Green shoots are for real

The improving global economic environment and an ability to sustain margins augur well for Infosys

Infosys Technologies’ December 2009 quarter results brought an air of optimism into the sector. The company not only managed to out-do its own conservative guidance but it also beat the Street’s expectations by a good margin. Higher volumes and steady pricing ensured that the IT bigwig’s results were better than expected. With improved demand from North America and the banking and financial services (BFSI) segment, Infosys delivered another quarter of robust growth. The company’s strategy to cross-sell and provide value enhancing services to its customers helped garner higher revenues from its top 10 clients; revenues from top 10 clients grew by 12.2 per cent sequentially and saw their contribution to revenues reach the highest in the last three quarters.

Emphasis on cost-light structure and higher employee utilisation helped churn better margins, though some of the gains were negated due to a strong rupee; the rupee’s appreciation may negate margin increases, going ahead. Nevertheless, an up-tick in IT spends by customers should see domestic players like Infosys benefit from greater business.
 

DEMAND BOOST
in Rs crore	FY09	FY10E	FY11E
Revenue	21,693	22,659	26,250
EBITDA margins (%)	33.2	34.7	34.8
Net profit	5,988	6,191	7,135
EPS (Rs)	104.3	107.9	124.3
P/E (x)	25.6	24.7	21.5
All figures are consolidated E: estimates

Demand up-tick
Revenues at $1.23 billion were up 6.8 per cent sequentially (highest in seven quarters) during the December 2009 quarter aided by better volumes in the BFSI vertical. BFSI revenues grew 6.2 per cent (2.8 per cent q-o-q to Rs 5,741 crore) sequentially with better traction from insurance sector that grew at a robust 18 per cent. The insurance vertical got a boost from the recent acquisition of McCamish systems; it expects to add another $7 million to revenues in the next quarter.

Regulatory compliance and M&A related projects had been doing well in the banking domain. After a decline for four consecutive quarters, revenue flow in the manufacturing and telecom verticals appear to be stabilising; each of the two delivered around 2.8 per cent sequential growth. Broadly, the revenue growth across all verticals suggests that recovery is increasingly turning out to be more realistic.

Aided by increased velocity in decision making, demand outlook remained robust with a pick-up in volumes of 6.1 per cent sequentially, up from 2.3 per cent in the September 2009 quarter. Indicatively, Infosys bagged four large outsourcing orders, one of which was a $200 million order, signing off a healthy quarter. Good traction was observed in the North American markets that saw its share in revenues grow further to 66.6 per cent.

Although the recovery in the European region is expected to come with a lag-effect, improving economic prospects in Germany and France provides some comfort for the future.

Among service offerings, volume boost came from the application maintenance space during the quarter. A strong global business demand and recovery in the US and European markets over the next couple of quarters, should further boost demand-led recovery for IT companies like Infosys. Any up-tick in IT spending, could churn higher revenues from application development, consulting and package implementation spheres. In view of an improving demand outlook for IT vendors, Infosys has revised upwards its 2009-10 revenue growth guidance to 3.6-3.8 per cent year-on-year, from 1.2-1.7 per cent earlier.

Healthy margins
At the operating level, profit margins improved by around 90 basis points to 35.5 per cent on account of pricing stability and better employee utilisations. The employee utilisation rate (excluding trainees) improved 300 basis points to 76.2 per cent and added about 60 basis points to margins while other cost-cutting initiatives contributed another 100 basis points during the quarter. However, a 3.7 per cent rupee aprreciation during Q3 impacted the overall margins by 180 basis points. Going ahead, unfavourable currency movements and an increase in hiring targets could put some pressure on the margins. On these counts, the management expects margins to decline by about 150 basis points in the March 2010 quarter.

Despite a 5.4 per cent sequential increase at EBIDTA level, Infosys’ net profit growth was restricted to 2.7 per cent (Rs 1,582 crore) in the December quarter on account of increased tax provisioning on account of higher proportion of revenues accruing from non-STP areas. Its major subsidiaries that account for 13 per cent of its revenues were less profitable sequentially, on account of the BPO and consulting divisions. Nevertheless, Infosys China’s performance had been robust off-late. Overall, expect margins at 34-35 per cent on account of volume ramp-ups, stable pricing and higher utilisation levels, going ahead.

Conclusion
The IT budgets of global companies should be finalised in the next few months. While initial indications suggest that spending could either be flat or increase modestly, Infosys’ management has been cautious in upping its revenue guidance for 2009-10. A stable pricing environment, faster decision making and the ongoing global economic recovery suggest that the demand environment should remain healthy, going ahead.

The management has also indicated that large deals are returning; additional hiring of 4,000 (2009-10 target increased to 24,000 from 20,000 earlier) indicates the company’s expectations of higher growth in the future. Overall, expect a 15-20 per cent growth in both top line and bottom line in rupee terms in 2010-11, much better than a subdued single-digit growth 2009-10. Going ahead, demand revival in discretionary spend services could accelerate revenue growth in 2010-11. With a cash balance of $3.1 billion, the company could also look at inorganic opportunities to corner a higher growth. At Rs 2,689.10, the stock is trading at 21.5 times its 2010-11 estimated earnings, and can be considered on dips.