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Infosys 3QFY06 results: Our view - Views on News from Equitymaster
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Infosys 3QFY06 results: Our view
Jan 11, 2006

Introduction to results
Infosys has announced its financial results for the third quarter and nine-month period ended December 2005. Driven by good volume growth and also partially due to the rupee movement, sequential revenues expanded at a double-digit pace in 3QFY06. Due mainly to savings on the SG&A side, margins showed an impressive expansion. However, due to a forex loss this quarter, the impact of the margin expansion was not reflected in the bottomline, which grew at a decent pace, albeit not quite the same pace as the topline. The company’s performance in the 9-month period has also been quite robust.

Financial performance (Consolidated): A snapshot…
(Rs m) 2QFY06 3QFY06 Change 9mFY05 9mFY06 Change
Sales 22,940 25,320 10.4% 51,420 68,970 34.1%
Expenditure 15,600 16,710 7.1% 34,740 46,390 33.5%
Operating profit (EBDITA) 7,340 8,610 17.3% 16,680 22,580 35.4%
Operating profit margin (%) 32.0% 34.0%   32.4% 32.7%  
Other income 440 (50) -111.4% 920 680 -26.1%
Depreciation 960 1,170 21.9% 1,870 2,930 56.7%
Profit before tax 6,820 7,390 8.4% 15,730 20,330 29.2%
Extraordinary items (10) -   - (10)  
Tax 690 830 20.3% 2,400 2,330 -2.9%
Minority interest 60 70   - 130  
Profit after tax/(loss) 6,060 6,490 7.1% 13,330 17,860 34.0%
Net profit margin (%) 26.4% 25.6%   25.9% 25.9%  
No. of shares 280.0 281.6   273.8 280.2  
Diluted earnings per share (Rs)*         85.0  
P/E ratio (x)**         35.6  
(* Annualised)            
(** P/E ratio calculated on a trailing 12-month basis)

What is the company’s business?
Infosys is India’s second largest software services exporter and offers a bouquet of services, which include software development (21% of revenues), maintenance (30%), IT consulting (3%), package implementation (16%), products (4%) and BPO (4%). Infosys’ management is acclaimed for its corporate governance practices and has been a source of competitive advantage for the company in its rapid growth over the past years. During the period between FY01 and FY05, the company’s revenues and net profits have grown at compounded rates of 39% and 32% respectively, outpacing the industry by a far margin.

What has driven performance in 3QFY06?
Volume-driven topline again plus a little extra: Infosys’ topline saw a robust double-digit sequential growth during 3QFY06, growing at 10.4%. This was driven by decent volume growth of 6.5% onsite and 6.2% offshore in the IT services business. Billing rates were flat, with onsite rates actually falling by 0.1% sequentially, while offshore rates grew by 0.2% sequentially. The fact that the topline grew at over 10% sequentially compared to the 6%+ volume growth and flat billing rates is an indication that Infosys benefited at the operating level from the weakness of the rupee in the initial part of the quarter.

This quarter as well, as in the previous quarter, the larger clients grew at a stable rate but below the company growth rate, clearly implying that the new client addition has been the major contributor to the healthy revenue growth. To put it in numbers, Infosys added 36 new clients during the quarter. The total number of active clients now stands at 454 (450 at the end of 2QFY06). The fact that the number of clients in almost all the higher revenues buckets grew is an indication of the robust business growth that Infosys is currently witnessing.

Cost savings drive margin expansion: Even though the utilisation levels reduced to 70.0% from 72.9% last quarter, Infosys witnessed a strong 200 basis points margin expansion due to savings in SG&A expenses. These expenses as a percentage of revenues reduced to 13.6% from 15.2% in 2QFY06, reflecting impressive cost control, thus, pushing up the margins. The rupee movement in the initial part of the quarter has also helped on this front.

Infosys saw a gross hiring of 5,135 employees and net hiring of 3,226 employees in 3QFY06. This takes the total headcount of the company to 49,422. A slight negative for the company this quarter is that employee attrition increased from 10.0% in 2QFY06 to 10.8%. Going forward, this is a major cause for concern, as the company will have to control attrition on a huge employee base.

The main question now remains is the sustainability of these margins. Operating margins for the nine-month period stood at 32.7%, a 30 basis points expansion over 9mFY05. We have factored in a slight reduction in the operating margins of Infosys till FY08 and, should the company be able to sustain this level of margins, we may have to take a re-look at our numbers.

Forex loss negates margin expansion: Despite the 200 basis points margin expansion this quarter, the fact that Infosys recorded a forex loss during 3QFY06 has led to the impact of the higher margins being totally wiped out. As a result, there was a loss in the other income component. Due also to higher depreciation charges and a considerably higher effective tax rate, net profit growth on a sequential basis was decent at 7.1%, but lagging considerably behind the topline growth.

Performance in the recent past…
  4QFY05 1QFY06 2QFY06 3QFY06
Sales growth (%, QoQ) 6.0 4.2 10.7 10.4
Development expenses (% of sales) 52.4 53.3 52.8 52.4
Selling expenses (% of sales) 5.9 6.8 6.5 6.2
Operating margins (%) 33.5 32.0 32.0 34.0
Profits growth (%, QoQ)* 12.3 (4.8) 13.9 7.1
Employees (Nos.) 36,750 39,806 46,196 49,422
Utilisation including trainees (%) 73.2 74.1 72.9 70.0
*Including extraordinary item in 4QFY05

What to expect?
At the current price of Rs 2,975, the stock is trading at a price to earnings multiple of 19.1 times our estimated FY08 earnings. The management has upgraded its FY06 revenue guidance to 33.1% to 33.2% growth, while EPS has also been upgraded slightly in the range of Rs 89.9 to Rs 90.3, up from Rs 89.0 to Rs 89.4 per share at the end of 2QFY06. This implies a YoY growth of around 30.7% to 31.3%.

We expect the company to grow revenues at a CAGR of 38% over the next three years, while profits are expected to clock a 30% growth rate over the same period. We are not surprised by the upward revision in guidance, as traditionally, the Infosys management has been conservative in its expectations and has always outperformed its guidance. Given this fact, this is a good sign, as it indicates increasing confidence in the business environment for IT spending and greater mainstream adoption of offshoring. Though valuations appear stretched from a medium term perspective, we continue to hold a positive view on the stock, taking a long-term view.

We had recommended a ‘Buy’ on Infosys in April 2005 at Rs 1,998 with a target price of Rs 2,750 from a 2-year investment perspective. At this juncture, the stock price has gained by almost 50% from the date of the recommendation. We believe that an investor needs to take a long-term view if he or she would like to buy into the Infosys stock at current levels. We maintain our positive stand on the company from a long-term perspective.

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