Infosys has come to be the gold standard in 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. It 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 35% and 37% respectively during the last five year period of FY04-FY09.

Reasons to buy

Sacred amongst black boxes like Satyam: India Inc. seems to be a changed place after eruption of the Satyam scam late last year. Companies are disclosing a lot, more than they’ve ever done, and managements are leaving no stones unturned to present the correct ‘audited’ numbers to investors. In such a scenario, Infosys remains like breath of fresh air. With its clean balance sheet, forthcoming-as-always disclosures and frank expectations of the management, the company presents remains amongst India’s most admirable global corporate brand. As for the company’s management, well it remains one of the strongest reasons to buy the stock from a long-term perspective. The company has a highly competent management team that is capable of envisioning future trends in the industry. Its 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. 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 from and outside the software industry.

Source: Equitymaster Research Warts and all: In its usual no holds barred approach to disclosing facts, Infosys recently unveiled its expectations for FY10 which, to say the least, will be amongst the company’s most muted performances. While the company estimates its revenues during the current fiscal to grow within a range of 1.7% to 5.7%, it expects profits to fall by 3.3% to 7.6%. This will, in fact be the first time the company will report a decline in its profits since its inception. So, simply said, times are bad for Infosys and the management has not denied the fact at all. However, it has clearly mentioned that the guidance it has given this time around is simply a statement of fact as it sees today, and might change depending in how the macro picture changes as the year progresses. Source: Equitymaster Research Coming to Infosys’ performance during the previous fiscal - FY09 - the company clocked a 30% and 29% growth in sales and profits respectively. Remember, this performance was in an year when the economic situation had already worsened and the currency volatility was at its best. In fact, the rupee moved from 39 to a US dollar to 50 within a span of the fiscal, a move of around 28%. Despite this, not only did Infosys maintain a strong profit growth, it did it while improving its operating margins to 33.2%, from 31.4% in FY08. On the back of pricing pressure, the management expects these margins to decline by around 3% in FY10, which we have duly factored in our estimates. Also, despite the challenging environment, the company continues to invest in its business – to add new services, solutions, and new markets to its folio. As per current plans, it will be hiring 18,000 employees during the current fiscal, including 16,000 from the campus and therefore at low salaries. Overall, the company has been able to manage the extreme volatility in the currency. It has been able to show good numbers in spite of the environment and has been very realistic in giving its guidance for FY10. These factors lead us to maintain our view on the stock, which we believe has the potential to give you strong returns over the next 2 to 3 years. The idea will be to look beyond a year’s estimates and performance and appreciate the fact that Infosys remains India’s lead technology offshoring story and has a very good growth potential over the next 5 to 10 years.

Reasons not to buy

	Things are really bad out there: The crisis that has impacted the entire global financial system is bound to affect the Indian technology industry. There already are talks of US corporations cutting back on their discretionary technology spending during 2009. While the value proposition offered by offshore outsourcing will be maintained, the fact that fresh contracts are coming in at a much slower pace will most likely impact the volumes of Indian IT players. Infosys is also facing severe headwinds in growing its business. And importantly, the challenges are not just on one account but three - volumes, pricing and currency volatility. Also, as outlined by the company’s management in its conference call after the announcement of FY09 results, around 89% of the company’s clients have indicated of a cutback in their technology budgets. Also, while 22% has said that their offshore spend will remain flat during the current year, only about 5% have hinted at a higher offshore spend in 2009. These statistics are worrying for the company’s short to medium term performance. Taking a conservative view on the back of the expected slowdown in technology spending, we expect Infosys’ revenues to grow at a compounded annual rate of 9% over the next three years.
	Source: Company, Equitymaster Research Growth pangs: The business model of the Indian IT services companies like Infosys is high on fixed-costs. 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 almost US$ 6 bn in revenues by FY12, from the FY09 revenues of under US$ 5 bn, Infosys would need around 145,000 employees (from around 105,000 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. Also, problems for Infosys would become grave in case there are shocks on the volumes front, i.e., business does not come as anticipated, as is already expected in the current fiscal.
	Currency risks: The sharp volatility in the value of the Indian rupee against the US dollar during FY09 has brought to the forefront concerns for 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. However, the concern in FY09 was one of a rising dollar and a falling rupee, which is otherwise good for export-dependent companies as they get to convert every dollar of income into a greater number of rupees. This concern was because while companies like Infosys had hedged their future receivables are near Rs per dollar, they missed out on the rupee’s depreciation against the dolar and had to provide for hedging losses in their books. Now, 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), and that that dollar is projected by economists to have a negative bias going forward, this would imply that the currency ‘could’ lose value in the long run. Infosys’ management is also of the view that while the dollar could appreciate against all global currencies in the short term, in the long term, the dollar could weaken as the world starts focusing on the currency’s intrinsic weakness. This would certainly be a big negative for 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.

Capex

We expect the company to spend, on an average, between 3% and 4% of its consolidated revenues annually, as capital expenditure towards setting up development centres and spending towards sales and marketing efforts.

Views on News IT: Forex is a big determinant (Feb 19, 2010) Infosys: Beats the street, yet again (Jan 12, 2010) Indian IT in 2009: A flashback (Dec 30, 2009) IT industry: Performance takeaways (Nov 12, 2009) Infosys: Inching towards recovery? (Oct 9, 2009) 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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