Playing it safe

BS Compass

Infotech investors had a pleasant surprise in store on Thursday morning, when they realised that Infosys Technologies had been overtly cautious, after all, when it had said in April that its FY04 earnings would grow between 11.3 and 12.7 per cent.

The company has now revised its earnings growth estimate upwards to 16.5 per cent. The revenue target is almost unchanged, but that's mainly because of the appreciation in the rupee. The guidance given in April was based on an exchange rate of Rs 47.4 per dollar, while the current guidance factors in a rate of Rs 46.4.

It was a better-than-expected performance in the June quarter that led to a revision in the full year guidance. In April, the company had projected flat sequential (q-o-q) growth for the June quarter, but it ended up with a 6.1 per cent revenue growth and a 7.4 per cent earnings growth.

Revenue growth was higher at 7.7 per cent in dollar terms, with a 9.6 per cent jump in volumes being offset by a 1.9 per cent decline in average pricing. The drop in billing rates, coupled with the appreciation in the rupee led to a 100 basis points decline in gross margins.

The average rupee rate for the quarter showed a 1.5 per cent appreciation vis-a-vis the March quarter, leading to a 61 basis points impact on the gross margins.

It's important to note here, however, that Infy has done well to restrict the decline in margins to a 100 basis points, especially since it also took salary hikes last quarter. The fall in gross margins would have been much worse, but for some cost containment measures.

First, the company replaced some high-cost sub-contracted professionals with its own employees, saving some $0.5 million in the process.

Besides, it reduced the number of non-billable people onsite, and increased utilisation rates (excluding trainees) from 82.1 per cent in the March quarter to 83.9 per cent last quarter. Lastly, offshore volumes increased 14 per cent, while onsite volumes grew at a lower rate of 6 per cent, leading to a considerable improvement in the offshore mix.

However, with the decline in profitability, operating profit growth was just 2.3 per cent, and the net profit growth of 7.4 per cent was possible only because of a huge reduction in provisions for depreciation and taxation.

The company has stated that the depreciation element would continue to fluctuate on a quarterly basis, the tax rate for the whole of FY04 would be lower than earlier expectations.

The fact that the tax rate assumption is now lower is one reason for the upward revision of the guidance. But the main reason is the better-than-expected performance in the June quarter.

In fact, with an EPS of Rs 41.98 in the June quarter as the base, all the company needs to do is post flat sequential growth rates in the next three quarters to achieve the Rs 168.5 EPS target for FY04.

On the revenue front, the requirement is slightly steeper at around 2 per cent. Going by the strong volume growth the company has seen in the past few quarters, this should be achieved rather easily.

In fact, considering that last quarter's net addition of around 1700 employees was one of the highest in any quarter for the company, one gets the feeling that even the revised guidance target is rather conservative.

In terms of business fundamentals, not much has changed since the company gave its original guidance in April - offshoring is increasingly becoming mainstream, but pricing is still challenging, global competition is still making inroads, and the rupee continues to appreciate,.

In terms of sentiment, though, the fact that the Iraq war and the severe acute respiratory syndrome issues have been resolved, is a big positive. It's interesting, therefore, that the company continues to be conservative with its estimates.

After yesterday's 12 per cent jump, the Infy stock now trades at 21 times FY04 estimates, which translates into a PEG of 1.3 times, which is close to the valuation its been getting post-April. But what's surprising is that there has been re-rating across the sector.

It would really be prudent to wait and see whether all these companies would be able to deliver similar results, especially since Infy's results were buoyed by cost cutting measures that were obviously specific to the company.

With contributions from Mobis Philipose