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Infosys FY07: Bangalore wins over Mumbai! - Views on News from Equitymaster

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Infosys FY07: Bangalore wins over Mumbai!

Apr 13, 2007

Introduction to results
Infosys has announced strong results for the quarter and full year ended March 2007. For FY07, the company has recorded a 46% YoY and 57% YoY growth in revenues and net profits respectively. However, led by higher sales and administrative expenses, the operating margins have shrunk by 90 basis points (0.9%) for the fiscal. The results are very much in line with our estimates with actual revenues lower by a mere 2% and net profits higher by 3% as compared to our estimates. The board has recommended a final dividend of Rs 6.5 per share (dividend yield of 0.3%). In a major change at the top management level, Kris Gopalkrishnan (currently COO, President and joint-MD) has been appointed as the CEO and MD of Infosys. Nandan Nilekani, the current CEO and MD will take over as Co-Chairman of the company.

Financial performance (Consolidated): A snapshot…
(Rs m) 3QFY07 4QFY07 Change FY06 FY07 Change
Sales 36,550 37,720 3.2% 95,210 138,930 45.9%
Expenditure 24,590 25,750 4.7% 64,300 95,020 47.8%
Operating profit (EBDITA) 11,960 11,970 0.1% 30,910 43,910 42.1%
Operating profit margin (%) 32.7% 31.7%   32.5% 31.6%  
Other income 590 1,190 101.7% 1,390 3,720 167.6%
Provision for investments - (10)   10 20 100.0%
Depreciation 1,410 1,450 2.8% 4,370 5,140 17.6%
Profit before tax 11,140 11,720 0 27,920 42,470 52.1%
Extraordinary items - -   - 60  
Tax 1,300 270 -79.2% 3,130 3,860 23.3%
Minority interest 10 10 0.0% 210 110 -47.6%
Profit after tax/(loss) 9,830 11,440 16.4% 24,580 38,560 56.9%
Net profit margin (%) 26.9% 30.3%   25.8% 27.8%  
No. of shares (m) 567.7       569.3  
Diluted earnings per share (Rs)         67.7  
P/E ratio (x)         30.8  

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 (18%), 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.

What has driven performance in FY07?
Growth everywhere: Defying all concerns of negative impact on revenues on account of an appreciating rupee against the US dollar, Infosys has recorded a strong 46% YoY growth in topline during FY07, which has taken the same to above the US$ 3 bn mark. This growth was a result of strong performance on both billing rates and volumes (man-hours) front. For 4QFY07, while billing rates rose by 1.8% and 1.4% QoQ for onsite and offshore services respectively, the volumes grew by 4% and 3.4% QoQ respectively. However, it must be noted that this was the slowest quarter in terms of sequential volume growth for Infosys during FY07.

Services split: 'Newer' service lines continue to enthuse
  FY06 FY07  
  Rs m % of total Rs m % of total Change
Development 19,232 20.2% 29,175 21.0% 51.7%
Maintenance 28,753 30.2% 40,706 29.3% 41.6%
Re-engineering 4,475 4.7% 2,918 2.1% -34.8%
Package implementation 15,424 16.2% 24,313 17.5% 57.6%
Consulting 3,332 3.5% 5,001 3.6% 50.1%
Testing 5,617 5.9% 9,586 6.9% 70.7%
Engineering services 1,714 1.8% 2,223 1.6% 29.7%
Business Process Management 3,808 4.0% 6,530 4.7% 71.5%
Other services 9,235 9.7% 13,059 9.4% 41.4%
Total services 91,592 96.2% 133,512 96.1% 45.8%
Products 3,618 3.8% 5,418 3.9% 49.8%
Total revenues 95,210 100.0% 138,930 100.0% 45.9%

If one were to analyse revenues in terms of service lines, it were the development, maintenance and package implementation businesses which stole the show with YoY growth rates of 52%, 42% and 58% respectively. The company also saw strong traction in consulting, BPO and products (Finacle, the banking suite) segments during the fiscal. Banking and retail verticals continued to be Infosys’ mainstays during the quarter, recording strong growth of 52% YoY and 45% YoY growth respectively. Based on geographies, while business from North America (63% of revenues) grew by 43% YoY during FY07, Europe (26% of revenues) continued to lead the way with a 57% YoY growth.

The company added a net of nearly 2,800 employees during 4QFY07 (3,300 during 3QFY07), thus taking the total net addition to 19,500 employees during the fiscal. The total employee base now stands at over 72,000. Attrition rates have also increased marginally during the fourth quarter, to 13.7% (13.5% in 3QFY07). 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 34 clients during the quarter (net addition of 12 clients). Importantly, the fourth quarter saw the company adding its first client in the US$ 200 revenue per annum bucket. Traction was also seen in US$ 90 m to US$ 100 m client buckets. Contribution from the company’s top 10 clients increased from 31% of revenues in 3QFY07 to over 33% in 4QFY07.

Cost savings aid margin expansion: The 3.1% appreciation of the rupee vis-à-vis the US dollar during FY07 seems to have taken its toll on Infosys’ operating margins, which have contracted by 90 basis points YoY during FY07. Based on cost heads, while software development expenses (85% made of employee costs) increased from 53.2% of sales in FY06 to 53.7% in FY07, sales and marketing costs also recorded a marginal increase (as percentage of revenues) during the fiscal, thus impacting operating margins. The fourth quarter margins declined by 100 basis points, duly aided by lower utilisation levels (excluding trainees). The company’s actual operating margin (31.6%) performance is almost on target with respect to our estimates of 31.5% margins. The company has announced a 12% to 15% hike in salaries for its offshore (India) employees, which shall impact its profitability in the current quarter (1QFY08).

Higher other income aids bottomline: Despite the contraction in operating margins during the fiscal, Infosys still managed to grow its bottomline at a rate faster than the topline growth. This was made possible by a strong growth in other income (168% YoY), which was due to significantly higher interest and dividend income on investments. At the end of March 2007, Infosys had cash and cash equivalents of nearly Rs 59 bn (approx US$ 1.4 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).

The benefit of this higher other income was seen in the 200 basis points expansion in Infosys’ net margins during FY07 (to 27.8%), which was eventually higher than what we had estimated for the company (26.2%).

What to expect?
At the current price of Rs 2,110, the stock is trading at a price-to-earnings multiple of 19.4 times our estimated FY09 earnings. The management has guided for a 23% to 25% YoY growth in revenues and 20% to 22% YoY growth in earnings for FY08, which we believe is conservative considering the strong traction that the company is witnessing in the offshoring of IT services from global corporations.

The management has indicated that the earnings growth guidance for the current fiscal has been lower on account of equity dilution due to ESOP allotment (there has been a 3% equity dilution due to ESOP allotment). The management also does not foresee any imminent slowdown in global IT spending, as has been feared by many ‘experts’. In fact, the pressure to cut costs is forcing more and more international companies to offshore their IT processes to Indian offshore service providers like Infosys.

We, however, maintain that the challenges for the company in terms of managing this growth, by way of attracting and retaining the right kind of talent as also managing the consistent rise in employee costs (which is expected to impact margins) will keep the management busy in times to come. Appreciation of the rupee and its impact on profitability will also be a thing to look out for in the future. However, as we have maintained in the past, improving revenue productivity, leverage from past sales and marketing initiatives, as also aggressive move towards offering high value services should more than negate the demons of rising costs and currency volatility.

We maintain our positive recommendation on the stock from a 2-3 years perspective.

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