Infosys : Earnings growth to bounce back in FY09; Maintain Buy

(BSE: 500209 | NSE: INFOSYSTCH | ISIN: INE009A01021)

Infosys’ Q1FY08 results have been above our expectations at net profit levels. Revenue growth, however, was lower than anticipated due to slower volume growth. Net profit was bolstered by higher other income and a tax write-back. Even after excluding the tax write-backs of Rs 510mn and Rs 1,250mn that occurred in Q1FY08 and Q4FY07 respectively, the net profit grew by 1% sequentially against our expectation of a 4.6% decline.

In line with our expectations, the company raised its dollar guidance for FY08. However, the magnitude of revision was less than anticipated, resulting in higher downward revision in the rupee guidance. Our evaluation of Q1FY08 results and FY08 guidance suggest a conservative management outlook. We view further rupee appreciation as the most significant risk to our estimates. We maintain our Buy recommendation on Infosys with a March 2008 target of Rs 2,466.

Parameters and their Comments

Volume growth : The onsite-offshore effort mix remained unchanged during the quarter. The volumes in Q1FY08 grew by 6.9% over Q4FY07 resulting in dollar revenue growth of 7.5% during the same period.

Pricing : Blended pricing improved by 1%; onsite and offshore billing rates rose 1.6% and 1.1% QoQ respectively. New clients are coming in at a premium of 3-4% over existing rates.

Onsite-Offshore mix :Revenue mix from onsite and offshore locations remained stable as compared to Q4FY07 at 49.7% and 50.3% respectively.

Employee addition : A gross addition of 7,000 employees was made during the quarter. The company plans to add 11,700 employees in Q2FY08, a good proportion of which would be fresh graduates. It has also increased the employee addition target for FY08 from 24,500 to 26,000.

Attrition rate : After consistently increasing for four sequential quarters, the attrition rate remained stable at 13.7% on LTM basis

Salary hikes : Salaries of offshore employees were increased by 13-15% whereas onsite salaries grew by 3-5%. Salary hikes resulted in a 250bps QoQ decline in the EBITDA margin.

Clients & deals : The company witnessed sustained growth momentum in client additions, with 35 clients added during the quarter. Three deals of over US$ 50mn each were bagged during the quarter.

Geographical mix : There were no significant changes in the geographical mix of revenues. The contribution from Europe improved marginally by 20bps QoQ

Utilisation levels : Utilisation including trainees increased by 300bps QOQ to 70.5%. Utilisation remains the single largest margin lever for sustaining EBITDA margins.

Client growth : After leading growth for the last few quarters, the top-10 clients grew by 4% sequentially. Other clients grew faster at 9.3% over Q4FY07. The top client grew 8.8% QoQ.

Services metrics : Consulting and Testing services witnessed the strongest growth at 22.5% and 10.5% QoQ respectively. New services introduced in the last five years now contribute ~44% of total revenue.

Vertical metrics : Growth in the BFSI segment is back on track, at 4.9% QoQ. Telecom and Utilities witnessed higher-than- company growth rates at 8% and 9.8% respectively over Q4FY07. EBITDA margin contracts 300bps The EBITDA margin declined 350bps QoQ as the rupee appreciated by 7% during the quarter. Higher visa expenses and salary hikes of 13-15% for offshore employees and 3-5% for onsite employees pulled the margin down a further 350bps. However, an improvement in blended pricing, utilisation rates and better performance from subsidiaries restricted the margin decline to only 300bps QoQ.

Rupee appreciation, higher visa expenses and salary hikes put a squeeze on the EBITDA margin

Utilisation rates – a key margin lever : We believe the level of employee utilisation is the most important margin lever available with the company. Infosys has invested in setting up a strategic bench of human resources which resulted in a dip in net utilisation rates from 82.4% in FY04 to 75.5% in FY07. In Q1FY08, the gross and net utilisation rates improved by 260bps and 90bps respectively. We expect the net utilisation rate to improve further to ~78% in FY09, thus protecting margins against a stronger rupee

Raised FY08 dollar revenue growth guidance from 28-30% to 29-31%, lower than expected

FY08 guidance revised : As expected, Infosys revised its dollar guidance for FY08 upwards, while lowering its rupee guidance to factor in the strong currency appreciation. However, the quantum of dollar guidance revision was lower than expected, resulting in a higher-than-anticipated decline in rupee guidance. We had anticipated a 33-34% upward revision in the dollar revenue growth guidance, whereas Infosys has now guided for 29-31% growth in FY08

Potential upsides from billing rates not factored into the guidance

Guidance implies conservative revenue CQGR of 5.8% : Our evaluation of the Q1FY08 results and FY08 guidance suggest a conservative management outlook. To achieve the fresh guidance for the fiscal, the company will have to grow at an implied compounded quarterly growth rate (CQGR) of ~5.8% QoQ in revenues and ~7% QoQ in EPS. This is much lower than the growth in the corresponding year-ago period (9.4% and 14.2% respectively), which was recorded despite an increasing base.

For Q2FY08, the management has given a revenue and EPS growth guidance of 6% and ~5% respectively. Seasonally, Q2 and Q3 are the strongest quarters for the company. Moreover, the management has not factored in any kind of upsides from billing rates. The company has been witnessing a steady increase in offshore as well as onsite billing rates in the last five consecutive quarters. We estimate that blended billing rates will improve 3.5% in FY08.

Strong revenue CQGR trend in preceding years despite increasing base

Growth momentum to return to form in FY09 : In the absence of further significant appreciation of the rupee against the US dollar, we expect Infosys to surpass its FY08 guidance comfortably. In dollar terms, we expect the company’s revenue to grow 35% over FY07 to reach US$ 4.2bn against the guidance of US$ 4.1bn. Our rupee estimates are at an average exchange rate of Rs 41/US$ as against Rs 40.6/US$ used by the management in its guidance. We expect the revenue and EPS in rupee terms to grow by ~23% and ~19% respectively versus the guided growth range of 16.9 – 18.3% and 13 – 14.1%.

FY08 guidance to be surpassed comfortably provided the rupee doesn’t play spoilsport

Valuation : Sensitivity of EPS estimates to exchange rate We have realigned our estimates for Infosys assuming an average exchange rate of Rs 41/US$ for FY08. However, in the table below we provide the sensitivity of our EPS estimates to further rupee appreciation.

Stock may underperform in the short term; Maintain Buy : We expect Infosys’ earnings to clock a CAGR of ~22% over FY07-FY09. At the current market price of Rs 1,930, the company is trading at 23.7x and 18.9x on expected FY08 and FY09 earnings of Rs 81.5 and Rs 102.3. The current pessimism in the stock price has resulted in contraction of the P/E multiple at which the company has traded historically. Due to the lower growth rate anticipated in FY08 and the impact of a strengthening rupee, the stock may remain an underperformer in the short term. We expect the growth rate in earnings to bounce back to ~25% in FY09 in the absence of the high rupee appreciation witnessed in FY08. We maintain our Buy recommendation on the stock with a March 2008 target price of Rs 2,466. At this price the stock would trade at 30x and 24x on FY08E and FY09E.

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Investment in equity shares has its own risks. Sincere efforts have been made to present the right investment perspective.The information contained herein is based on analysis and up on sources that we consider reliable. I, however, do not vouch for the accuracy or the completeness thereof. This material is for personal information and I am not responsible for any loss incurred based upon it.& take no responsibility whatsoever for any financial profits or loss which may arise from the recommendations given in this blog.