Infosys Q4FY15 numbers were disappointing on all parameters :: HDFC Securities

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In our Q3FY15 results review dated Jan 13, 2015, we had recommended investors to buy Infosys at the then CMP of Rs. 2114.8 and average it on dips to Rs. 1924-1984 for our price target of Rs. 2285 over the next quarter. Thereafter, the stock met our price target on Feb 10, 2015 and subsequently touched a new high of Rs. 2335.2 on Feb 20, 2015 before correcting sharply to a low of Rs. 1932.7 on April 30, 2015 (on the back of disappointing Q4FY15 results). Currently, it is quoting at Rs. 1942.4. Infosys Q4FY15 numbers were disappointing and below the street as well as our estimates on all parameters. We present an update on the stock.  The USD revenues declined by 2.7% Q-o-Q to USD 2159 mn, impacted significantly by cross currency headwinds. Also, the growth in CC was much below our expectations at -0.4% Q-o-Q. The fall was led by steep decline in the pricing (down 3.8% Q-o-Q, indicating pressure in commoditized services). Onsite pricing declined by 2.5% Q-o-Q, while offshore pricing fell by 4.1% Q-o-Q. Volume growth stood at 0.8% Q-o-Q with onsite volumes up 2.1% Q-o-Q & offshore volumes up by 0.4% Q-oQ. In INR terms, the revenues de-grew by 2.8% Q-o-Q.  Operating profit declined by 5.6% Q-o-Q, while OPM fell by 83 bps Q-o-Q to 27.8%. EBIT declined by 6.5% Q-o-Q, while EBIT margins declined by 102 bps Q-o-Q to 25.7%. OPM contraction was due to lower utilization levels & higher SG&A (up 150 bps Q-o-Q). This along with higher depreciation cost (up 6.8% Q-o-Q) impacted the EBIT margins. This was a currency impact of 70 bps on margins during the quarter.  PAT declined by 4.7% Q-o-Q, while PAT margins declined by 46 bps Q-o-Q to 23.1%, impacted by higher effective tax rate (up 22 bps Q-o-Q to 28.5%). EPS for the quarter stood at Rs. 27.1 vs. Rs. 28.4 in Q3FY15.

 Utilization, including trainees fell by 290 bps Q-o-Q & 10 bps Y-o-Y to 72.8%. Excluding the trainees, it fell by 410 bps Q-o-Q (possibly due to lower execution during the quarter and strong hiring), but rose 190 bps Y-o-Y to 78.6%. According to the management, the utilization levels could stay in the range of 80‐83%.  There was a net addition of 6549 employees against net addition of 4227 employees in Q3FY15 and gross addition of 14471 of which 8334 were lateral recruitment against 13154 employees, of which 6094 were lateral recruitment in Q3FY15. The total employee strength stood at 1,76,187 nos.  Attrition declined by 150 bps Q-o-Q to 18.9% after 11 straight quarters of rise, which is encouraging. High attrition has always been a concern for Infosys. However, the fear is now subsiding. Employee engagement initiatives including promotions, higher variable payouts (like 100% variable payouts in Q3) could help in reducing attrition rate going forward.  Growth across the verticals was subdued in reported as well as in CC (except FSI & Manufacturing, which grew in CC). FSI declined by 1.3% Q-o-Q; and grew by 1.0% in CC. Manufacturing declined by 1.1% Q-o-Q; and grew by 1.1% in CC. RCL declined by 2.6% Q-o-Q; and 1.1% in CC on the back of weakness in Retail vertical. ECS declined by 6.7% sequentially; and 3.8% in CC on the back of continued pressure on IT budgets, weakness in oil and gas sector & continued weakness in telecom space.  Amongst services lines, growth was driven by Products, Platforms & Solutions (up 5.8% Q-o-Q, led by strong growth of 14.1% in Product Revenues, while BPM platform was down 11.5% Q-o-Q) and Product Engineering services (up 0.2% Q-o-Q). However, Application development was down by 6.6% Q-o-Q, second straight quarter of sharp decline. Application maintenance was down 1.7% Q-o-Q, testing services was down 4.8% Q-o-Q, Infrastructure management services was down 3.8% Q-o-Q (its revenue share dropped after a steady rise over the last few quarters), while Business process management fell by 4.5% Q-o-Q.

Guidance Infosys expects FY16 dollar revenue to grow 10-12% in constant currency terms. The company aims for revenue growth of 6.2-8.2% in dollar terms and rupee revenue growth of 8.4-10.4% during FY16. Infosys has maintained aspiration to reach industry growth by 2017 and also maintained margin band of 25% plus / minus 100 bps.  Five-Year Vision: The firm wants to reach USD 20 bn in revenues by 2020 compared to USD 8.7 bn in FY15 and expects operating profit margin at 30% by 2020 against 25.9% in financial year gone by. The management aspires to increase revenue productivity to $80k/person/year from current $53k/person/year. It is expected to generate at least 30% productivity improvement in existing service line from these solutions and new platforms in Edge portfolio. It expects new services like Design Thinking, AI and the IP‐Led businesses to contribute at least 10% of revenue for Infosys. Inorganic investments are expected to contribute ~$1.5bn revenue.  Acquisitions, Investments and Partnerships: i) This quarter, Infosys completed the acquisition of Panaya, a leading provider of automation technology. Panaya’s CloudQuality™ suite would enable the company to leverage automation for several of its service lines through an agile SaaS model, and help mitigate risk, reduce costs and decrease time-to-market for clients. ii) The company recently entered into a definitive agreement to acquire Kallidus Inc. (d.b.a Skava) and its affiliate, a leading provider of digital experience solutions, including mobile commerce and in-store shopping experiences to large retail clients. This acquisition is an all-cash deal for a total consideration of $120 mn including retention bonus and a deferred component. Skava delivers a cloud hosted platform for mobile websites, apps, and other digital shopping experiences across mobile, tablet, desktop, in-store, and all emerging channels to large retail clients worldwide. The platform enables retailers to provide a mobile specific experience to their customers through an agile and flexible environment, enabling personalization and delivering customer analytics across multiple channels. iii) The company also entered into a definitive agreement for an early-stage investment of $ 2 mn in Airviz, to acquire a minority share. Airviz is a personal air quality monitoring startup and spinout from Carnegie Mellon University. This investment was made out of the $ 500 mn Innovation Fund earmarked for investments in disruptive new technologies, and positions us as a driving force in the fast-growing personal health monitoring market with a big data solution that provides indoor air pollution sensing and visualization. Airviz Speck, an affordable, fine particulate monitor, which uses patent-pending technology from Carnegie Mellon University, can empower individuals and communities to understand and identify health hazards related to air quality.  The management highlighted that the services growth in the fourth quarter was lower than we expected, though it saw healthy growth in Finacle and its Edge suite. Pricing continues to be under pressure due to increasing commoditization in the traditional outsourcing business, requiring us to ramp up productivity through automation, and enhance our differentiation in large engagements  Infosys recommended a bonus issue of 1:1 and a stock dividend of one American Depositary Share (ADS) for every ADS held, subject to shareholders' approval. It also recommended a final dividend of Rs. 29.50 per share (equivalent to Rs 14.75 per share after 1:1 bonus issue).  The company’s current policy is to pay dividends of up to 40% of post-tax profits. The Board has decided to increase the dividend pay-out ratio to up to 50% of posttax profits effective fiscal 2015.  The company won five new deals during the quarter worth USD 440mn. The deals were spread across regions (3 in North America and 1 each in Europe and ROW). Vertical-wise, 3 deals were in retail and 2 in Manufacturing. According to the management, the deal pipeline continues to remain healthy with strong opportunities in ERP implementations, Cloud, SAAS based solutions, Analytics and Compliance.  The proportion of fixed price contracts (excluding products) stood at 43.8%, as compared to 42.9% in Q3FY1

Liquid assets including cash and cash equivalents, available-for-sale financial assets, certificates of deposits and government bonds were Rs. 32,585 cr as on March 31, 2015 as compared to Rs. 34,873 cr as on Dec 31, 2014. The decline in Cash and cash equivalents was due to payment of Rs. 34.5 bn of contested tax claims on the company and Rs. 13.76 bn paid for acquisition and stakes in investee companies. Conclusion & Recommendation Infosys Q4FY15 numbers were disappointing on all parameters. Especially the Q-o-Q revenues growth in USD (-2.7%) & CC (-0.4%) was way below our as well as the street estimates. The fall was led by steep decline in the pricing (down 3.8% Q-o-Q), indicating pressure in commoditized services. Volume growth of 0.8% Q-o-Q was not encouraging. Further, revenue growth was weak across most of the geographies, verticals & service offerings (except product services, which reported healthy growth). Sharp fall in the utilization rate was another discouraging factor. Lower utilization, higher SGA impacted the margins. However, decline in the attrition rate, bonus issue (1:1), increase in dividend payout, optimistic guidance for FY17, positive long term growth vision were some of the positive highlights of the quarter. Industry lobby Nasscom has factored in weaker technology budgets and cut its software exports growth forecast from last year to 12-14% for this financial year. Further, worldwide IT spending is also expected to shrink by 1.3%, according to technology researcher Gartner. This, along with subdued Q4FY14 reported by Infosys makes us feel that the company could fall short of our revenue & profit projections for FY16. Achieving the lower end of the 10-12% CC revenue growth guidance for FY16 could be challenging, as it implies ~2.4%-2.9% CQGR, which is optimistic. One or two more quarters would give us better clarity on whether the guidance is achievable. Wage hikes could continue to put pressure on the margins in the coming quarters. We feel it could take longer than expected time for new areas to start yielding benefits and reflecting in financials, considering the challenges in the near term. We are downgrading our net sales, operating profit & PAT estimates by 3.3%, 5.4% & 5.4% respectively. Accordingly, revised EPS for FY16 would stand at Rs. 113.8. We have incorporated projections for FY17, wherein we expect the net sales, operating profit & PAT to grow by 12%, 13.2% & 14.5% respectively. EPS for FY17 is estimated at Rs. 130.2. At the CMP, the stock trades at 14.9xFY17E EPS, which is at a discount of 13% to TCS and at a premium of 17% to Wipro. Post Strong Q2 & Q3, the discount in valuations to TCS narrowed significantly. However, Infosys has disappointed in Q4 and has underperformed its peers TCS, HCL Tech & Wipro in terms of USD & CC Q-o-Q revenue growth. For further narrowing of discount to TCS, Infosys will have to deliver superior performance. While we don’t expect the company to be re-rated significantly from here (based on weak Q4, doubts on achieving the optimistic guidance for FY16 and near term challenges being faced by the IT industry), bonus issue of 1:1, increase in dividend payouts (in line with Dr. Sikka’s capital allocation strategy), positive long term vision and reducing attrition (which was earlier the biggest concern) could protect the downside in the stock price in near term. Valuing the stock at 15.5xFY17E Revised EPS, we arrive at price target of Rs. 2019 (reduced from Rs. 2285). We feel investors could buy the stock on dips to Rs. 1823-1888 (14-14.5xFY16E EPS) for our price target over the next quarter

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