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Infosys FY06 results: Our view - Views on News from Equitymaster
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Infosys FY06 results: Our view
Apr 14, 2006

Infosys has announced its financial results for the fourth quarter and full-year ended March 2006. Despite decent volume growth, revenues expanded only at a muted pace during the fourth quarter, chiefly impacted by a stronger rupee. The rupee appreciation also impacted operating margins, which fell significantly during the quarter and, in fact, were actually lower on an absolute basis as well. Net profit, however, witnessed an expansion, albeit subdued, due to strong other income earned, as also a lower effective tax rate. For the full-year FY06, the performance has been good, albeit marginally lower than our estimates.

Financial performance (Consolidated): A snapshot
(Rs m) 3QFY06 4QFY06 Change FY05 FY06 Change
Sales 25,320 26,240 3.6% 71,300 95,210 33.5%
Expenditure 16,710 17,910 7.2% 47,950 64,300 34.1%
Operating profit (EBDITA) 8,610 8,330 -3.3% 23,350 30,910 32.4%
Operating profit margin (%) 34.0% 31.7%   32.7% 32.5%  
Other income (50) 720   1,240 1,390 12.1%
Provision for investments - -   - 10  
Depreciation 1,170 1,440 23.1% 2,870 4,370 52.3%
Profit before tax 7,390 7,610 3.0% 21,720 27,920 28.5%
Extraordinary items - -   450 -  
Tax 830 810 -2.4% 3,260 3,130 -4.0%
Minority interest 70 70   - 210  
Profit after tax/(loss) 6,490 6,730 3.7% 18,910 24,580 30.0%
Net profit margin (%) 25.6% 25.6%   26.5% 25.8%  
No. of shares (m) 281.6 282.3   275.6 280.8  
Diluted earnings per share (Rs)       67.3 87.5  
P/E ratio (x)         34.5  

What is the company's business?
Infosys is India's second largest software services exporter and offers a bouquet of services, including software development (20% of revenues), maintenance (30%), IT consulting (4%), package implementation (16%), products (4%) and BPO (4%). Infosys' 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. During the period between FY01 and FY06, the company's revenues and net profits have grown at compounded rates of 38% and 31% respectively, outpacing the industry by a far margin.

What has driven performance in FY06?
Volume-driven topline: Infosys' topline saw a robust growth of 34% YoY during FY06. This was led by strong volume growth, particularly onsite. Initial calculations show that onsite volumes grew by over 36% YoY during the fiscal. Billing rates this year were relatively flat. Good traction in major horizontals, particularly new services, such as package implementation, testing and BPO, led to the strong overall growth in the topline. To give a perspective, revenues from new service lines (excluding development, maintenance, re-engineering and products) grew at almost 46% YoY, considerably faster than the overall revenues, and revenues from such services constituted 41% of the total revenues in FY06, as compared to less than 38% in FY05.

Revenue streams: New services drive the topline!*
  FY05 FY06  
  Rs m % of total Rs m % of total Change
Development 16,542 23.2% 19,232 20.2% 16.3%
Maintenance 21,319 29.9% 28,753 30.2% 34.9%
Re-engineering 4,421 6.2% 4,475 4.7% 1.2%
Package implementation 10,838 15.2% 15,424 16.2% 42.3%
Consulting 2,567 3.6% 3,332 3.5% 29.8%
Testing 4,135 5.8% 5,617 5.9% 35.8%
Engineering services 1,426 2.0% 1,714 1.8% 20.2%
Business Process Management 1,925 2.7% 3,808 4.0% 97.8%
Other services 5,989 8.4% 9,235 9.7% 54.2%
Total services 69,161 97.0% 91,592 96.2% 32.4%
Products 2,139 3.0% 3,618 3.8% 69.1%
Total revenues 71,300 100.0% 95,210 100.0% 33.5%
* New services exclude development, maintenance, re-engineering and products

During the fourth quarter, however, topline saw a subdued growth of less than 4% sequentially. This was achieved, despite decent volume growth of 7% QoQ onsite, and 6% QoQ offshore. Billing rates improved by 0.6% QoQ onsite and 0.3% QoQ offshore during the quarter. Clearly, the rupee movement during the quarter impacted Infosys, with the company stating that the realised rupee rate during 4QFY06 was Rs 44.22 to the dollar, as compared to Rs 45.30 in 3QFY06. As regards client addition, the company added 38 new clients during 4QFY06, taking the total number of active clients to 460 (438 at the end of FY05). The number of clients in all major revenue buckets grew, with a total of 9 clients now giving the company revenues in excess of US$ 50 m per year. This shows strong visibility in revenues going forward.

Margins take a hit: For 4QFY06, margins declined from 34% to less than 32%, mainly due to a significant rise in general and administrative expenses. However, sales and marketing (S&M) expenses reduced as a percentage of sales, from 6.2% in 3QFY06 to 5.8% this quarter. The total cost of sales also increased to over 54% of sales, from around 52% last quarter. This was also a result of the lower rupee realised rate. In fact, even on an absolute basis, the operating profit was lower than in 3QFY06.

For the full-year FY06, operating margins dipped slightly by nearly 30 basis points. The expenses increased in line with the revenues, resulting in this performance. Nonetheless, S&M leverage continues for Infosys, with these expenses constituting 6.3% of sales in FY06, as compared to 6.5% in FY05. We have indicated in the past that the company is likely to get scale benefits from past investments in S&M, and this decline, albeit slight, does vindicate our stance. The ever-improving client metrics are also testimony to the fact that Infosys will need to spend less on S&M in order to effectively mine its clients. This will be a major lever that the company has to pare the pace of margin decline in future.

Infosys saw a net hiring of 3,293 employees in 4QFY06. For the fiscal, the net hiring stood at 15,965. This takes the total headcount of the company and its subsidiaries to 52,715. The attrition rate has increased to 11.2%, as compared to 9.7% in FY05. Undoubtedly, this is a sign that competition for good talent is intensifying, and indications from various companies are that this is being witnessed more at the mid-management levels. This, we believe, is here to stay, and software companies will need to take effective measures to retain their best talent in order to compete effectively against their Indian peers as well as global competitors.

Other income saves the day: In 4QFY06, net profits grew at a rate of 3.7% sequentially. This was despite the significant decline in margins. The major drivers of growth in the bottomline were a strong other income component, as compared to a loss in the previous quarter, and a decline in the effective tax rate. For FY06, net profit growth stood at a strong 30% YoY. In fact, if we remove the extraordinary item of income received on sale of the company's stake in Yantra Corporation (Rs 450 m) in FY05, net profits grew at over 33% YoY, almost the same rate as revenues.

Performance in the recent past…
  1QFY06 2QFY06 3QFY06 4QFY06
Sales growth (%, QoQ) 4.2 10.7 10.4 3.6
Development expenses (% of sales) 53.3 52.8 52.4 54.2
Selling expenses (% of sales) 6.8 6.5 6.2 5.8
Operating margins (%) 32.0 32.0 34.0 31.7
Profits growth (%, QoQ) (4.8) 13.9 7.1 3.7
Employees (Nos.) 39,806 46,196 49,422 52,715
Utilisation including trainees (%) 74.1 72.9 70.0 69.7

What to expect?
At the current price of Rs 3,021, the stock is trading at a price to earnings multiple of 19.9 times our estimated FY08 earnings. The company has slightly under-performed our FY06 estimates on the revenue front by 1.2% and on the net profits front by 1.7%. As regards margins, while we had estimated EBIDTA margins to be at 33.0% in FY06, the company has achieved 32.5%.

For FY07, the management has projected revenues and profits to grow by 28.7%-30.7% and 26.4%-28.4% respectively. The board has recommended a final dividend of Rs 8.5 per share, and also a special dividend of Rs 30 per share in view of the company completing its 'Silver Jubilee' of existence. This takes the total dividend for FY06 to Rs 45 per share (dividend yield of 1.5%). The board has also recommended a bonus issue of shares in the ratio of 1:1 (one additional share for every existing share held).

The guidance given clearly shows confidence of the management in the company's future growth prospects. In fact, in the past, the company has generally been conservative in its initial guidance at the start of the fiscal. This year, the management has stated that the demand environment is looking stronger than what it was at the same time last year. Thus, Infosys, being a key player, seems poised to benefit from this.

The bonus issue and the dividend are also good for shareholders, given that the company has Rs 47.1 bn (US$ 1.05 bn) in cash and cash equivalents. The company expects to spend Rs 16 bn to Rs 18 bn towards capex in FY07. Clearly, given improving client metrics and a maturing environment in the offshoring business, business prospects appear strong. It must be noted that this guidance is without considering any large deals that may be won by the company. If this happens, then the actual performance could far exceed the guidance, as has been the case in the past.

Of course, the risks need to be taken into account as well. The increasing attrition rates point towards intensifying competition for talent, and wage inflation could also become more severe. Increasing competition in terms of increasing offshore presence of MNCs is also likely to intensify the pressure on Infosys as well as other Indian software companies. Margin pressure, thus, is very much a reality. However, we believe that the top-tier players in the sector, including Infosys, are in the best position to overcome these hurdles. Thus, we remain positive on these companies from a longer-term perspective.

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