Infosys has come to be the hallmark of the Indian IT industry’s success. From humble beginnings in 1981, the company today is the second largest exporter of software services from the country. The company is recognised globally for its world-class management practices and work ethics. It has been making conscious and constant efforts to move up the software value chain and offers services like software development, maintenance, technology consulting, testing and package implementation. Infosys offers all these services through its highly integrated and widely acclaimed global delivery model. The company’s revenues and profits have grown at compounded rates of 36% and 37% respectively during the period FY03 to FY08.

Reasons to buy

	Management excellence: Management is probably one of the strongest reasons to buy into Infosys from a long-term perspective. As has been reiterated innumerable times in the past, the company has a highly competent management that is capable of envisioning future trends in the industry. Thus the management’s solid depth of experience gives the company a sustainable competitive advantage over its peers, especially in uncertain times like these. The company has also set exemplary standards in corporate disclosure and human resource management. The management was one of the first to share wealth with its employees through ESOPs (employee stock options). Considering the knowledge-intensive nature of the software industry, the ability to attract and retain the right talent gives Infosys an edge over other companies.
	Spearheading the momentum: Notwithstanding the current slowdown an uncertainty over short term business prospects, Infosys continues to lead the Indian technology offshoring story, as seen from the strong growth and superior performance metrics that the company has recorded over the past few years. In fact, if one were to take note of the company’s US dollar denominated revenue growth (that excludes the impact of the rupee appreciation against the dollar) over the past five fiscals, the same has consistently been in a range of 35% to 50%. What is more, despite the rupee appreciation and its negative implication on profitability, Infosys has managed to maintain its operating and net profit margins, which is commendable. All in all, the company’s strategy of moving up the value chain is working out well. This is also vindicated by the rise in billing rates, both from new clients as well as on renewal contracts. As for concerns raised about any slowdown in the global (read, the US) economy, Infosys’ management has indicated that there might be some short-term challenges on account of business restructuring and leadership changes at the clients’ side. However, it remains positive on the offshoring momentum from the medium to long-term perspective, given the fact that global sourcing (offshoring) is gradually becoming mainstream, and more and more clients are looking at this in a big way. The management also believes that risk perception for offshoring has gone down in the sense that companies who were willing to have just a couple of thousand people working for them in India, are now willing to scale up faster, either through captives or through their partners (like Infosys). In this backdrop, we maintain our positive stance on the company, and believe that it will benefit on the back of its ability to scale up, financial stability, broad range of service offerings, ability to handle large contracts and a wide global coverage. Also, its aggressive client mining strategies (97% repeat business during FY08) could give it better yields and superior employee productivity to manage the wage inflation and other input costs in the future.
	Cashing in on the global delivery model: Like most industries in their growth phases, the global technology industry has been highly fragmented in nature. The industry is basically made up of two types of companies. First are the ‘incumbents’, like the IBMs, Microsofts, and Oracles of the world who have experienced management teams at the helm, dominate almost all spheres of the industry, have established customer relationships, tried-and-tested products and services, powerful brands and considerable scale advantages. The second breed includes the ‘challengers’, like Infosys, Cognizant, TCS and Wipro, who have created successful business models by devising cheaper (offshore-centric) and more convenient ways to serve targeted customer niches that are below the incumbents’ radar. This has allowed these challengers to mine profits in ways that are not cost-effective for incumbent companies, which have higher cost structures and broader focus. Now, what we are increasingly seeing in the global technology industry is heightened consolidation activity, through which these challengers are acquiring other niche smaller players to improve their geographical reach, enhance their competencies, broaden their services and products portfolio and create strong client relationships. While Infosys has been questioned time and again of being slow on this path despite having the wherewithal (cash balances and investments in liquid mutual funds to the tune of over US$ 2 bn) to be a part of this change, we believe that increased consolidation activity in the industry will indirectly benefit the company, which is one of the pioneers of the much acclaimed global delivery model. Infosys has all the competencies to deliver powerful customer experiences by coordinating efforts across business functions. This is the reason we believe that Infosys shall emerge a bigger threat to the incumbents going forward. The drive towards consolidation shall also provide large players like Infosys with leverage to better control operating costs by taking advantage of broader customer relationships and wider geographical reach. This we believe is one of the biggest positive to keep holding on to the stock.
	One up on peers: In terms of operating margins, Infosys has consistently outperformed its peers, including TCS and Wipro. It enjoys the highest operating margins among its peers and in fact, this year it has actually managed to maintain the same due to the SM&A (sales, marketing and administrative) leverage that it has enjoyed apart from managing to control employee costs. In terms of return on equity, the company outperforms its peers, reflecting the value generated for its shareholders. The company’s client baskets are also among the best in the industry, with 6 clients (3 in March 2007) now giving the company revenues of US$ 100 m plus, reflecting the strong relationships that it has built with them over a period of time.

Reasons not to buy

Growth pangs: The business model of the Indian IT services companies like Infosys is high on fixed-cost and highly capital-intensive. Growth is generally linear, i.e., for every dollar of new sales, companies generally have to add employees and new infrastructure. Since these companies have to keep some of their employees unutilised (expecting to deploy them on sudden short-term projects), delay in addition of new employees can ruin the company’s chances of wining a ‘crucial’ contract. Hence, most of these Indian IT services companies enjoy virtually no operating leverage, which is to say that a change in revenues might, in most cases, not lead to a more than equal change in earnings because incremental costs have to be incurred on creating the additional headcount. While there is no arguing that Infosys’ management has time and again proved its capabilities on the scalability front (ability to grow in size despite maintaining high margins), we are concerned about the company’s ability to manage growth as it grows larger in size. Our calculations show that to grow to a size of US$ 7.8 bn in revenues by FY11, from the FY08 revenues of US$ 4.2 bn, Infosys would need around 150,000 employees (from around 91,000 currently). This is huge by any standards and further more considering that there could be problems pertaining to the availability of highly skilled manpower, particularly at the mid-management level. Further, problems for Infosys would become grave in case there are shocks on the volumes front, i.e., business does not come as anticipated. In that case, the company could have large number of employees on the bench and this would severely dent its operating margins (as salaries would be paid even when employees would not be earning any revenues). Infosys’ attrition levels have been on a gradual rise over the past few quarters. Even if one were to exclude the involuntary attrition (on account of people not passing the company’s training course), there has been an uptick in attrition rate for the company, which is a cause for concern.

Currency risks: The sharp appreciation (11%) in the value of the Indian rupee against the US dollar during FY08 has brought to the fore concerns of its impact being felt by Indian IT services companies who derive large proportion of their revenues in US dollar denominations. Infosys, for instance, has a majority (over 70%) of its billings in dollar terms. This makes the company vulnerable to any loss in value of the US dollar. This is because if the dollar depreciates against the rupee (or conversely, the rupee appreciates against the dollar), Infosys will get lesser rupees per dollar earned, which in turn, will impact its margins. On an average, every 1% appreciation of the rupee against the US dollar causes margins shrinkage of 30 to 40 basis points (0.3% to 0.4%). While we are no experts in predicting the future movement of the rupee vis-à-vis the dollar or, for that matter, any other currency, there are expectations that considering the fact that the US has a massive current account deficit (imports more than exports), this would imply that its currency ‘could’ lose value going forward. This would certainly be a big negative from Indian exporters, including technology services companies like Infosys. While the company is taking steps to diversify its basket of currencies for billing (Euro, for example) as also hedging, the fact that it is still, to a large extent, dependent on the US dollar, makes it vulnerable. The above chart is indicative of the impact that a change in the Rs/US$ rate has caused to the variation between Infosys’ rupee denominated revenues and those calculated in US dollar terms. Simply put, the variation is the difference between growth in rupee-denominated sales and US dollar denominated sales. We believe that it is due to the company negating the adverse impact of rupee appreciation against the dollar by way of improved revenue productivity (through moving up the value chain) and SG&A leverage.

Capex

We expect the company to spend, on an average, between 6% and 7% of its consolidated revenues annually, as capital expenditure towards setting up development centres and sales and marketing offices globally.

Views on News Infosys acquires Axon: Our view (Aug 26, 2008) Software: 1QFY09 review (Aug 5, 2008) IT firms: Moving up the value chain (Jul 15, 2008) Infosys: No ‘surprises’ here (Jul 11, 2008) Software: What can change the outlook? (Jul 4, 2008) More Views on News

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Disclosure: The analyst and dependent family members do not hold shares in this Company. Please read QIS' Share Trading Guidelines.

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