Infosys reported robust revenues of $1,358 million, +4.8% QoQ (quarter-on-quarter) in line with our estimate of $1,359 million. However, earnings were below expectation [EPS (earnings per share) of Rs 26.05, against our expectation of Rs 28, led by marginally lower Ebitda (earnings before interest, taxes, depreciation and amortisation) margin, higher tax and lower other income]. While, the results are unlikely to influence earnings revisions for FY11/12, it’s noteworthy that the robust 7.6% volume growth was driven by 70% of the revenues, while 30% of revenues from telecom, Europe, BPO and products remained flat.
Positives: Upward revision of FY11 topline growth in dollar guidance in dollar from 16-18% to 19-21% (22% in constant currency) and positive commentary over continued robust demand from the US. Furthermore, the management has alluded to a minimal impact from the European debt crisis and any client-specific issues.
Negatives: High attrition at 15.8% on LTM (last twelve months) basis (which is, c20% on an annualised basis). We believe the high attrition was partially driven by graduates leaving for higher education; we expect that the overall churn in the sector is likely to subside in the coming quarters. The pricing (realisation per head) decline of 300 bps in offshore was driven by the change in revenue mix (application maintenance grew 10% QoQ vs c5% total company growth). Management also alluded to pricing discounts offered earlier in 2009, impacting realisations. We expect that, as growth in higher value services such as consulting and package implementation picks up further during the year, realisations will improve from the current levels.
We forecast that Infosys remains well poised to grow revenues at a +20% CAGR (compound annual growth rate) in FY10-12 against 15% for the sector. In FY11, the company has better margin levers due to higher bench strength and pyramid leverage. The stock is trading at 22x our FY11e EPS in line with the historical seven-year average. Low risk to earnings and strong long-term fundamentals lead us to assume a target multiple of 22x on FY12e EPS in arriving at our target price. We maintain an OW (overweight) rating and Rs 3,200 target price.
Highlights of Q1FY11 results: IT services and consulting volumes grew strongly by 7.6% QoQ. However, pricing declined c3% in offshore. While the change in the services mix (higher application maintenance) explains the decline partially, we believe it could be driven by volume discounts. We are not overly worried with this pricing decline. As revenues from Europe, consulting, package implementation and telecom improved in H2FY10, we believe realisation (pricing) is likely to improve.
Divisional performance: Banking and financial services led the growth again this quarter, followed by retail and other verticals such as energy and the utilities market. Telecom and Europe remained laggards. The management expects a likely pick up in telecom and Europe in H2FY11.
Ebitda margins declined by c200 bps this quarter and attrition shot up to c20% on an annualised basis. We believe that Ebitda margins would only decline by 100 bps for the full year FY11, as the company would be able to leverage its employee pyramid further. This quarter witnessed improvement in utilisation (including trainees) by c450 bps.
Valuation: Under our research model, for stocks without a volatility indicator, the Neutral band is 5 percentage points above and below the hurdle rate of 10.5% for India (risk-free rate plus risk premium). We value Infosys at a PE (price-to-earnings) of 22x on our FY12e EPS at Rs 3,200, and believe upside would be driven by earnings growth. Historically, the stock has traded at a seven-year average and at a 12-month forward earnings multiple of c22x. That’s the reason we use to get this target multiple. Our target price indicates c16% total return (including dividend yield of 1.5%), which is above our Neutral band of 5.5-15.5%. We, therefore, retain our Overweight rating on the stock.
Downside risks: (i) Although we do not expect any more industry pricing pressure, Infosys may still face some pressure due to its premium pricing; (ii) rupee appreciation vs dollar (1% appreciation affects margins by 30-40 bps); and (iii) IT budgets for 2011 not growing as expected.