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Infosys: Beating the street! - Views on News from Equitymaster
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Infosys: Beating the street!
Jan 11, 2007

Introduction to results
Infosys has announced strong results for the quarter and nine-month ended December 2006. For 3QFY07, revenues and net profits have each grown by 6% QoQ. What is, however, more noticeable is that the company has been able to expand its operating margins during the quarter, despite the pressure on the rupee (which appreciated by almost 3% against the US dollar during the quarter). For the nine-month period, however, operating margins have declined by 110 basis points (1.1%).

Financial performance (Consolidated): A snapshot…
(Rs m) 2QFY07 3QFY07 Change 9mFY06 9mFY07 Change
Sales 34,510 36,550 5.9% 68,970 101,210 46.7%
Expenditure 23,420 24,590 5.0% 46,390 69,270 49.3%
Operating profit (EBDITA) 11,090 11,960 7.8% 22,580 31,940 41.5%
Operating profit margin (%) 32.1% 32.7%   32.7% 31.6%  
Other income 660 590 -10.6% 680 2,530 272.1%
Provision for investments - -   10 30 200.0%
Depreciation 1,220 1,410 15.6% 2,930 3,690 25.9%
Profit before tax 10,530 11,140 0 20,320 30,750 51.3%
Extraordinary items - -   - 60  
Tax 1,230 1,300 5.7% 2,330 3,590 54.1%
Minority interest 10 10 0.0% 130 100 -23.1%
Profit after tax/(loss) 9,290 9,830 5.8% 17,860 27,120 51.8%
Net profit margin (%) 26.9% 26.9%   25.9% 26.8%  
No. of shares (m) 567.7 567.7   560.5 568.2  
Diluted earnings per share (Rs)*         59.6  
P/E ratio (x)*         35.8  
* 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, including software development (21% of revenues), maintenance (29%), IT consulting (4%), package implementation (17%), products (4%) and BPO (5%). The company has been one of the pioneers of the much acclaimed ‘Global Delivery Model’ and its management is acclaimed for 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 FY06, the company’s revenues and net profits grew at compounded rates of 38% and 31% respectively, outpacing the industry by a far margin.

What has driven performance in 3QFY07?
Higher billing rate prop topline: If one were to analyse the charts below, it becomes amply clear that Infosys’ has benefited from a combined effort of upsurge in billing rates and volumes (though the latter has tapered down marginally during the past two quarters). During 3QFY07, while volumes (number of man-hours, or total hours worked by each employee of the company during the entire quarter) grew by 8% QoQ and 6.1% QoQ for offshore and onsite services, billing rates grew by 1.7% QoQ and 1.9% QoQ respectively.

The fact that the rupee appreciation impacted the company’s topline growth can be understood simply from the fact that the company’s topline grew by 10.1% QoQ in US dollar terms during 3QFY07, against the rupee-based topline growth of 6% QoQ. This was reverse of the previous quarter, when depreciation of the rupee against the US dollar led to rupee denominated revenues clocking a 14.5% QoQ growth, against the US dollar denominated revenues growth of 12.6% QoQ.

Based on geographies, Infosys raked in a relatively higher growth from Europe (10% QoQ, 27% of sales) than the US (5% QoQ, 63% of sales). In terms of service lines, the strongest growth was recorded by BPO services (15% QoQ, 5% of sales). On the other hand, development services (20% of sales) reported a 0.5% sequential decline in sales.

The company added a net of nearly 3,300 employees during the quarter, thus taking its total base to about 69,500. More importantly, attrition rates have also increased with an increase in the employee base. During 3QFY07, Infosys has reported an attrition rate of 13.5%, against 12.9% and 10.8% in 2QFY07 and 3QFY06 respectively. Apart from wage inflation, this is another sticky issue faced by Indian technology companies, as competition for talent has intensified from domestic and global players operating in the Indian marketplace. Here the tough part is that, considering the strong outlook for growth (in businesses and hiring) in the future, the managements (especially of second and third tier software companies) see no respite on these fronts. We have duly factored in these effects into our profitability estimates for Infosys and other software companies.

On the clientele front, Infosys added a gross of 43 clients during the quarter (net addition of 12 clients). Traction was specially seen in US$ 60 m to US$ 80 m client buckets. Contribution from the company’s top 10 clients reduced from 33% of revenues in 2QFY07 to 31% in 3QFY07.

Cost savings aid margin expansion: Despite the 3% appreciation of the rupee vis-à-vis the US dollar, Infosys was still able to prop up its operating margins by 60 basis points (0.6%) during 3QFY07. This was mainly brought about by a reduction (as percentage of sales) in development, general and administrative expenses). Inclusive in these broader cost heads, the employee costs declined from 51.3% of sales in 2QFY07 to 50.3% of sales in 3QFY07. Also, the fact that utilisation levels (including trainees) were maintained at 67.5% (as in 2QFY07) helped the company in getting the utmost benefit of volume and billing rate improvements.

Other income impact bottomline: The benefit of expansion in operating margins could not filter into Infosys’ net margins. This was due to an 11% QoQ decline in other income, which was a consequence of the company booking Rs 200 m as a foreign exchange loss. As a matter of fact, against Infosys’ estimates of Rs/US$ rate of Rs 45.6 for 3QFY07, the actual rate was Rs 44.1, thus leading to an exchange loss. If one were to exclude the exchange gains/losses from 2QFY07 and 3QFY07, other income has actually grown by 44% QoQ during the quarter, mainly on the back of strong growth in interest and dividend income. At the end of December 2006, Infosys had cash and cash equivalents of nearly Rs 48 bn (approx US$ 1.1 bn). Investment of the same in bank deposits and mutual funds has earned the company strong returns, thus leading to a robust growth in other income (excluding foreign exchange adjustments).

Performance in the recent past…
  3QFY06 4QFY06 1QFY07 2QFY07 3QFY07
Sales growth (%, QoQ) 10.4 3.6 14.9 14.5 5.9
Development expenses (% of sales) 52.4 54.2 55.3 53.1 53.0
Selling expenses (% of sales) 6.2 5.8 6.8 6.4 6.5
Operating margins (%) 34.0 31.7 29.5 32.1 32.7
Profits growth (%, QoQ)* 7.1 3.7 18.0 17.0 5.8
Employees (Nos.) 49,422 52,715 58,409 66,150 69,432
Utilisation including trainees (%) 70.0 69.7 71.1 67.5 67.5
*Excluding extraordinary items

What to expect?
At the current price of Rs 1,620, the stock is trading at 12.1 times our estimated FY10 earnings. The past three quarters of this fiscal have been tough for Infosys mainly due to appreciating rupee. During this period, the company has lost Rs 21 bn (over US$ 500 m) in topline to rupee appreciation but has still been able to maintain margins, which is appreciable. The company is confident of maintaining the same margins as in FY07 and will be able to absorb appreciation of 3% to 5% in the currency.

On the demand side, the management has maintained that it has not seen any cancellation or postponements of projects, which we believe is a positive sign. However, the fact that the IT budgets, which gets finalised by end of December/January every year, have been postponed by one month on account of deeper due diligence by client companies, makes us a bit cautious on the demand environment. On the supply side, the company for next year has already made 18,000 campus offers as against 12,000 for the previous year indicating that the deal pipelines is robust. More so when the company has concluded 9 multi million transformational deals in this quarter.

Finally, while the results have come as a good surprise in adverse macro-economic environment for the tech sector, the fact that volume growth has been slower is a negative. In the long run there can be two things, which can adversely impact the company – decline in margins, and lower volumes. While the fall in margins due to rising costs and appreciating currency can be mitigated, as many operational levers are available, the company has to deal with any pressure on volumes. Infosys changed the industry dynamics when it pioneered the global delivery model and now when most of the factors are against the industry as a whole, we expect it to repeat with something new, which will bring on a paradigm shift for the industry again.

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