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Infosys: A conservative stance

Apr 10, 2003

Infosys closed FY03 with a 39% growth in revenues and a 19% growth in net profits. However, the stock is taking a severe beating on the bourses. This is due to the fact that the company has given an EPS growth guidance of 12% for FY04. This is on the back of significant 24% expected growth in revenues. View Infosys results

This means that the company is factoring in a significant margin decline. The markets have been concerned about falling margins. There is a view that the company is losing margins due to intense pricing pressure, which is to due to competition increasing as a number of global IT services companies are setting up shop in India. This a moot point and we believe that the concerns are over hyped.

(Rs m) FY02 FY03 Change
Revenues 26,036 36,227 39.1%
       
Software development expenses 12,248 18,133 48.0%
% Of revenues 47.0% 50.1%  
Selling and marketing expenses 1,298 2,670 105.7%
% Of revenues 5.0% 7.4%  
General and administrative expenses 2,114 2,704 27.9%
% Of revenues 8.1% 7.5%  
Total expenses 15,660 23,507 50.1%
% Of revenues 60.1% 64.9%  
Operating profit 10,376 12,720 22.6%
Operating margin 39.9% 35.1%  

Our view is based on a closer look at Infosys’ margins for FY03. Infosys’ operating margins have declined by 4.8%. While increased software development expenses have caused 3.1% erosion in operating margins, the company has managed to offset the impact by cutting corners. Lower general and administrative costs have helped cushion the operating margin decline by 0.6%. Thus, net, net, there has been a negative impact of 2.5%. An equally strong blow has, however, come from the company stepping up its selling and marketing expenses. The figure has shot up from 5% of revenues in FY02 to 7.4% of revenues in FY03, thus shaving off 2.4% from operating margins.

But that is not to say that there is no margin pressure on the software companies. The point we are trying to make is that the pressure exists, but going forward the decline in margins is likely to be gradual as compared to expectations of a steep fall (seen in FY03).

Before looking into the future let us look that the company’s performance in FY03.

Client additions
The company added 28 new clients during the quarter compared to 23 clients added in 3QFY03. This is the highest number of client added in the past four quarters. Considering the tough business environment this is quite an achievement. The total number of active clients at the end of the fiscal stood at 345. The company witnessed some client visit cancellations due to the war in Iraq and the SARS outbreak in the Far East.

Client additions 1Q 2Q 3Q 4Q Total
FY02 26 28 33 29 116
FY03 23 18 23 28 92

Verticals
Business for the year was driven by growth from the BFSI (banking, financial services and insurance) verticals. While the growth in business from banking and financial services industry was robust, the growth from the insurance vertical was subdued. Infact in 4QFY03, revenues from this vertical have shown a decline compared to 3QFY03. Insurance companies are reeling from the underwriting losses arising due to the WTC terrorist attacks and accounting scams. The banking business unit added another new client to its folds. Canara Bank decided to deploy FINACLE eChannles and FINACLE eCorporate. Two of the company’s clients Union Bank and Bank of Bahrain and Kuwait went live with Infosys’s flagship banking product FINACLE.

(Rs m) 3QFY03 % of total 4QFY03 % of total Change FY02 % of total FY03 % of total Change
Insurance, banking & financial services 3,614 37.7% 3,773 37.0% 4.4% 9,555 36.7% 13,621 37.6% 42.6%
Insurance 1,352 14.1% 1,244 12.2% -8.0% 4,244 16.3% 5,180 14.3% 22.1%
Banking & financial services 2,262 23.6% 2,529 24.8% 11.8% 5,311 20.4% 8,441 23.3% 58.9%
Manufacturing 1,649 17.2% 1,540 15.1% -6.6% 4,452 17.1% 5,941 16.4% 33.4%
Retail 1,122 11.7% 1,132 11.1% 0.9% 3,202 12.3% 4,130 11.4% 29.0%
Telecom 1,390 14.5% 1,662 16.3% 19.6% 4,062 15.6% 5,506 15.2% 35.6%
Energy & Utilities 249 2.6% 357 3.5% 43.2% 521 2.0% 1,051 2.9% 101.8%
Transportation & logistics 633 6.6% 744 7.3% 17.7% 703 2.7% 2,463 6.8% 250.4%
Others 930 9.7% 989 9.7% 6.4% 3,541 13.6% 3,514 9.7% -0.8%
Total 9,586 100.0% 10,199 100.0% 6.4% 26,036 100.0% 36,227 100.0% 39.1%

A positive development is the strong growth in revenues from telecommunications vertical. In 4QFY03 the revenues from this vertical grew 16% sequentially. For the full year FY03, growth in revenues from this vertical was 36% (16% in FY02). The IT services companies had initially focused on the equipment manufactures like Cisco and Nortel in the vertical. However, these companies were the worst affected due to the technology meltdown and therefore, growth business flow from this segment was weak. Companies like Infosys had sometime back decided to target the Telecom Service Providers (TSP) segment for growth. The strategy seems to be paying off. During the quarter, the company added TeliaSonera a Europe based TSP to its client list.

Also business from verticals like energy, utilities and transportation showed significant growth, much higher than seen in FY02. This is despite a much higher base in FY03. This indicates the company’s ability to tap new business opportunities and consistently deliver.

Service offerings
The software sector’s bread and butter - business development and maintenance - continued to show steady growth. However, it was interesting to note that the revenues from package implementation spiked, growing 36% in 4QFY03. For the full year however, revenues from this service offering were much lower at 56% compared to 86% in FY02. Growth in revenues from the consulting business was quite heartening. Compared to a growth of 17% in FY02, the growth in revenues from consulting was 42% in FY03. Infosys has been focusing on this area for future growth. We believe that the company’s focus on consulting is the key factor that differentiates Infosys from its peers. Going forward not only will the company have a competitive advantage of implementing in recommendations to its clients, but the company will also have the advantage of a high barrier to entry.

(Rs m) 3QFY03 % of total 4QFY03 % of total Change FY02 % of total FY03 % of total Change
Development 3,144 32.8% 3,182 31.2% 1.2% 8,331 32.0% 11,629 32.1% 39.6%
Maintenance 2,675 27.9% 2,682 26.3% 0.3% 7,550 29.0% 10,216 28.2% 35.3%
Re-engineering 479 5.0% 551 5.4% 14.9% 2,630 10.1% 1,992 5.5% -24.2%
Package implementation 1,055 11.0% 1,438 14.1% 36.4% 2,552 9.8% 3,985 11.0% 56.2%
Consulting 431 4.5% 398 3.9% -7.8% 1,094 4.2% 1,558 4.3% 42.5%
Testing 336 3.5% 377 3.7% 12.5% 755 2.9% 1,232 3.4% 63.1%
Engineering services 230 2.4% 245 2.4% 6.4% 677 2.6% 942 2.6% 39.1%
Other services 824 8.6% 836 8.2% 1.4% 1,406 5.4% 3,007 8.3% 113.9%
Total services 9,174 95.7% 9,709 95.2% 5.8% 24,994 96.0% 34,560 95.4% 38.3%
Products 412 4.3% 490 4.8% 18.8% 1,041 4.0% 1,666 4.6% 60.0%
Total revenues 9,586 100.0% 10,199 100.0% 6.4% 26,036 100.0% 36,227 100.0% 39.1%

Growth in the products business halved from 119% in FY02 to 60% in FY03. This is due to stiff competition from other players like i-flex. According to a report by Gartner, worldwide banking and credit industry was expected to spend US$ 29 bn (Rs 1,392 bn) on software and US$ 95 bn on external services in 2002. This means with revenues of Rs 1,041 m in FY02, Infosys had a market share of 0.1%. i-flex Solutions with revenues of Rs 2,462 m from its products business in FY02 had a market share of just 0.2%. Like other market estimates, the size potential of the markets could be grossly over estimated. However, even if we cut the market size to half, with less than 1% penetration of the markets, a huge opportunity lies in waiting for the Indian IT services industry.

Outlook
Thus, as far as FY03 is concerned, the company not only delivered on what it has committed also consolidated its presence in areas that promise growth. The markets are nervous about the company’s guidance for FY04. But this comes at a time when there is a lot of uncertainty in the global economic environment. While it is extremely difficult to predict the turnaround, but when it happens companies like Infosys will be the biggest beneficiaries. Thus, with expectations of future growth investors could look at investing the stock for a long-term (three to five year) perspective. For those holding the stock, there is no need to panic. The reaction on the bourses is not a credible source for judging the future growth prospects for quality of a company. We will be updating our research report on the company soon. Please read our research report before making your investment decision.

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