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Infosys: Our post 1QFY06 view - Views on News from Equitymaster
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Infosys: Our post 1QFY06 view
Jul 12, 2005

Introduction to results
Infosys has announced its financial results for the first quarter ended June 2005. Improvement in utilisation and stable billing rates has led the topline growth for the quarter. However, first quarter salary revision has led to the expenses rising faster than revenues, thus depressing operating margins. While the bottomline seems subdued at first glance, if one were to remove the effect to the extraordinary income in the previous quarter, the net profit growth has almost kept pace with the growth in topline.

Financial performance (Consolidated): A snapshot…
(Rs m) 4QFY05 1QFY06 Change
Sales 19,873 20,716 4.2%
Expenditure 13,206 14,078 6.6%
Operating profit (EBDITA) 6,667 6,638 -0.4%
Operating profit margin (%) 33.5% 32.0%  
Other income 323 286 -11.5%
Depreciation 998 801 -19.7%
Profit before tax 5,992 6,123 2.2%
Extraordinary items 450 (1)  
Tax 855 802 -6.2%
Minority interest 0 2 400.0%
Profit after tax/(loss) 5,586 5,319 -4.8%
Net profit margin (%) 28.1% 25.7%  
No. of shares 270.6 271.4  
Diluted earnings per share* (Rs) 82.3 78.4  
P/E ratio (x)   28.7  
(* 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 offerings, which include software development (19% of revenues) and maintenance (30%), IT Consulting (4%), package implementation (15%), products (5%) 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 FY05, Infosys’ revenues and net profits have grown at compounded rates of 39% and 32% respectively, outpacing the industry by a far margin.

What has driven performance in 1QFY06?
Volume-driven topline:  Revenues grew sequentially by 4% during 1QFY06. This was mainly a result of good volume growth. Onsite volumes grew by a strong 6% QoQ, while offshore volumes rose by 5% QoQ. The billing rate environment appears to be largely stable, with onsite and offshore rates declining only slightly. Billing rates are expected to remain largely stable in the near future as well, as companies are finding it difficult to get billing rate increases from existing clients, particularly large clients. Utilisation rates also improved during the quarter, leading to better productivity. They were at 74.1% (including trainees) in 1QFY06, as compared to 73.2% in 4QFY05. Infosys added a net of 3,056 employees during the quarter, and now has 39,806 employees on its rolls.

Revenue streams: Moving up the value chain!
  4QFY05 1QFY06  
  Rs m % of total Rs m % of total Change
Development 4,114 20.7% 4,019 19.4% -2.3%
Maintenance 6,141 30.9% 6,298 30.4% 2.6%
Re-engineering 1,292 6.5% 1,057 5.1% -18.2%
Package implementation 3,041 15.3% 3,149 15.2% 3.6%
Consulting 815 4.1% 870 4.2% 6.8%
Testing 1,212 6.1% 1,347 6.5% 11.1%
Engineering services 358 1.8% 373 1.8% 4.2%
Business Process Management 636 3.2% 787 3.8% 23.8%
Other services 1,590 8.0% 1,844 8.9% 16.0%
Total services 19,198 96.6% 19,742 95.3% 2.8%
Products 676 3.4% 974 4.7% 44.1%
Total revenues 19,873 100.0% 20,716 100.0% 4.2%

One interesting aspect that comes out of the above table is that the company’s development and maintenance revenues have shown either a weak or negative growth. On the other hand, services like consulting, BPO and products have shown good traction. The products business in particular appears to be picking up some steam, as Infosys attempts to move higher up the value chain. This business has grown by 44% on a QoQ basis. The company’s banking product, Finacle, is ranked alongside the likes of Flexcube (i-flex) and OPICS (Misys) in the annual sales league table rankings of IBS, UK. The company added a net of 5 clients during the quarter, taking its active client base to 443. The number of clients in virtually all the buckets has increased, with one client now giving the company in excess of US$ 90 m in annual revenues.

Higher salaries, rupee appreciation impacts margins:  Infosys incurred considerably higher salary costs during the quarter due to the upward revision in salaries in April, an annual event. In fact, the quantum of the impact can be gauged from the fact that the company’s cost of revenues increased from 52.4% of sales in 4QFY05 to 53.3% of sales in this quarter. As a percentage of revenues, S&M expenses have also increased to 6.8% as against 5.9% in 4QFY05. Also, while the US$/Rs rate was almost flat in the quarter, the 7% appreciation of the rupee against the Euro impacted margins negatively. As a result, operating margins were down by 150 basis points during the quarter. However, we believe that with the salary increases out of the way, operating margins could remain largely stable over the next few quarters due to the SG&A leverage that can be expected. We expect operating margins to decline at a slow rate in the future. We anticipate margins to touch 30% by the end of FY07, a 2% decline from the current levels.

Lower margins and other income slow down profits:  Due to the contraction in operating margins, compounded by a fall in other income, profit growth was largely subdued at 4% QoQ growth. This would have been even lower, had it not been for lower depreciation costs incurred by the company. This is before taking into account extraordinary income of Rs 451 m earned during 4QFY05 on account of sale of the company’s stake in Yantra Corporation.

Performance in the recent past…
  2QFY05 3QFY05 4QFY05 1QFY06
Sales growth (%, QoQ) 15.3 7.2 6.0 4.2
Development expenses (% of sales) 53.0 52.9 52.4 53.3
Selling expenses (% of sales) 7.0 6.2 5.9 6.8
Operating margins (%) 32.1 32.9 33.5 32.0
Profits growth (%, QoQ)* 15.2 11.2 12.3 -4.8
Employees (Nos.) 32,949 35,229 36,750 39,806
Utilisation (%) 71.4 71.4 73.2 74.1
* Net profit growth for 4QFY05 and 1QFY06 includes the effect of extraordinary items. Without taking these into consideration, profits in 1QFY06 have grown by 4% QoQ.

What to expect?
At the current price of Rs 2,250, the stock is trading at a price to earnings multiple of 28.7 times annualised 1QFY06 earnings and 25.1 times our estimated FY06 earnings. The management has upgraded its FY06 revenue guidance to 26% to 27% growth, while EPS is expected to be in the range of Rs 84.7 and Rs 86 per share, a YoY growth of around 23% to 25%.

We expect the company to grow revenues at a 38% CAGR over the next three years, while profits are expected to clock a 30% growth rate over the same period. We are not surprised by the upward revision in guidance, as traditionally, the Infosys management has been conservative in its expectations and has always outperformed its guidance. Given this fact, this is a good sign, as it indicates increasing confidence in the business environment for IT spending. The problems faced by the company’s clients with respect to regulatory compliance issues, such as Sarbanes-Oxley appear to have receded. Though valuations appear stretched from a medium term perspective, we continue to hold a positive view on the stock, taking a long-term view.

We had recommended a ‘Buy’ on Infosys in April 2005 at Rs 1,998 with a target price of Rs 2,750 from a 2-year investment perspective. At this juncture, despite the stock price having recorded 12% gains from the date of the recommendation, we maintain our stand on the company from a long-term perspective.

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