Trading below 5-year average valuations, Infosys’ execution on margin and key operating metrics has been robust despite the slowdown; growth trajectory expected to improve
Two questions would dominate discussions into FY17 results: (i) If the company would give guidance and what it would be; (ii) extent of buyback and capital allocation strategy, if any. Our recent meeting with management suggests that growth and margin are likely to remain stable in FY18. Over a longer term, despite the structural shifts in IT spend at enterprises, services will remain important even though more software should continue to be embedded in services.
Growth and profitability for next year — likely stable
Our meeting with UB Pravin Rao, COO and Board Member, suggests stable growth trends into FY18 with major verticals, banking and financial services (33% of revenue) and manufacturing (23% of revenue) looking strong with no major client-specific issue like RBS last year. Geopolitical issues and US immigration would have to be watched, even though company believes that broad macro is looking better than last year. We believe that concerns on large clients in previous quarter was a function of weak overall quarter and furloughs. Margin commentary remains unchanged.
Structural shifts, hiring, 2020 target
Infosys stated the extent of software embedded in services should go up even though services will continue to remain important. This should also cause a steady reduction in net hiring in future years (5.7K new hires in 9MFY17 vs 17.8K in FY16). The company is tweaking its hiring in US to accommodate more locals (to hedge against potential immigration reforms) and sales hiring to reach more touch points at clients. 2020 target remains aspirational, even though some variable components of long-term management compensation are tied to it.
Buyback question, how much?
While not discussed in our meeting, CTSH and TCS’ precedent should create pressure on Infosys to follow suit. With $5.5 bn in net cash as of Dec-16, Infosys is well placed to undertake a larger buyback, in our view.
Infosys is trading below 5-year average valuations. Despite the recent slowdown, execution on margin and key operating metrics have been robust.
Strong deal wins should help improve growth trajectory going forward as client specific issues are now behind the company. Recent spat between founders and board has been an overhang although concerns should alleviate as growth trajectory improves. Our 12M PT is based on 16x PE applied to FY19e EPS. Risks are weak macro, high competition, cross currency, stronger Rupee.
New (and old) questions for the next fiscal results
Growth outlook—Things looking better in both Americas and EU. By verticals as follows:
*Banking and financial services and manufacturing verticals seeing uptick.
*Hi-Tech is seeing some furloughs and going through structural changes, so in wait and watch mode.
*Energy sector continues to remain in flux and not much has changed y-o-y.
*Telecom could see some near softness although that’s not worrying, especially longer term.
*Utilities continues to remain strong.
*Retail could expect some near term volatility.
*Macro and geo-politics— Overall macro has seen an improvement y-o-y but the geo-political concerns have taken over. The company is keeping tabs on elections in France/Germany which could delay some decision making as companies go into wait and watch mode.
*The issue around growth has been due to cost take out by companies not being offset adequately by investments in newer areas.
*Decision making slowdown is already apparent although they have not seen any large scale project cancellations.
*Infosys is not seeing any client specific issues at this stage.
NASSCOM guidance—COO suggested that NASSCOM might have deferred guidance due to a possibly higher range given global uncertainties and that it could be released in a quarter or two.
Structural shifts in industry—He does not agree that there is a shift from products towards services. Software embedded with services would gain importance but services would still remain critical. On Infrastructure Management Services, cost take out due to cloud transition is also creating other opportunities.
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Employee additions—Net addition of employees to show a downward trend although it is difficult to outline pace at this time. The changing nature of services would prompt a larger change in hiring patterns for companies.
Margins—No target ambition other than what is already stated for short term and until 2020. All efforts are on to move towards fixed price projects for cost savings to have a higher positive impact on margins.