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  • Stock Recommendation | Infosys - ADD - Target price : Rs 780

    Publish date: OCTOBER 17, 2018

    Strong 2Q steadies course for FY2019. Infosys reported strong constant-currency revenue growth of 4.2% qoq and 8.1% yoy. Large deal wins were at an all-time high of US$2 bn. The company has impressed with its ability to solve the demand side of the equation. However, high and sticky attrition showed up in the cost structure resulting in a margin miss. On balance, the performance was strong and gives comfort on the pace of turnaround and catch-up with leaders on growth. We maintain ADD rating with broadly unchanged estimates. Target price revised to ₹780 (from ₹770).

    Infosys reported strong c/c revenue growth of 4.2% qoq and 8.1% yoy. Revenue growth was broad-based and particularly impressive in financial services (+5.8% in c/c) and retail (+5.9%) verticals. Revenue growth from the top client and top-10 clients was strong at 9% and 4% on a sequential basis. EBIT margin of 23.7% (flat qoq and down 50 bps yoy) disappointed with the entire currency gain (+80 bps margin kicker) and productivity improvement (+70 bps from realization increase and offshore shift) offset by subcontractor cost (-50 bps impact) and wage revision and higher-than-expected promotions (-100 bps impact). EPS of ₹9.45, grew 16% yoy and 14% sequentially and was in line with our estimate.

    Even as attrition reduced by 80 bps sequentially, it is still high at 22.2%. The cost of attrition showed up in two areas-(1) higher-than-expected promotions and incentives and (2) higher subcontracting cost, which is partly fuelled by high onsite attrition. Compensation revision and promotions combined with other soft factors should help in driving down attrition rates. However, this leaves Infosys a little vulnerable on profitability in case the competition ends up passing the currency gains to clients; in a way Infosys cannot afford a currency-driven pricing adjustment since it has partly used the same to pay more to employees with the increase being sticky in nature. We moderate FY2019-21E EBIT margin assumption by 30-40 bps.

    Infosys has impressed with key metrics that are important for a turnaround, viz. defense of revenues from large clients and strong TCV of large deals. Initial sign of progress is visible in strong growth in digital revenues. Infosys would require time to build out and close out gap with larger competitors in some of the areas. Chief among them are large multi-service deals and building muscle in BPO offerings, a critical element to large integrated deals. However, this does not necessarily mean revenue growth underperformance since low legacy drag in the overall portfolio comes to the company's rescue. We marginally raise FY2019E revenue growth, cut our EBIT margin estimate and keep EPS unchanged. Target price revised to ₹780, at ~17.5X Sep 2020E earnings, a 10% discount to TCS' valuations.
    Our FY2019E and FY2020E EPS estimates are based on INR/USD rate of 70 and 72, respectively. Further thoughts on margin disappointment
    Infosys' gross margin declined 90 bps on yoy comparison despite 9.5% depreciation of the INR against USD. In a way the company lost close to 220 bps of margin tailwind. On sequential basis as well, gross margin declined despite currency tailwind. We believe the sequential decline has three aspects.
    Reinvestment in business. We estimate Infosys has invested less than 50 bps of the 100 bps investment it outlined at the beginning of the year. These investments have gone in to sales hiring, building up of select digital competencies and localization imperative. These investments will pick pace in 2HFY19. We note that Infosys had announced a cut in the margin band by 100 bps to 22-24% in April 2018 to create more sustainable growth opportunities. This cut was to fund sales force repurposing and investments in digital competencies.
    Cost of attrition. Infosys' attrition rates have been sticky across various levels. The company is using a mix of financial incentives and soft factors to bring attrition under control. The cost of attrition is visible from higher-than-expected promotions and wage revisions for select employees. The cost of attrition is also visible in increase in subcontracting cost (up by 70 bps qoq to 7.4% of revenue) onsite. While there are other elements to increase in subcontracting costs such as lack of availability of visas combined with digital skill shortage, high attrition also has a role to play. The cost of interventions could be sticky in nature but will pay off over a period of time with improved predictability in delivery and staffing of projects. In a way these interventions would help overall productivity though costs are upfront while benefits come with a lag.
    Subcontracting costs. Part of the increase in subcontracting cost can be attributed to- (1) visa constraints that will not go away in a hurry and (2) high demand for constrained digital skills.
    Infosys could be a bit vulnerable in case competition prices away the currency gains
    While Infosys is utilizing the currency gains for reinvestment in business and bring attrition under control, the competition may not follow this approach. Infosys could end up a bit vulnerable in case the competition was to price away the currency gains. Infosys will have to accelerate efficiency gains from reinvestments and delivery (from potential lower attrition) to counteract the pricing pressure in such a scenario.
    Overall, we forecast EBIT margin of 23.7%, 23.9 and 24% for FY2019E, FY2020E and FY2021E, respectively. We forecast EBIT margin of 23.7% in 2HFY19. Key headwinds in 2HFY19 are-(1) compensation revision for title holders, (2) acceleration in investment plan, (3) further compensation interventions for key skills, if necessary. Tailwinds are-(1) spot INR is higher than average realized rate of 2QFY19 and (2) fresher hiring that will flatten the pyramid.
    Strong growth brings the upper end of the guidance into picture
    Even as Infosys retained revenue growth guidance band of 6-8%, strong 2QFY19 combined with broad-based nature of growth brings upper end of the guidance band into play. The company requires 1% CQGR from 3Q-4QFY19 to achieve the upper end of the guidance band. This is achievable in light of strong deal wins in 1HFY19 that will start contributing to revenues in the December 2018 quarter.
    Order backlog increases by 14% sequentially
    Infosys' backlog of fixed price contracts increased to US$6,815 mn, up from ~US$6 bn at end-June 2018 quarter. This represents 14% sequential increase. Of the fixed price order backlog, 50% is executable over the next 12 months. This represents 56% of annual FP revenues of Infosys. This standalone number may not provide much insight but when disclosed consistently over a period of time, such data can provide useful information on revenue visibility of an organization.

    The Infosys story has been characterized by three key themes; two positives and one negative. The progress on defense in share from large accounts and deal wins is comforting while attrition control remains work in progress.
    Strong TCV of deal wins. Infosys TCV of deal wins started trending up in the past three quarters and has picked pace. The company signed 12 large deals with TCV of US$2,029 mn of which over 60% are net new deals. 1HFY19 deal TCV of US$3,145 mn has increased more than 2X over the corresponding period last year. What has been impressive is that TCV started picking up towards 2HFY18 and at a time of high management churn and uncertainty. Deal wins have picked up with greater focus under the current CEO and helped by an improving demand environment.
    Stable delivery leadership to the rescue in defending share of business from large
    clients. Infosys has added two clients on sequential to US$50 mn bucket. Client metrics also have been remarkably stable with 4.3% sequential revenue growth from top-10 clients. These numbers are impressive against the backdrop of high attrition in clientfacing teams. What has helped Infosys is stability in delivery leadership with key practice heads running their respective service lines for a long period of time. Stable and consistent delivery has been instrumental in high customer satisfaction scores and in turn aiding growth from large accounts.
    Attrition-continues to be a key focus area. Attrition at 22.2 % is extremely high and outside the comfort zone. Infosys believes that attrition is above the comfort zone and has made the following interventions that will bring it under control-(1) advanced the wage hike to April as compared to July last year, (2) ensured more promotions, and (3) greater differentiation in variable compensation between best performers and average performers. Infosys believes that the attrition rate will decline after these interventions.
    The results for the quarter indicate a continued progress on creating demand. Talent retention to execute the programs won by the company has scope for improvement.

    Infosys has stepped up investments in hiring digital practitioners, building up of large deals and even acquiring to accelerate time to market in key competencies. Specifically, we highlight:
    Digital. Digital revenue grew 13.8% qoq and now accounts for 31% of revenues. The company has started using acquisitions (Fluido for Salesforce in Nordics, Wongdoody for digital studio) to catch up with competition in digital competencies. Even as the company had developed significant competencies under its hood, awareness was low on this front on account of insufficient communication and an overbearing emphasis on the people+ software model in the past. The low key narrative under the earlier CEO is being corrected with a more overt narrative around digital competencies, enhanced disclosure of revenues from digital offerings and building of separate practice sales for digital offerings that will work closely with account managers in ensuring wider acceptance of such offerings by clients. Digital offerings of Infosys have higher gross margin, revenue per person and growth rates.
    Large deals. The company has revamped its approach to large deals and is looking to strengthen large deal leadership. Deals above a certain threshold (let's say US$200 mn) require a full stack approach wherein an entire range of offerings of application, infra and business process can be offered as a single operating cost model and effectively stitched together on an outcome basis for the client. The deal signed recently with John Hancock is one such example.

    Margin walk-through. EBIT margin remained flat sequentially at 23.7% due to (1) headwinds of 100 bps arising from variable pay and compensation increases to restrict attrition, (2) headwinds of 50 bps from increased subcontractor expenses and investments in sales and localization, offset by (3) 80 bps tailwind from rupee depreciation net of cross-currency headwinds and (4) 70 bps gain from better pricing, reduction in onsite mix and lower visa costs.
    FY2019E guidance. Infosys retained revenue guidance in the 6%-8% range for the full year. Infosys also retained EBIT margin guidance for the full year in the 22%-24% range.
    Vertical-wise commentary. (1) BFSI-client-specific headwinds have reduced to a large extent. Spending of large US banks has increased aided by tax cuts and rising interest rates in the US. Infosys expects strong momentum in the vertical to continue in the medium term on the back of a robust deal pipeline, (2) retail-growth was led by CPG, transportation, logistics and consumer technology sub-segments. Sub-segments within retail continue to undergo structural shifts. Infosys reported a strong deal pipeline in the vertical, (3) communication- recent deal wins in the quarter will aid growth in the near term. Revenues in the next quarter will be impacted by transition and seasonality. Infosys is investing in adoption and deployment of 5G in consumer IoT and is developing 5G use cases to monetize 5G networks, (4) manufacturing-Infosys reported sustained momentum in the vertical led by Europe and America geographies. Automotive and industrial manufacturing sub-segments in Europe and aerospace sub-segment in America drove growth. Infosys expects recent acquisitions to boost its expertise in the vertical, and (5) energy, utilities, resources and services-strong growth from ramp-up of deals and growth in client accounts. Enhanced information system to drive customized customer services, investment on smart grid, automation for safety and sustainability are key focus areas for the utilities vertical. Infosys reported healthy growth in deal pipeline in the vertical.
    Large deal wins. TCV of large deal wins increased to US$2 bn, a multi-year high. 1HFY19 deal wins have increased by over 2X compared to the same period in the previous year. The company won 12 large deals in the quarter. Geography-wise break-up of large deal wins- 7 in North America, 4 in Europe and 1 in RoW. Vertical-wise breakup of large deal wins-3 in BFSI, 3 in manufacturing, 2 in hi-tech, 1 in retail, 3 in other verticals.
    Client metrics. # of US$100 mn clients declined by 1 on sequential basis while it increased by 4 on yoy comparison. Infosys added two clients to US$50 mn on a sequential basis. Revenues from top 10 and 25 accounts grew sequentially by 4.3% and 2.6%, respectively.
    Attrition. Attrition declined 80 bps sequentially to 22.2%. Infosys reported that high attrition was mainly in the 3-5 years' experience band. The company has structured new career paths and offered higher number of promotions and targeted raises for high performers to retain talent. Infosys expects attrition rate to moderate in the next few quarters.
    Subcontracting costs. Subcontracting costs as a % of revenue increased to 7.4% from 6.8% in 1QFY19 indicating initial staffing of new projects through high cost resources due to talent shortage, visa issues and elevated levels of onsite attrition. Infosys expects subcontracting levels to remain high in the short term. Onsite pyramid through local fresh hires is expected to reduce expenses in the medium term.
    Investments. Management indicated that investments towards building digital competencies, sales repurposing and onsite localization will be restricted to 100 bps despite surplus from rupee depreciation. Investment-related spending will be higher during the second half of the fiscal.
    Dividend. Infosys board has declared an interim dividend of ₹7/share in the quarter.

    Definitions of ratings

    BUY - We expect this stock to deliver more than 15% returns over the next 12 months.
    ADD - We expect this stock to deliver 5-15% returns over the next 12 months.
    REDUCE - We expect this stock to deliver -5-+5% returns over the next 12 months.
    SELL - We expect this stock to deliver

    Our target prices are also on a 12-month horizon basis.

    Other definitions

    Coverage view. The coverage view represents each analyst's overall fundamental outlook on the Sector. The coverage view will consist of one of the following designations: Attractive, Neutral, Cautious.

    Other ratings/identifiers

    NR = Not Rated. The investment rating and target price, if any, have been suspended temporarily. Such suspension is in compliance with applicable regulation(s) and/or Kotak Securities policies in circumstances when Kotak Securities or its affiliates is acting in an advisory capacity in a merger or strategic transaction involving this company and in certain other circumstances.
    CS = Coverage Suspended. Kotak Securities has suspended coverage of this company.
    NC = Not Covered. Kotak Securities does not cover this company.
    RS = Rating Suspended. Kotak Securities Research has suspended the investment rating and price target, if any, for this stock, because there is not a sufficient fundamental basis for determining an investment rating or target. The previous investment rating and price target, if any, are no longer in effect for this stock and should not be relied upon.
    NA = Not Available or Not Applicable. The information is not available for display or is not applicable.
    NM = Not Meaningful. The information is not meaningful and is therefore excluded.

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