Infosys: An offshore IT opportunity

Infosys Ltd is an Indian multinational corporation that provides business consulting, information technology, software engineering and outsourcing services in the global marketplace. It is headquartered in Bangalore, India. By revenues it is the third largest Indian-based provider of IT services and is the fifth largest company in India by market capitalisation.

Infosys is a good example of the successful Indian “global multinational”, with 60% of revenues from North America, 25% from Europe, and roughly 12% from “rest of the world”. India accounts for less than 3% of total revenues. Infosys specialises in serving businesses operating in the insurance, financial, telecommunications, life sciences/healthcare and manufacturing industries.

I have been investing in the Indian IT sector for a number of years, mostly in Infosys' main rival Tata Consultancy Services, the largest and most successful of the Indian IT service providers. Lately though, I have been warming up to the Infosys story again on the basis of a new CEO being appointed in August 2014 and two pretty good earnings reports (the last on January 9, 2015). Since Infosys offers an NYSE-traded ADR in US dollars (NYSE: INFY), it could be a good opportunity to participate in a high-quality turnaround story.

Prior to the appointment of the new CEO, Infosys had been lagging its rivals in profitability, new contract wins and innovation. Employee attrition was high, particularly in senior management. Pricing was inflexible, leading to contract losses. An over-reliance on choosing CEOs from the original founders of the company was preventing the company from being able to compete.

Fortunately, chairman and founder Narayana Murthy stepped back and in mid- 2014 appointed the first non-founding CEO in the company's history, SAP veteran Vishal Sikka, who has been promoting the German company's extremely successful HANA “in memory” database platform in the region. I think this could be an important inflection point for the company.

Infosys reported its 3QFY15 results on January 9, 2015 and for a change they didn't disappoint. Although total revenues were only up 0.8% quarter on quarter (qoq), growth was broad-based across geographies. The US grew 2.3% qoq, Europe grew 1.9% qoq, India was 16.7% qoq, and rest of the world was up 3.4% qoq in constant currency.

Net profit rose 13% to 32.5 billion rupees ($US522 million), ahead of market expectations. Among major verticals, growth was led by Financial Services ( 4% qoq).

Company guidance was positive, flagging 7-9% revenue growth in FY15 with an operating margin of 25%. In 2014 Infosys generated revenues of $US8.25 billion. Commentary regarding verticals also suggested a continuation of current trends.

Within its financials vertical, the company sees a continuation of strong spending in digital, cybersecurity, analytics and compliance. In insurance, Infosys predicts a strong deal flow over the next few quarters based on higher discretionary spend from the property and casualty (general insurance) sector. Manufacturing is a bit mixed with weakness in aerospace but management sees strength in selected discretionary sectors such as retail.

The market liked the earnings report and guidance as Infosys stock gained 5% on the day.

Infosys, as well as its peer companies Tata Consultancy Services, Wipro, and HCL Technologies, have built great businesses based on the outsourcing phenomenon. Although the IT industry in India has existed since the early 1980s (Infosys was founded in 1982), it was the early 90s which experienced the emergence of outsourcing.

First, some global airlines began outsourcing their back office work to India, and then IT companies followed. Some of the earliest allocators to the Indian outsourcing market were Texas Instruments, American Express, Swissair, British Airways and GE. More corporations and public institutions followed. The value proposition then as now is very low costs combined with a high level of technological expertise, underpinned by the ability of these companies to attract the brightest graduates from India's best universities.

Developments in telephony, fibre optics and satellite communications made internet-based communication and transfer of data possible. This also paved the path for outsourcing to India. Today India remains one of the fastest-growing IT services markets in the world. It is also the world's largest sourcing destination, accounting for approximately 52% of the $US124-130 billion market.

The investment case for IT outsourcing and Infosys

Over the past 25 years this industry has seen phenomenal growth. Even over the past five years, the industry has grown at a compound annual growth rate (CAGR) of 13.1%. There is still substantial upside, since globally the penetration of outsourcing is still low.

However, it will be the so-called “emerging technologies” that will present new opportunities for Infosys and the other Indian IT firms. Social, mobility, analytics and the cloud (SMAC) collectively provide a $US1 trillion opportunity, according to some industry analysts.

The cloud represents the largest opportunity under SMAC, estimated to increase at a CAGR of approximately 30% to around $US650-700 billion by 2020. Social media is the second most lucrative segment for IT firms, offering a $US250 billion market opportunity by 2020. “Big data” is also a growth area where Infosys has expertise.

Had Infosys not deviated from its founder-sourced management strategy, I would look elsewhere for investments in Indian IT. However, the new CEO has extensive experience in developing cloud-based platforms (SAP's HANA) and new products so at least on paper he's the right choice to take advantage of opportunities in SMAC. That he's the first company CEO to be based in the US (San Francisco) would suggest he and the company are serious.

Assuming Mr Sikka addresses employee attrition, restores client confidence, and articulates (and executes) a clear strategic direction for the company towards new technologies, then investor sentiment towards Infosys will improve. It's early days, but the most recent earnings release would suggest the process is on track.

Infosys added 59 new clients during the quarter including Deutsche Bank, who selected Infosys “as one of its strategic partners to help consolidate and renew its enterprise application landscape with the benefits of cloud re-platforming, mobile access, analytics and other operational efficiencies”.

The company also announced an important joint venture with DreamWorks Animation, in which Infosys will deploy its global talent pool, available across cloud, big data, Java and open source capabilities, to develop next generation solutions based on DreamWorks technology. Another step in the right (digital) direction.

Recommendation

I'm going to give Mr Sikka and Infosys the benefit of the doubt here and buy the stock at current levels. The recent US dollar ADR price is $33.00. My target price is $US40.00 based on a multiple of 18x 2017 EPS or $US40.00.

Other positives:

- The industry remains attractive; growth rates could accelerate.

- Infosys valuation is undemanding in my view at 17.6x 2016 EPS, and 15.8x 2017 EPS. It also trades at a substantial discount to its rival Tata Consultancy Services (22.9x 2015 EPS and 19.7x 2016 EPS).

 - The company has a bulletproof balance sheet with $US5.5 billion in cash and no debt.

- Infosys has strong FCF generation and a high ROIC.

- While the majority of its business is offshore, Infosys, given its size, is still a substantial part of the equity indices (the “Nifty” and the BSE) in the Indian market, so it does give some exposure to India. I remain positive on the Indian market and believe Mr Modi and the central bank will get India back on a growth trajectory with lower inflation and a current account deficit in check.

Risks

The key downside risks for Infosys are:

- Any significant appreciation of the rupee against the USD/EUR/GBP.

- Any pressure on billing rates.

- A prolonged slowdown in the US economy.

- Execution risk: inability to capitalise on client usage of new technologies.

To see Infosys' forecasts and financial summary, click here.