still just a handful) but in the depth of competition
offered by the handful.
The upshot is that with clients increasingly pursuing multi-vendor strategies the
notion of pricing premium (so cherished by Infosys) in the industry is an
outdated one. As discussed in our note, “Winning a sustainable pricing premium is
a difficult proposition” (dated August 3rd, 2010) the ability to improve pricing today
depends more on the macro-environment than any, individualized intrinsic ability.
Firms’ pricing behavior may be determined less by their own, individual ability to
favorably influence pricing but more by industry dynamics (such as favorable vendor
supply – outsourcing demand equation). In such a scenario, realization (pricing)
increases accruing to a player are likely to be in step with what peers manage in a
healthy environment. In other words, billing rates/pricing is incrementally getting
equalized among the Big 4 (Infosys, TCS, Wipro and Cognizant) with Accenture and
IBM bringing more credibility to the process. We think that tier-1 players can drive
1-2% increase in pricing in a favorable environment with little/no likelihood of any
benefiting outlier emerging.
Hence, the bias on driving industry leading revenue/profit growth may shift to
volumes rather than pricing. This is a departure from the past when Infosys drew on a
combination of both volume growth and meaningful price rises to drive performance.
Therefore, to attribute Infosys relatively subdued performance since 2008 to
dilution of management caliber is unjustified. The rules of the game that were in
Infosys’ favor shifted away from what prevailed under the leadership of hallowed
leaders such as Messrs.NRN Murthy and Nandan Nilekani to a more competitive
game characterized by increasing depth from competition, multi-vendor sourcing,
dissipation of pricing premium etc. If one could fault Infosys, it is that management
could have responded nimbler to the changing rules of the game.
Table 1: Pricing determinants - Past and Present - rising competition renders the advantage of pricing premium transient
No. Factor in determining pricing Comment and Conclusion
1 Demonstrated or demonstrable domain or
technology leadership
Today, this is undifferentiated among the Big 3 (TCS, Infosys and
Wipro).
2
Contract signed at what stage in the evolution
of the IT industry, company (e.g. Infosys
signing the British Telecom contract at
healthy pricing and BT strongly ramping up
through FY06-08).
Such differences will narrow going forward. Right place at the
right time and at the right price will be arbitraged away as
competitive intelligence picks up and multi-vendor situations
increasingly emerge.
3 Multi-vendor situations
Clients increasingly diversify across service providers to reduce
vendor dependency. It will be difficult for a service-provider to
have an unfettered run on a single account if capability exists
elsewhere. Multi-vendor situations bring honesty to pricing. We
gather that increasingly fewer and fewer large accounts are
exclusive to a vendor and margins thereof in such accounts stem
more from volumes and economies of scale rather than pricing.
4 Contribution of value-added service lines
such as enterprise solutions
Among the Big 3, Infosys enjoyed a pricing premium as it was
early in investing and reaping fruits in higher-value enterprise
solutions. However, over time, peers have built strength in highervalue
service lines, thus diminishing the premium.
5 Areas of value/specialization within a client
Certain premiums could depend on special knowledge of
technology, geography, domain, or the client’s portfolio, within
the pie distributed (e.g. business process optimization and
integration); such areas of specialization constitute a small
percentage of revenues.
6 Specific expertise in unique/less-penetrated
verticals such as healthcare
For example, Cognizant’s expertise in healthcare is likely to
protect its pricing in a non-commoditized vertical.
7
Aberrations in reported quarterly pricing due
to (over) staffing/abnormal incidents of
project starts
When companies are overstaffed relative to business needs, they
occasionally feel tempted to deploy extra effort (more than
needed) to keep bench more utilized. This inflates volumes and
depresses reported realization. But the reported realization
(pricing) decline is not real as this is purely induced as a result of
overstaffing which duly corrects itself in due course.
Also, in a quarter marked by abnormal peaks in project starts
onsite, realizations (onsite) suffer if revenue does not synchronize
with effort expended in transitions/starts (e.g. Wipro in 1QFY11
on onsite pricing). Again, this is a temporary factor.
8 Balance sheet, governance, relationship,
brand and trust
For the Tier-1 vendors, this is a hygiene factor as all three rank
high on this parameter.
Source: J.P. Morgan.
Concern 2: Is the Infosys business model “stuck in the
middle”? What is its primary articulation?
Over the years, Infosys has a constructed a business model that allowed industryleading
profitability combined with growth. One of the bright spots of the Infosys
business model was its early identification of higher-margin enterprise solutions as a
mainstream opportunity and investments made therein. However, down the road as
TCS substantially catches up on margins while keeping a step ahead of growth,
Cognizant leads on growth, Accenture pushes system integration and consulting
offshore & HCLT becomes a force to reckon with in select quarters, investors ask,
“What is distinctive about Infosys’ business model? What does it stand for? What is
the manifestation in financial numbers given that it does not seem to be seen in
growth and/or margins?”
Infosys 3.0 is Infosys’ answer to this relevant question. The company has chosen
elements of best practices of its competitors (which we do not interpret as lacking
originality). Sample the following:
1. Infosys hopes to emulate Accenture’s positioning in consulting and its
people investments made thus far are testament to that.
2. Its positioning in “bread-and-butter” service lines that constitute over 75%
of the addressable market such as infra management, testing, BPO, system
integration is relatively weak vis-à-vis TCS and as we have pointed out
repeatedly, this is where TCS has stolen an absolute march. Infosys now has
business operations heads embedded in each of the four major verticals
solely concerned with developing Infosys’ value propositions in such
segments (see table 1).
3. Infosys 3.0 is completely verticalized by delivery (not just at the front-end)
and in this respect has taken a leaf out of Cognizant’s book towards the aim
of specialization and achieving client-centricity
4. Its IP-driven initiatives (BPO platforms, proprietary offerings on a pay-asyou-
go model) are a step in the new direction that its peers too are taking.
This is tried and untested for the industry as a whole.
To sum up, Infosys 3.0 is not unique by itself as it combines best practices by others
while attempting to distinguish itself IP-driven non-linearity. This is not necessarily
negative provided Infosys suitably customizes the various elements to its own
strengths.
What about margins? Will the new business model settle for lower but
sustainable margins and/or ROIC? We believe so. The new normal on margins
and/or ROIC may be a lower normal and this should be evident by 4QFY12, in our
view. Dissipation of pricing premium that we discussed under Concern 1 is one
factor that contributes to this. Market-share gains especially in “bread-and-butter”
offerings make take precedence in the new Infosys model. We welcome this as stuck
in a strategic bind between pricing and volumes post-downturn , Infosys, in our view,
veered too strongly towards protecting pricing, with the result that volume growth
suffered. Trading off against volumes is not necessarily the best course of action if
75-80% of volumes are obtained from “bread and butter” segments. Volumes also
offer relative scalability and predictability to the business model. (see box below).
Pricing or volume - which is a truer underlying indicator of sustaining health in
Indian IT?
Expanding volumes at increasing price points is the ideal scenario – likely in a bullcase
scenario for Indian IT. But pricing improvements that are mix-led may not
sustain going forward unless mix continues to enrich. Mix-led pricing behavior in a
quarter can be erratic and cannot be relied upon to as a trend as it depends on which
part of the business portfolio grows ahead of company average. In one quarter, the
discretionary aspect(s) of the business portfolio may grow ahead of the defensive
portfolio yielding higher overall price point (aggregate level). But this can reverse
quickly in the following quarter if ADM and plain vanilla service lines (BPO, IMS)
lead the incremental ramp up. Pricing is not a true barometer of predictability of
business momentum if it is primarily (a) mix-driven or (b) skewed by pronounced
shift towards onsite from offshore.
Concern 3: Has the legendary Beat and raise philosophy
towards guidance has changed favoring a norm of “perform
within limits of guidance”?
There is increasingly an uncomfortable change in how Infosys views its own
performance versus guidance gap has shrunk to as to be virtually non-existent. The
legendary beat is a thing of the past. Infosys’ performance versus guidance equation
of late increasingly resembles Wipro (see figure 2). This begs the question – what is
the management trying to commit through its guidance today? Is it a bar that it
expects to easily leap over (as in the past) or should investors interpret this to be the
most likely outcome? If the latter, then investors will likely price their expectations
into the stock accordingly.
There is another softer aspect of ambition and aspiration to this – Is the Infosys
management of today content with just issuing guidance and perform in line with it?
Is there a sense of complacency within Infosys today that it is happy to beat industry
averages and meet its guidance as opposed to keeping its proud tradition of industry
leadership and significant guidance beat alive? In our view, Infosys is best placed to
answer these questions.
Concern 4: Not flexible enough on pricing, engagement
structures or, leveraging the balance sheet
The changing nature of demand from clients entails adjustments that
vendors have to make. TCS, we understand, has sophisticated risk analytics
team across verticals to assess the level of risk in large programs which
involve differentiated contract structuring. Some of Cognizant’s top pharma
relationships are completely outcome-based (>USD 100 million clients).
HCLT has shown willingness to onboard employees from client
organizations. TCS also leads the industry in promising annual productivity
improvements to clients, and does not shy away from making its pay-off
linked to SLA and productivity.
Too much of back-and-forth. At Infosys, whenever such adjustments were
to be made, we gather that at times, negotiations would run back and forth
between the individual go-to-market industry units and a centralized
council. That might have slowed down decision-making in the past. No
longer as we gather as the four go-to-market industry units (verticals) have
been conferred substantial autonomy in crafting engagement structures,
deciding pricing subject to overall, broader corporate goals. We believe that
this has empowered Infosys’ account managers in their decision-making.
More seriously is the question of Infosys’ willingness to leverage its mighty
and pristine balance sheet to drive earnings growth. At ROIC (ex-cash)
exceeding 50%, Infosys can and should trade its balance sheet in favor of
earnings growth. Partner-led/data-centre-based strategies that help enhance
the earnings growth profile leveraging the cushion offered by a rich ROIC
aids valuation and investor returns (see box).
The right trade-off between growth and Return on invested capital (ROIC)
depends on where the firm is with respect to the ROIC curve. Our valuation
framework suggests that valuations are a rather weak function of ROIC if ROIC is
already above a comfortable threshold benchmark (~ 30-35%). If Infosys drops its
ROIC by 10% from the current levels of ~55% in the quest of greater earnings
growth, then that benefits investors. Cognizant, the fastest growing company among
the Big 4 in Indian IT, operates at a comfortable ROIC of 34%, a level that allows
them to drive leading growth without affecting investor returns. It would have been a
different matter if this growth comes at a much lower ROIC.
Developing growth strategies judiciously drawing on ROIC need not
compromise margins as TCS has admirably shown. It’s not a growth versus
margin debate but a growth versus ROIC debate. This is because ROIC is not
only a function of margins and profitability but also of how firms manage their
balance sheet. If vendors concede concessions to clients that entail initial investments
(data-centers for example), or back-loaded cash flows or relaxed payment terms, all
of these is likely to impact the balance sheet. There is benefit in doing this to drive
earnings growth if firm’s existing ROIC is already high. HCLT faces the opposite
imperative – it needs to pursue ROIC-improvement strategies more than earnings
growth to drive a better outcome for investors.
The big message: There is great option value embedded in favor of growth that
Indian IT firms (most notably Infosys) have in current ROIC/operating margins.
Above all, it is a mindset change that Infosys will have to conquer given the
latitude/room that it has (in our view, Infosys can afford to loosen up given its bestin-
class ~55% ROIC). For example, an acquisition strategy that dilutes return metrics
over the long term within an acceptable band, but propels trajectory of earnings
growth to a higher level (by even 3-4% per year) is beneficial for shareholders in the
long run. Tweaking the perfect balance sheet in favor of incrementally better
operating metrics and return ratios yields diminishing returns beyond a point as
our analysis concludes. There is great option value embedded in favor of growth
that Indian IT firms (most notably Infosys) have in current ROIC/operating margins.
Above all, it is a mindset change that Infosys will have to conquer given the
latitude/room that it has (in our view, Infosys can afford to loosen up given its bestin-
class ~55% ROIC). For example, an acquisition strategy that dilutes return metrics
over the long term within an acceptable band, but propels trajectory of earnings
growth to a higher level (by even 3-4% per year) is beneficial for shareholders in the
long run. Tweaking the perfect balance sheet in favor of incrementally better
operating metrics and return ratios yields diminishing returns beyond a point as
our analysis concludes.
Concern 5: People or process? Is Infosys getting too
fixated with processes/systems rather than focusing on the
profile/satisfaction of people it hires?
Infosys has led the industry in establishing processes and systems. Its processes
are so tight that if technical personnel were unbilled, the project manager and his
seniors could get to know of that on a very regular basis; project profitability was
calculated for every project on a periodic basis based on effort accrual. Also, the
sales pipeline predictive mechanism (CRM) at Infosys was so precise and
sophisticated that senior engagement managers and top management could see on a
dynamic basis pipelines of those sales/account management folks whose prospective
pipeline was not filling as fast as their confirmed order pipeline was getting executed
(or depleted). Also, on a dynamic basis, Infosys management could see the deviation
of both the individual and overall pipeline from Infosys’ desired revenue mix.
Our question is: How does all that help if top management, senior officers and
account managers managing P&Ls do not generate enough demand out there in the
market-place? With the benefit of hindsight, processes and systems will raise red
flags but only top management can address the red flags when they see them or better
still pre-empt them altogether in the first place.
So, has Infosys underinvested in profiles of people who can create demand? We
believe that this has been the case till FY10with Infosys waiting out the downturn
hunkering down. However, per capita salary costs suggest that this underinvestment
is now reversed (starting FY11). Infosys’ per capita onsite costs are the highest in the
industry and more important has shown an increasing trend (see figure 3). To some
extent, this has had an impact on Infosys’ margins.
Also, this indicates that today, Infosys is investing more in profiles of professionals
who are domain experts, consultants, account managers – those who can create
demand (volume generation) at higher billing rates (onsite) as opposed to technical
(engineering) resources who would not normally command such per capita wages.
We believe that indicators of success of making such people investments must be
consistent volume growth at above-average billing rates. We await results.
And finally the common concern on hoarding cash: This has been a historic (and
persistent) concern of investors and therefore, we have not discussed this at length
preferring to focus on the more recent investor misgivings. Our view is simply this –
Infosys generates well over USD 1 billion of free cash flow today – this is only likely
to increase with size. So, over the next 3-4 years, cumulative free cash flow
generation would be upwards of USD 5 billion. Acquisitions are hardly likely to
need a good proportion of this (particularly for Infosys given its conservativeness on
this score).
No linkage between going ex-growth and increasing cash pay-out. Also, we
believe that by increasing dividend pay-out, reinstating special dividends, or
initiating buy-backs, Infosys is not sending out signals of moderating growth (as it
believes) but really that it generates more cash that it needs for its operational and
investment needs (a reality of profitable, well-run companies). It also signals wise
capital allocation.
Can Infosys surprise on the upside in 2QFY12?
It seems inconceivable that Infosys would want to continue to operate at utilization at
or below 73% for a protracted period despite its statements on this. Given this and
also Infosys’ employee hiring target of 12,000 (gross) in 2QFY12, we believe that
Infosys could be preparing for a much stronger 2QFY11 (seasonally its strongest
quarter) than what its guidance (3.5%-5.0% Q/Q revenue growth) suggests. So, we
would not rule out a significant upside to Infosys’ own guidance for 2QFY12.
Investment view
Some investor concerns that we have highlighted in this report are legitimate. Infosys
is diligently at work to address some of them. A good entry-point for a 15%+ upside
from the Infosys stock would be at Rs 2,700-2,800. We stay Neutral on Infosys and
continue to prefer TCS (OW). We believe that stocks of both TCS (OW) and Wipro
(OW) should return more to the investor than Infosys (Neutral).
Appendix – Our 3 specific concerns on
Infosys getting addressed
Organizational structure – better now for improved results
than before
As discussed in our March 3rd report, “Still a few wrinkles to iron out; some are new
and some are old; reiterate Neutral”, one of the factors that have held Infosys back,
in our view, is the overconcentration of responsibility in few hands in the name of
empowerment. This can prove burdensome in large companies.
What we found particularly uncomfortable at Infosys is dual ownership of verticals
and horizontals (service-lines) by an individual. Breadth of responsibility that
senior managers handle in roles versus depth in managing dedicated P&Ls
exceeding USD 1bn. Breadth is inappropriate in larger companies. Managing a
vertical (P&L) is quite different in its dynamics from managing a horizontal or
service-line (important KRAs for service heads relate to cost & productivity
management, solution and Centre of Excellence development as opposed to P&L).
We like split in leadership of verticals and horizontals (seen in Infosys 3.0) which
was not there in the prior Infosys structure. That said, Infosys 3.0 is now more
vertically concentrated with energy & utilities rolled into telecom, healthcare rolled
into retail & logistics.
(For greater details on this subject refer to our report " Importance of organization
structure & accountability mapping in Indian IT grows with size; mastering tradeoffs
the name of the game” dated May 16th, 2011).
Traction in “bread and butter” offerings should not suffer
because of high-value positioning aspiration
Infosys has articulated its intent to achieve credible positioning in consulting,
enterprise solutions & system integration. This is partly reflected in the rising per
capita onsite costs as consulting/system integration professionals are expensive
resources (see figure 5). This is good but we caution that this could come at the
expense of traction in “bread-and-butter” offerings such as testing, BPO, inframanagement
and ADM.
As we have repeatedly emphasized, “bread-and-butter” offerings are essential to
the full-services model, which we believe that TCS has managed much better than
Infosys. After all, over 75% of the addressable market for IT-Services lies in the
“bread-and-butter” offerings encompassing ADM, BPO, testing, infra management
and application integration. This dominance of TCS is particularly seen in infra
management, a service line that Infosys has barely grown in the last 12-months. We
regard this as underperformance given the significant and sustainable offshorization
of infra management.
Priority for bread-and-butter offerings recognized in Infosys 3.0. Today Infosys
3.0 envisages separate, dedicated leadership for business operations (or what we call
“bread-and-butter” offerings) in each of the four primary go-to-market verticals. At
the corporate level, responsibility for business operations lies with Mr.
Chandrasekhar Kakal – who earlier did a fine job as head of enterprise solutions –
powering Infosys to leadership in this segment. We are hopeful.
Optimizing the Hunters versus Farmers balance – too much
focus traditionally on farmers (mining)
Infosys is on par with TCS (despite 40% lower revenue base of Infosys) when it
comes to cultivating USD 50 mn+ and USD 100 mn+ accounts (see figure 6) but
typically these accounts grow slower than company-average once they cross such
critical thresholds. Thus, when top-20 accounts saturate, it becomes essential to rev
up growth from elsewhere. However, Infosys derives significantly lower revenues
from new clients in a year than TCS (significantly lower than HCLT as well, a
smaller company).
The new accounts hunted today will be accounts to farm tomorrow. As a rule of
thumb, the 3-4% revenues from new accounts in a year typically grows to 15% in 3
years – accounts bagged over a 4-year period could cumulatively contribute about
30-35% of incremental revenues by year-5. Traditionally, Infosys has leaned on
account farming - thus managing the balance is critical.
We believe that Infosys is conscious of this and hence, this might be changing with
the appointment to the Head of Sales role of Mr. Basab Pradhan – an old Infosys
hand. Basab, in our view, will drive new account penetration, new market penetration
more aggressively than Infosys has been able to demonstrate in the pas
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