| Infosys (INFO IN) Revenue growth recovery will likely get delayed due to the management change; this could be a long haul for Infosys | Overweight Price Target: Rs4,000.00 PT End Date: 31 Mar 2015 | |
Infosys announced that Dr. Vishal Sikka will be the next CEO of Infosys effective Aug. 1, 2014. Mr. Sikka has excellent credentials in products business, but his exposure to (traditional) IT services has been limited. Even if he is the right man for the job (only time will tell), he will take time to understand the company and devise & implement his strategy/vision for Infosys. Hence, we believe that Infosys is unlikely to return to an industry-level growth rate in FY16 as previously expected. To sum up, we believe this will likely be a really long haul for both Mr. Sikka and Infosys.
· Infosys revenue growth recovery will likely be delayed to FY17E or beyond. Dr. Vishal Sikka is an outsider to Infosys and the IT services industry; hence, he will likely take some time to understand the company, its cultural fabric, competitive landscape, politics, ways of working and the issues Infosys is facing. Infosys is a large company with more than 160,000 employees working on diverse service offerings/industry verticals and Dr. Sikka might take considerable time before getting comfortable in his new role. Hence, we believe the company will be on auto-pilot for the next few months. Mr. Murthy and Mr. Gopalakrishnan’s exit suggests that Dr. Sikka will likely devise his own strategy to run the company, which might not necessarily be a continuation of the current strategy. The crafting of the new strategy/vision and its implementation might take 4-8 quarters, in our view. Hence, we do not expect Infosys to return to an industry-level growth rate in FY16. However, Dr. Sikka’s communication of his strategy/vision can be a key catalyst in the next 1-3 quarters.
· Dr. Sikka has impressive credentials on the products side, but his performance in services business needs watching. Dr. Sikka was the CTO of SAP and the principal architect behind the enormously successful SAP-HANA (SAP’s analytics engine) and he is highly regarded as a technocrat. However, so far, he has not handled a services business and P&L responsibility. Though we admit that the line between products and services is incrementally blurring, there is a significant difference in running a predominantly services company (with minor product component) and a product company (with minor services component). Notably, Infosys generates less than 6% of its revenues from products, platforms and services (PPS), while more than 95% revenues originate from services. Hence, even if Mr. Sikka is the right man for the job at Infosys (only time will say so), he will take some time to understand the workings of Infosys. However, the bigger risk is that if the new organization puts excessive focus on products, platforms and solutions, traditional ‘bread-and-butter’ services might get neglected, which could cause revenue growth drag and further market share loss (which has been the case earlier as well when the company intensified focus on consulting and system integration at the cost of traditional IT services, as a result Infosys lost market share in ‘bread-and-butter’ services). Hence, Dr. Sikka’s views/strategy on traditional ‘bread-and-butter’ IT services need watching.
· Dr. Sikka’s appointment will likely provide the much-needed stability to the organizational structure. Infosys’s top management has been in a state of flux over the last one year with 12 senior leaders leaving the company (including Mr. Ashok Vemuri and Mr. B.G. Srinivas, the initially expected front runners for the top job). Though we expect a few more exits as the internal CEO hopefuls might resign, the organization will likely stabilize after that in our opinion. More importantly, the exit of top-leaders also drives attrition at mid-management level i.e., account managers at the client end & project/program managers at the delivery end. We believe that mid-level managers are the true value zones in an IT firm as they are the ones who manage on-the-ground issues, effectiveness of servicing & ensuring predictable outcomes. Senior management helps open doors but it is mid-management that is the key to mining & deepening accounts, in our view. The stability at the top level will likely help check the attrition at the mid-management level providing continuity. Moreover, Infosys has decided to promote 12 leaders to Executive Vice President (EVP) position, which might act as a morale booster.
· Some of the initiatives taken for the three-plank strategy might continue based on their merit. Under Mr. Murthy, Infosys had hinged its revival strategy on three identified planks: (a) Sales effectiveness, (b) delivery productivity (e.g., development and use of tools/solutions, particularly for the bread-and-butter business, reworking role ratios/span of control), and (c) cost optimization. The company has taken several initiatives to deliver on these three parameters, but we did not see firm signs of progress on the first two planks (sales effectiveness and delivery productivity). Mr. Murthy’s commentary suggests that the new leadership might re-evaluate these initiatives and continue some of these based on their merits. We believe taking a hard look at the earlier initiatives is a positive.
· We are maintaining our estimates pending further review post the management change.
Investment Thesis
Infosys appears to have more realistic targets in the current environment, which we believe is positive. Its win rates in the bread-and-butter segments (including large deals) seem to be improving. The company has also said it is prepared to temper the near-term margin profile for market share. The growth focus is encouraging, in our view. The other positives are: (a) strong deals wins over the last 3-4 quarters provide some visibility into CY14, (b) meaningful headroom for cost-optimization (and margin expansion) through rationalizing cost structure, increasing offshore effort and taking out redundant onsite costs, (c) management seems committed to bring the company back to industry-level growth rates, and (d) a relatively healthy demand environment in CY14 coupled with improved win rates should boost growth.
Valuation
We stay OW on Infosys with a Mar-15 price target of Rs4,000. Our price target is based on a one-year forward P/E of 16.5x, at a modest (~15%) discount to TCS’s target multiple of 19.0x. We believe the discount is justified as TCS’s revenue growth and margin profile are better than Infosys’s, in our view. Notably, our exchange rate assumption is Rs60/US$ for the next two years (FY15 and FY16).
Risks to Rating and Price Target
Downside risks: Lower-than-expected volume growth, weakness in the demand environment, a meaningful decline in pricing/realizations, an adverse US immigration bill, meaningful rupee appreciation (vs the US$), and higher-than-expected attrition.
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