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Sunday, April 15, 2007

Infosys: Buy


Infosys Technologies has delivered a revenue and per-share earnings guidance for 2007-08 that is largely in line with market expectations. The projected revenue growth of 24 per cent and 21 per cent (in rupee terms) for 2007-08 is similar to the guidance announced at the start of 2004-05. It is, however, sharply lower than 29 per cent and 27 per cent forecast for 2006-07.

With the overhang of a possible US slowdown, the sharply appreciating rupee and turbulence in the BFSI (banking, financial services and insurance) space building up in the homestretch to the earnings announcement, an element of moderation had already been factored into market expectations. In this backdrop, the guidance offered by Infosys soothed the somewhat frayed nerves of the market, with software service stocks rallying on Friday's trade.

THE GUIDANCE ARITHMETIC

Based on senior management comments in the earnings call, the variables that appear to have influenced the Infosys guidance are:

On the revenue front, Infosys has stated that it is not seeing any signs of slowdown in IT budgets or spending patterns of the clients. For instance, the management indicated that the software development and consulting revenues improved by over a percentage point on a sequential basis in the fourth quarter of 2006-07, with a dip in maintenance revenues. For the revenue guidance of Rs 17,170 crore (at the mid-point of the range), it has not factored in large deals and assumed no billing rate hikes.

Based on an offshore salary hike of 13-15 per cent and onsite hike of 5-6 per cent (higher than normal), the company is factoring in a 300 basis points (one basis point is one-hundredth of a per cent) decline in operating margins. It has also factored in a 150-160 basis point decline in margins on account of an appreciating rupee (taken at Rs 43.10 compared to an average of Rs 45 for the year). Infosys plans to limit the impact on operating margins to a narrow range through three elements.

One, increase the employee utilisation from 74 per cent in the January-March quarter to the high 70s (say, 78 per cent). As a thumb rule, every one percentage point increase in utilisation can improve the operating margin by 40 basis points. Two, the reduction in the selling, general and administrative (SG&A) expense is expected to improve margins by 150-160 basis points. And the balance will come from improvement in performance of the subsidiaries, Infosys Consulting and China.

Clearly, a part of the lower guidance can be attributed to a relatively sluggish growth in revenue and post-tax earnings notched (compared to projections) in the fourth quarter of 2006-07.

However, with revenues from top-ten clients growing strongly, its client mining potential across the entire revenue pipeline starting from $1 million all the way to $100 million remains intact. In the fourth quarter, Infosys had one client from which it logged $200-million-plus in revenues. Repeat business continues to be robust at 93 per cent. The contribution from verticals such as telecom, manufacturing and retail are likely to remain robust, even if the BFSI segment displays some slack during the course of this year. And among service offerings, the management is bullish on the demand for packaged implementation and testing services.

Considering the conservative stance that Infosys takes on its earnings guidance, we recommend investors to stay invested and take fresh exposure in small lots. Any weakness in the broad markets can be used to step up exposure. At the projected per share earnings of Rs 81, the stock trades at a price-earnings multiple of 25 times its 2007-08 earnings.

It appears likely that the extent of outperformance (guidance vs actuals) may also be somewhat in line with 2004-05, when it ended the year with actual revenue growth of 33 per cent and per share earnings growth of 31 per cent. From an investment standpoint, we prefer Tata Consultancy Services to Infosys in the short run, but Infosys Technologies has to be a core investment in any software portfolio.