Infosys: Volume growth supports bottomline

Infosys Ltd announced third second quarter results for the financial year 2012-2013 (3QFY13) today. The company reported a 5.7% quarter-on-quarter (QoQ) growth in its sales while QoQ net profit growth was flat. Here is our analysis of the results.

Performance summary

• Sales grew by 5.7% QoQ in rupee terms during 3QFY13. The growth figure was higher at 6.3% in US dollar terms.
• Volume growth was 2 % QoQ as compared to 3.8 % in the last quarter.
• Operating margins declined by 0.6% QoQ to 25.7% during the quarter as compared to 26.3% recorded in the previous quarter (2QFY13). This was attributable to the rise in cost of sales and a marginal rise in selling and marketing expenses.
• Other Income fell by 29% QoQ. This negatively impacted the profit before tax, which fell by 3.7% QoQ.
• Profit after tax remained flat over the quarter. Growth would have been lower if not for the decrease in tax rates. Effective tax rate decreased by 2.8% QoQ to 25.5% in 3QFY13.
• The company added 89 new clients on a gross basis during the quarter taking the total number of active clients to 776.

Consolidated Financial Snapshot (IFRS)

(Rs m)	2QFY13	3QFY13	Change
Sales	98,580	104,240	5.7%
Expenditure	72,610	77,470	6.7%
Operating profit (EBIT)	25,970	26,770	3.1%
Operating profit margin (%)	26.3%	25.7%	-2.5%
Other income	7,060	5,030	-28.8%
Profit before tax	33,030	31,800	-3.7%
Tax	9,340	8,110	-13.2%
Profit after tax/(loss)	23,690	23,690	0.0%
Net profit margin (%)	24.0%	22.7%
No. of shares		571.4
Diluted earnings per share (Rs)*		163.5
P/E ratio (x)*		16.4

*On a trailing 12 months basis

What has driven performance in 2QFY13?

• Sales growth (combining all segments) of 5.7% QoQ in rupee terms was possible because there was a volume growth of roughly 2% QoQ. This in turn was aided by organic volume growth as well as volume growth on account of the Lodestone acquisition. Revenue growth was also supported by the pricing growth of 1.8%. Excluding Lodestone, the sequential organic revenue growth was 3.6%, and volume growth was 1.5%.

• The IT products business and BPO business delivered a growth surprise by growing at 8.9% and 13.6% sequentially.

• With regard to service offerings, Application Development and Maintenance continued to be the major revenue contributor (35.8% of 3QFY13 revenue) but it saw a de-growth of 1.4% compared to 2QFY13. The highest growth came from Business Process Management, which grew by 17% QoQ and contributed to 5.2% of 3QFY13 revenues. It was followed by Infrastructure Management, which grew by 7.3% QoQ and contributed to 6.9% of 3QFY13 revenue. Testing services grew by 3.3% QoQ while Other Services de-grew by -2.4%. Product Engineering Services de-grew by 0.5% QoQ and contributed to 3.2% of 3QFY13 revenue. Because of the positive growth pattern exhibited by most of the service offerings, the IT Services segment as a whole saw a growth of 1.5%. The other two segments, viz. Consulting and Products, Platforms and Solutions made up for the sub-optimal growth of IT services segment by growing at roughly 15% and 5.7% respectively. The Lodestone acquisition boosted the Consulting service offering's contribution to revenue, which increased to 32.6% as compared to 30% in 2QFY13.

• In terms of industry verticals, Banking, Financial Services and Insurance (BFSI) continued to be the largest revenue contributor making up 33.7% of 3QFY13 revenue, and growing by 5.7% QoQ. The Manufacturing vertical contributed to 21.7% of the total 3QFY13 revenues and saw a growth of 3.8%QoQ. Retail saw a QoQ de-growth of -0.5% whileTransportation & Logistics saw a 12% QoQ growth. Telecom saw a growth of 2.5% and. Energy, Lifesciences and Others verticals saw a growth of 7.7%, 25.7% and 16.3% QoQ respectively .

• On a geographic basis, revenues from the North America and Rest of the World grew by 0.9% and 7.4% respectively during 3QFY13.Revenues from India showed the highest jump and grew by 45.4% QoQ. Revenues from Europe also climbed up by 15.9% QoQ. The growth figures in Europe and India were in sharp contrast to what was observed in 2QFY13, when revenues from the two regions had declined by 2.8% and 18% QoQ.

• The offshore billing rate improved by 17.8% QoQ, while the onsite billing rate saw a marginal decline of 0.9% QoQ.

• Employee utilization (excluding trainees) declined by 0.1% to 73.2% during the quarter. Infosys hired 1,868 employees (on a net basis) during the quarter. Attrition rates went up marginally on a sequential basis and stood at 15.1% at the end of the quarter, compared to 15% at the end of the 2QFY13.
  Reveneu break-up...

  Rs m	2QFY13	3QFY13	Change
  By service offerings
  Application development and maintenance	37,855	37,318	-1.4%
  Application development	16,759	16,470	-1.7%
  Application maintenance	21,096	20,848	-1.2%
  Business Process Management	4,633	5,420	17.0%
  Infrastructure Management	6,703	7,193	7.3%
  Product Engineering Services	3,352	3,336	-0.5%
  Testing Services	8,478	8,756	3.3%
  Others	2,563	2,502	-2.4%
  Total IT services	63,584	64,525	1.5%
  Consulting, Package Implementation & Others	29,574	33,982	14.9%
  Products, Platforms and Solutions	5,422	5,733	5.7%
  Total revenues	98,580	104,240	5.7%
  By industry vertical
  Insurance, Banking and Financial services	33,221	35,129	5.7%
  Manufacturing	21,786	22,620	3.8%
  Retail	16,759	16,678	-0.5%
  Communication (Telecom)	9,759	10,007	2.5%
  Energy (Utilities )	5,225	5,629	7.7%
  Transportation & Logistics	1,676	1,876	12.0%
  Lifesciences & Healthcare	5,225	6,567	25.7%
  Others	4,929	5,733	16.3%
  By geography
  North America	62,993	63,586	0.9%
  Europe	21,589	25,018	15.9%
  India	1,577	2,293	45.4%
  Rest of world	12,421	13,343	7.4%

What to expect?

Like last quarter, the current quarter too turned out to be positive one for Infosys with a sequential growth in sales both in rupee terms as well as in USD terms. The growth in volumes was again an indication towards the improving scenario. What was more impressive was the superior performance from the Products, Platforms and Solutions, which included Finacle and Consulting , Package implementation and Others. At the same time the BPO segment continued to do well too.

The pricing growth was something that should be taken as a good sign. Accordingly, the management was confident in maintaining the USD revenue guidance for FY13 excluding Lodestone. Taking Lodestone into account, the USD revenue growth for the year was guided further up by 1.5%.

While the above paragraphs may indicate that all is fine, we are slightly concerned with the continued fall in operating margin since the last five quarters. The operating margin stood at 31.2% at the end of 3QFY12 but has declined to 25.7% at the end of 3QFY13. Further, there was also a sequential drop in gross margins, since the last three quarters. The gross margin of 37.01% seen during 3QFY13 fell short of the gross margins of 41.28% and 42.13% achieved at the end of FY12 and FY11 respectively.

What gave us relief from the margin pressure aspect was the gradual shaping up of Infosys 3.0 strategy. The benefit of the strategy is visible in the growth in the Consulting business (aided by Lodestone) and the growth of the Products and Platforms businesses. The total contracts booked in these segments increased from US$ 485 mln to US$ 603 mln. Further 20 unique products and platforms were launched and sold to 70 clients. Finacle alone saw a growth of around 9% during the quarter.

Management's confidence with regard to the stable pricing environment also adds to the comfort. If one compared the utilization figure at the end of December 2012 with that of December 2011, one would have seen a drop from 77.4% to 73.2%, which could prove to be a growth lever going forward, assuming utilization reverts towards the average of around 76%.

Deal wins have been very impressive. 8 large deals amounting to $730 mln were closed in 3QFY13.

A closer look at the balance sheet would reveal a large accumulation of cash and cash equivalents, which stood at Rs 224.36 bln at the end of 3QFY13. However, from a value perspective, that should add as a comfort to investors, because Infosys has always been a conservative company and it could be very fair to assume that they would not deploy cash in unrelated activities. Rather the management is expected to use it for value-accretive acquisition as has been observed with Lodestone.

Considering all the above aspects and our conservative projections including expected revenue from the Lodestone acquisition, we continue to maintain our Buy view on the stock from an FY15 perspective.