<>Infosys Technologies Limited, considered to be the benchmark of the <>Indian IT sector, is India's second-largest software services exporter, with annual revenues of over US$ 1 bn. The company has been at the forefront of the growth of the Indian IT sector over the past few years, outperforming (its peers and the sector) even when the times were not so ripe. The company's 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 few years.
In this article, we analyse the patterns shown by the company in terms of its movement up the value chain and attempt to analyse factors, which would give investors - current and potential - a perspective on the company's stock.
Moving up the value chain...
** Contribution of 'new services' like package implementation,
IT consulting and systems integration
One of the prominent growth factors of Infosys over these years has been its continued initiative towards rapidly moving up the software value chain. The graph below indicates the rise in contribution from new services (those other than software development, maintenance, reengineering and BPO) that has been a vindication of the company's efforts in this regard. Also, in FY03, the company restructured its processes from being geography-based to vertical-based, which has further helped it in developing its domain competencies, thus aiding the move up the value chain. In the early part of FY05, the company established a focused entity - Infosys Consulting - to cater to the IT consulting business, and this shows a clear intent on the company's part to increase the share of this high-end business.
The 'catch-22' situation...
However, this move up the value chain has not come without its share of challenges, one of the foremost being the impact on operating margins of the company. Over the years, the operating as well as net margins of the company have been reducing. Operating margins of over 40% in FY01 have come down to around 33% in FY04. Apart from the fact that billing rates have been under pressure, another critical reason has been the company's move up the value chain.
The company, at the lower end of the value chain, enjoyed higher margins, since, although the billing rates earned were lower, the costs were lower as well. Therefore, the margins were high. Now, as the company moved up the value chain towards providing high-end services, which although command relatively higher billing rates, the impact of higher salaries to domain experts/consultants led to a rise in Infosys' operating costs, thus adding to the margin woes. The impact was also on account of the fact that most of the high-end services have a higher onsite component, which have relatively lower margins than offshore services.
Also, the fact that Infosys has been very aggressive in adding to its employee base and spending towards building up the sales and marketing (S&M) network, has led to a negative impact on the margins. The company currently spends around 7% of its revenues towards S&M initiatives and considering the global average of around 15%, we expect the margins to be impacted further on this account.
Following the 'PSPD' model...
The mantra for Infosys' success in the past has been the 'PSPD' model that stands for -
Predictability: The company has had long-term relationships with its key clients and this has helped it in a better understanding of the future trends in the global technology marketplace. Infosys' repeat business levels (at 95%+ levels) are among the highest in the industry. This has helped in better visibility of growth for the management.
Sustainability: Apart from the above factor of long-term client relationships, the company has, over the years transformed a large number of its customers into partners, which whom the company has build on innovative processes and technologies. This has provided the much-required sustainability to the company's growth.
Profitability: As mentioned above, Infosys has been gradually moving up the value chain. While this has impacted margins in recent times on account of a higher onsite proportion that these services carry, the fact that a lot of these are being gradually moved offshore will help the company pare margin decline. Rising contribution of high-value services also aids improvement in the productivity levels.
De-risking: The company has been gradually shifting its revenues from the US region to other large markets like the EU and Asia Pacific. Apart from this, the company has also reduced its exposure from a few clients and now has one of the largest client bases in the industry. These moves are all in line with the company's aim of de-risking its business model.
With the outsourcing story expected to gain momentum, and with the company's focus on improving its business mix through moving up the value chain, and also diversifying into new markets to de-risk its business model and grow revenues, the outlook for the next few years seems bright. Given its scalable business model and globally recognized execution and delivery capabilities, we believe that Infosys will be at the forefront of the Indian offshoring story in the future. Investors may stay invested at current levels.
Since near-term valuations are at the higher end of the spectrum (31 times expected FY05 earnings), potential investors need to exercise caution at current levels, as the risk-reward balance is skewed towards risk. However, if one is to take a long-term view (3 years or more), Infosys remains one of our top picks from the sector.
The growth achieved over the years (even in times of turbulence) clearly shows that the company's management is highly competent, visionary, can anticipate future trends, and one that can be trusted. And this is one of the foremost factors that need to be considered before investing in a software stock.