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Infosys: Back to the future
Mar 23, 2007

As the date for reporting fourth quarter and full year FY07 results nears, all eyes are set on as to what Infosys, one of the firsts to announce results, will have in store in terms of its expectations from the future of the technology sector. In this article, we have broadly outlined what investors can expect from the company over the next few years as also given a perspective of why the company has been successful in guarding its profitability against competition from peers, both domestic and global. Brief financial analysis

In terms of overall revenues, Infosys has grown at a CAGR of 37% during the period FY01 to FY06. In terms of EBITDA and PAT margins, the company has outperformed its peers over these years. In spite of the challenges in terms of rising employee costs and competition for business and talent, the fact that the company has managed to maintain an EBITDA margin of 33% - 35% over the last five years, which is the highest in the industry, is commendable.

Brief financial analysis
Infosys FY 01 FY 02 FY 03 FY 04 FY 05 FY 06 Q1FY07 Q2FY07 Q3FY07
Revenue 19,006 26,036 36,227 47,609 68,597 90,280 28,670 32,730 34,540
EBITDA 7,648 10,376 12,720 15,837 23,251 29,890 8,740 10,540 11,490
PAT 6,233 8,080 9,579 12,435 18,592 24,210 7,990 8,960 9,580
EBITDA Margin 40.2% 39.9% 35.1% 33.3% 33.9% 33.1% 30.5% 32.2% 33.3%
Net Margin 32.8% 31.0% 26.4% 26.1% 27.1% 26.8% 27.9% 27.4% 27.7%

How Infosys has managed to maintain its margins?
While Infosys’ operating margins have tapered down over the years (see above table), the decline has been less severe than what has been reported by its peers. One of the foremost reasons for the same is the fact that the company, over the years, has maintained a good blend of onsite and offshore revenues. Greater onsite component results in higher billing rates but it is lower in terms of margins whereas offshore is lower in term of billing rates but higher on margins. This is simply due to the fact that onsite presence entails higher cost of employees vis-à-vis offshore employee costs. Along with that, the company has successfully executed on its global delivery model by way of transferring work offshore (as seen from the reduction in share of onsite volumes, or person months, to total volumes).

Revenues by location (including product revenues)
  FY 01 FY 02 FY 03 FY 04 FY 05 FY 06 Q1FY07 Q2FY07 Q3FY07
Onsite 51.5% 50.8% 54.7% 53.0% 50.2% 49.8% 50.5% 50.3% 49.2%
Offshore 48.5% 49.2% 49.3% 47.0% 49.8% 50.2% 49.5% 49.7% 50.8%
Person months                  
  FY 01 FY 02 FY 03 FY 04 FY 05 FY 06 Q1FY07 Q2FY07 Q3FY07
Onsite 34.0% 30.7% 33.7% 31.6% 29.4% 29.2% 27.4% 27.4% 26.5%
Offshore 66.0% 69.3% 66.3% 68.4% 70.6% 70.8% 72.6% 72.6% 73.5%

Secondly, the company’ gradual move towards increasing revenues from high-end value creating services like package implementation, systems integration and IT Consulting has also helped the things on the profitability front. There has been a marked shift towards these services over the last few years. These high-end services command higher billing rates and are also higher in terms of margins. Going forward, with Infosys focusing on these services more than before, maintaining tight control on margin deceleration will not be a tough task. However, rising employee costs and expansion by way of setting onsite development centres, as also appreciation of the rupee, might be dampeners to the company’s margin profile.

Talent management: An IT company, which is human capital intensive, will not survive in the long run if it does not have a strong human resource policy. One of the main strengths of Infosys’ success over the years has been its strong human resource team. The company has grown its employee base at a compounded annual growth rate of 40% during the period FY01 to FY06. However, with rise in employee base, also intensive competition for talent from peers, the company has reported increasing attrition levels, which is a cause for concern. While the company’s attrition rate is still lower than most of its peers, the fact that it has been rising over the past few quarters is a matter of utmost concern

Utilisation rates FY 01 FY 02 FY 03 FY 04 FY 05 FY 06 Q1FY07 Q2FY07 Q3FY07
Including trainees 67.4% 70.1% 77.6% 73.5% 72.9% 71.4% 71.1% 67.5% 67.5%
Excluding trainees 78.3% 72.9% 82.2% 82.1% 80.0% 78.6% 76.1% 77.5% 75.8%
Employees 9,831 10,738 15,356 25,634 36,750 52,715 58,409 66,150 69,432
Attrition rate 11.2% 6.2% 6.9% 10.5% 9.7% 11.2% 11.9% 12.9% 13.5%

What to expect?
At the current price of Rs 2,092, the stock is trading at a multiple of 19.3 times our estimated FY09 earnings. While we are not in the business of making quarterly or short-term calls on companies, we do believe that the appreciation in the value of the Indian rupee vis-à-vis the US dollar will impact Infosys’ (as also its peers’) operating margins in the latest quarter. As a matter of fact, every 1% appreciation in the value of rupee impacts Indian software companies’ operating margins by around 0.3% (30 basis points). This is die to the fact the that while these companies generally derive 100% of their revenues in foreign currencies (largely US dollar), only about 70% of their costs are in these foreign currencies (which negates the effect of rupee appreciation).

We have factored in slight margin pressure for most of the top tier IT companies for the next 2-3 years, base on our assumptions of rising employee costs and rupee appreciation. Any slowdown in the US economy might make matters worse, especially for mid-size players. However, we expect companies like Infosys to continue their journey onto the growth path, mainly on the back of their superior execution skills and scalable business models.

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