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Infosys: Stay tuned!

Apr 14, 2005

Performance Summary
In line with our expectations and the management's earlier projections, Infosys has announced strong results for FY05. However, while the sequential topline growth for the fourth quarter of the fiscal has been decent, the profit growth has not been enthusing if one were to remove the effect of a one time income from the sale of Yantra Corporation. On the margins front, while 4QFY05 margins have expanded sequentially by 60 basis points, those for FY05 have remained flat.

Financial performance (Consolidated): A snapshot…
(Rs m) 3QFY05 4QFY05 Change FY04 FY05 Change
Sales 18,756 19,873 6.0% 48,530 71,297 46.9%
Expenditure 12,576 13,206 5.0% 32,588 47,946 47.1%
Operating profit (EBDITA) 6,180 6,667 7.9% 15,942 23,350 46.5%
Operating profit margin (%) 32.9% 33.5%   32.8% 32.8%  
Other income 463 323 -30.3% 1,234 1,239 0.4%
Depreciation 739 998 35.0% 2,367 2,869 21.2%
Profit before tax 5,904 5,992 1.5% 14,808 21,720 46.7%
Extraordinary items 4 449   (97) 453  
Tax 934 855 -8.5% 2,275 3,256 43.1%
Profit after tax/(loss) 4,973 5,586 12.3% 12,436 18,917 52.1%
Net profit margin (%) 26.5% 28.1%   25.6% 26.5%  
No. of shares 267.9 270.6   266.6 270.6  
Diluted earnings per share* (Rs) 73.5 82.6   46.0 69.9  
P/E ratio (x)         30.0  
(* annualised)            

What is the company's business?
Infosys is India's second largest software services exporter and has a presence in a vast array of service segments, which include software development (23% of revenues) and maintenance (30%), IT Consulting (4%), package implementation (15%), products (3%) and BPO (3%). 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 years.

What has driven performance in FY05?
All-round growth aids topline: The strong YoY growth in the topline in FY05 was a combined result of growth in both onsite and offshore volumes and billing rates and improvement in utilization. On the volumes front, while onsite and offshore volumes have grown sequentially by 5% and 7% respectively in 4QFY05, the growth is significantly lower than what was seen in the third quarter of the fiscal, where onsite and offshore volumes grew by 11% and 13% respectively.

There were some reasons to cheer on the billing rates front. Compared to the sequential declines seen in both onsite and offshore rates in 3QFY05 these improved by 1.3% and 0.9% respectively during 4QFY05. The management has indicated getting higher than average rates from their new clients as the reason for the same. Moreover, the management has maintained that stability in billing rates is likely to continue going forward as well. Utilisation rates (including trainees) improved from 71% in 3QFY05 to 73% in this quarter and this has further bolstered the topline growth. The increase in utilisation seems to be an effect of the fact that the company hired only 1,521 employees in the quarter, something which is much slower than what has been seen in the earlier quarters.

Revenue streams: All-round growth!
FY04 FY05
Rs m % of total Rs m % of total Change
Development 12,472 25.7% 16,541 23.2% 32.6%
Maintenance 14,607 30.1% 21,318 29.9% 45.9%
Re-engineering 2,912 6.0% 4,420 6.2% 51.8%
Package implementation 7,037 14.5% 10,837 15.2% 54.0%
Consulting 1,796 3.7% 2,567 3.6% 42.9%
Testing 2,572 5.3% 4,135 5.8% 60.8%
Engineering services 1,068 2.2% 1,426 2.0% 33.6%
Business Process Management 776 1.6% 1,925 2.7% 147.9%
Other services 3,931 8.1% 5,989 8.4% 52.4%
Total services 47,171 97.2% 69,158 97.0% 46.6%
Products 1,359 2.8% 2,139 3.0% 57.4%
Total revenues 48,530 100.0% 71,297 100.0% 46.9%

One important facet of Infosys' topline growth in FY05 is that revenues from all its services have grown strongly on a YoY basis, the most important being growth in development, consulting and products. Development services, which contributed to around 23% of the company's FY05 revenues, witnessed a YoY growth of 33%. Importantly, as we had mentioned in the past, growth in this segment indicates an increasing focus towards discretionary spending, or to put it simply, it means that clients are demanding new software development, something that has taken the backseat during the years of slowdown in technology spending. The strong growth in FY05, thus, comes as a good omen for the company! Also, the fact hat consulting revenues have grown YoY by 43%, shows that the benefits of having a focused approach (through Infosys Consulting) towards this high-end business are finally filtering for the company.

The company added a gross of 37 clients in the quarter (38 in 3QFY05) and the active client base now stands at 438. One thing, however, is disappointing that the net addition in clients has only been 4, from 434 in 3QFY05. This means that, during 4QFY05, around 33 clients ended their relationship with the company.

Low S&M helps margin stability: Infosys consolidated margins remained flat at 32.8% in FY05. This was when its development expenses and general & overhead expenses have increased as a percentage of sales. The stability in margins was due to a fall in sales and marketing (S&M) expenses, from 7.2% of sales in FY04 to 6.5% of sales in FY05. We had indicated in the past that the company is likely to get scale benefits from the S&M expenditure made in the past and the decline in FY05 only goes to vindicate the same. Even going forward, we expect this to be a guiding force in paring the pace of margin decline.

Yantra spells ‘mantra' for net profits: During 4QFY05, Infosys sold its entire investment in Yantra Corporation for a total consideration of US$ 12.6 m. The realized gains from this sale were Rs 451.9 m, which is shown as an extraordinary item in the profit and loss account. While this item has seemingly not cast its effect on the full year results, if one were to consider 4QFY05 profits, the growth reduces to 3.2% QoQ, from the actual 12.3%, if we exclude the effect of this income.

Performance in the recent past…
1QFY05 2QFY05 3QFY05 4QFY05
Sales growth (%, QoQ) 12.4 15.3 7.2 6.0
Development expenses (% of sales) 53.1 53.0 52.9 52.4
Selling expenses (% of sales) 6.9 7.0 6.2 5.9
Operating margins (%) 32.2 32.1 32.9 33.5
Profits growth (%, QoQ) 15.8 15.2 11.2 12.3
Employees (Nos.) 27,939 32,949 35,229 36,750
Utilisation (%) 73.4 71.4 71.4 73.2

What to expect?
At the current price of Rs 2,100, the stock is trading at a price to earnings multiple of 30.0 times FY05 EPS and 24.7 times management's estimated FY06 EPS of Rs 85 per share. For FY06, the management has projected revenues and profits to grow by 25%-26% and 23%-25% respectively. The board has recommended a final dividend of Rs 6.5 per share (dividend yield of 0.3%).

As per our projections, we expect FY06 and FY07 EPS to be Rs 88 per share and Rs 111 per share respectively. At the current price, this implies price to earning multiples of 23.9 times (for FY06) and 18.9 times (FY07). This indicates that investors can realize a return of around 26% point-to-point through holding the stock till FY07 (CAGR of over 12%).

While the management's growth projections for FY06 seem suppressed considering the company's past track record, investors should note that Infosys has a history of underpromising and overperforming. Also, we believe that rather than taking this as an estimate for future growth, investors should take this as an underlying rate below which Infosys ‘would not' perform, whatever the case may be! Also, the FY06 revenue guidance seems muted in the face of uncertainly surrounding the fringe benefit tax and the movement of the currency rate.

What is more important, however, is the fact that the company is putting the right strategies into place and some have actually started bearing fruit (like the leverage from past S&M investments and strong growth from the consulting business). Overall, we continue to believe that Infosys is likely to be amongst the foremost beneficiaries of growth in offshoring going forward.

We shall put up the updated research report on the company after a conference call with the management. Stay tuned!

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