We received a business update from Infosys CFO V. Balakrishnan (August 27, 2012). The stock has outperformed the Sensex by 8% over the last month on expectations of a near-term business improvement. The conversation with the CFO suggests there has been no change in the business outlook since the June quarter.
In the long-term, despite a supportive valuation, we are worried about market share loss, dwindling growth in traditional services, inferior positioning in the new growth market (Continental Europe) and reduced focus on less than-$50-million clients. Thus, we retain our Hold rating with a target price of R2,350.
We value Indian IT services firms on a price-to-earnings (P/E) basis relative to their historical trading range, compared with both peers and growth rates. We value Infosys at 15x FY13e (estimates). We believe the multiple is justified since the company should report an earnings CAGR (compound annual growth rate) of 12.5% over FY13-15e, and is better positioned than in 2003 on such key factors as revenue size, net worth, dependence on the US, and client concentration. Given the muted earnings growth in FY13e, we have a price-to-earnings growth ratio of 1.2.
Drop in discretionary spending continues to impact growth: There has been no change in the business outlook since the June quarter. While greater exposure to discretionary spending and negative operating leverage are likely to hurt revenue growth and margins in the near term, the significant rupee depreciation more than offsets the impact of these headwinds. For the long-term, we believe that the company is making the right investments to pursue high quality growth by making the desired changes in its business model to enhance market share in products. Despite the near-term challenges, Continental Europe is likely to be a key growth market over the long term.
No change in near-term business outlook: There is no change in the business outlook across sectors since the end of the June quarter. Global macroeconomic challenges continue to adversely impact customersí IT service spending. Discretionary spending still happens sporadically. In general, customers are conservative and are focused on conserving cash. As a result, deferrals of decisions still happen with increased scrutiny of large projects.
Negative operating leverage hurting near-term earnings: The company continues to focus on high quality growth with stable margins and pricing. It has made a conscious choice of staying away from short-term focused, high risk commoditised business.
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