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Infosys: People pressure! - Views on News from Equitymaster
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Infosys: People pressure!
Sep 27, 2005

Infosys is India’s second-largest software services company, with revenues of Rs 71.3 bn in FY05. The company has been a model of good corporate governance and its management is highly visionary, with the ability to envision future trends in the industry. Infosys has been constantly moving higher up the software value chain, with revenues from ‘higher-end’ services like consulting and package implementation forming an increasing proportion of revenues over the past few years. The company recently won its largest-ever order of US$ 140 m from ABN Amro, which handed out parts of its outsourcing contract to TCS, Patni, Accenture and IBM as well, apart from Infosys. This clearly shows that Indian vendors have arrived on the scene and are giving tough competition to the erstwhile giants, IBM, Accenture, EDS et al.

However, a key concern for any software company is its people. Attrition rates in the industry are around 16% to 17%. Given that software is a people-intensive industry and people are at the core of any company’s success, this aspect is crucial. We give a perspective on how employee costs have impacted Infosys over the past few years and what the company needs to do to minimise the impact of the same.

Margin-shrinking effect!
Infosys earned operating margins of 32.8% in FY05. Though this may seem high and is, in fact, the highest in the industry, these have actually reduced from much higher levels over the past five years. In FY01, Infosys’ operating margins were as high as 40.2%. One needs to understand the main reasons behind this fall in margins.

Since software is a people-oriented industry, continuously employing and retaining key personnel is the major factor and therefore, the largest cost head. It should be understood that software as an industry does not enjoy the benefits of operating leverage like a manufacturing company, but faces all the negative aspects. For example, when business is good, companies have to recruit more people to execute a greater number of projects. You cannot have the same people working on two different projects at the same time. During a downturn however, the company will incur all the costs but not revenues, as the employees that are on the bench will have to be paid, whether or not they are working on projects. Or, they have to be fired!

Therefore, people management is the most crucial factor. Infosys has increased its employee base at a CAGR of 39.0% from FY01 to FY05. Revenues, on the other hand, have increased at a virtually identical CAGR of 39.2%. However, operating margins, as mentioned above, have reduced steadily from 40.2% to 32.8%. The major factor has, undoubtedly, been employee costs. In all the years, except FY05, they have increased as a percentage of revenues, from 38.8% in FY01 to 49.6% in FY05. In fact, in FY05, mainly due to employee costs reducing as a percentage of revenues, the company managed to maintain operating margins at the same level as in FY04.

Employee costs: Pressurising margins
  FY01 FY02 FY03 FY04 FY05
Emp. costs (Rs m) 7,382 11,400 16,971 24,934 35,391
% increase 115.8% 54.4% 48.9% 46.9% 41.9%
% of revenues 38.8% 43.8% 46.6% 51.4% 49.6%
Operating margins (%) 40.2% 39.9% 34.9% 32.8% 32.8%
Employees (Nos.) 9,831 10,738 15,356 25,634 36,750
% increase 82.4% 9.2% 43.0% 66.9% 43.4%

A deeper look
However, one must not look at these numbers in isolation and in fact, try to understand the main drivers behind them. The company’s consistent drive to move up the value chain necessitates a higher onsite presence at the client’s site (front end). For onsite revenues, though billing rates are higher than in offshore revenues, margins are lower, as the company has to pay higher salaries/fees to domain consultants and experts. This is reflected in the onsite-offshore mix. In FY03, in fact, the onsite revenues rose to 58.3% of total revenues from 50.8% in FY02.

Therefore, this ratio is largely a factor of the business mix of the company. It should, thus, be clearly understood that lower margins need not be construed as a bad thing, as long as the company is moving higher up the value chain and is moving in the right direction as far as its business is concerned.

What to expect?
Going forward, the company expects consulting, BPO, infrastructure management, products and independent validation services (IVS-software testing) to be the major growth drivers. While consulting is highly onsite, clients are also looking to send as much work offshore as they possibly can. Infrastructure management services and software testing services have a high offshore component and thus, margins can be expected to be higher in these services.

Obviously, wage inflation is a reality that the industry has to live with. Margin expansion in future will be a function of higher rates from new clients, vendor consolidation in favour of larger vendors by clients, a greater shift towards offshore, a greater proportion of freshers in overall hiring and the overall business mix. On an overall basis, we do expect some margin pressure on Infosys, mainly due to rising employee costs.

At the current market price of Rs 2,483, the stock trades at a price to earnings multiple of 16.5 times our estimated FY08 earnings. Given the fact that offshoring is becoming more mainstream as witnessed by the recent ABN Amro deal, strong management quality, scalability and execution excellence, the stock remains one of our top picks in the sector.

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