We expect Infosys’ performance to improve moderately through a number of initiatives and foresee steadier operating performance.
The company has suffered from its slow-moving legacy past (smaller, more discretionary projects) and out-of-date go-to-market strategy, resulting in low revenue growth relative to peers, margin compression, leadership churn, and high employee attrition.
Infosys has launched a number of initiatives to improve its performance but the company has some way to go before rectifying its position. However, signs are promising, with revenue growth, margins, client mining, and employee attrition improving.
Infosys benefits from high switching costs, thanks to its commitment to building lasting client relationships, embedded systems and processes, and intimate knowledge of clients’ IT infrastructure. Such switching costs ensure a certain level of operational consistency, and the company’s good financial health reflects this. As a result, Infosys will look to leverage its financial stability and increase its top line while improving its competitive performance relative to peers such as Wipro and TCS.
To reinvigorate revenue growth, the company is pursuing larger outsourcing opportunities rather than smaller discretionary deals. Infosys plans to hire a raft of new salespeople to open more client opportunities, while offering greater differentiation in contract proposals and using greater process automation (via partnerships such as IPsoft and internally developed platforms like Infosys Automation Platform). In terms of operating margins, management has aggressively reduced costs and launched some optimization initiatives. It will also look to increase its offshore business mix and improve utilization rates.
Finally, Infosys has sought to reduce its high attrition rate by giving compensation increases, issuing employees stock, restructuring salaries, and offering more promotions. Consequently, we forecast a steadier operating performance.
Economic Moat: Narrow
The moat results from high switching costs (roughly 96%-98% of revenue is from repeat business and has been around these levels for many years).
The company’s commitment to building lasting relationships, embedded systems and processes, and intimate knowledge of clients’ IT infrastructure means customers are averse to switching between vendors.
On a gross basis, Infosys continually adds over 200 clients per year, which is an encouraging sign and cements further long-dated business given switching costs. Such switching costs ensure a certain level of operational consistency and the company’s exemplary financial health reflects this.
We forecast Infosys to easily generate a return on invested capital in excess of its cost of capital for the foreseeable future, and we believe its lower-cost offshore delivery model allows for this assumption.
Fair Value Estimate: Rs 1,177
Our FVE implies forward fiscal-year price/earnings of 17.5 times, an enterprise value/EBITDA of 11.6 times, and a free cash flow yield of 5.1%. We forecast a 5-year revenue compound annual growth rate of 9.5% and expect a broad-based contribution from the company's four major industry segments. We think the firm will actively pursue top-line growth and use its significant financial flexibility to achieve this. Infosys is targeting larger outsourcing deals and has hired a raft of new salespeople to assist with these endeavors (the company added five $100 million clients in fiscal 2017).
In addition, with clients increasingly investing in compliance, infrastructure modernization, digital transformation, analytics and cloud, and cyber security, Infosys has established the Center of Innovation for Tomorrow's Enterprise to help develop relevant next-generation products and services.
Furthermore, the acquisition of Lodestone signifies a bigger focus on European growth, and we think the firm will attract more business from this region.
Operating margins are forecast to remain around the mid-20s in the short term, and going forward, we think margins will marginally improve because of cost reduction, process optimization initiatives, and significant emphasis on automation. Our discounted cash flow model assumes a return on invested capital that comfortably surpasses the company's 10.5% weighted average cost of capital.
Risk
Infosys has highlighted issues regarding relatively low revenue growth, margin compression, leadership churn, and high employee attrition. Management has taken steps to remedy this, but it is still early and there is the risk that these problems become inflated.
Poor macroeconomic conditions, visa restrictions, competitive threats, and foreign exchange movements are also external risks that could generate further downside for the company.
The firm must differentiate itself to avoid commodification of its services (roughly 25% of the firm’s revenue is exposed to a high degree of commodification, according to management).
Stewardship: Standard
Cofounder and executive chairman N.R. Narayana Murthy came out of retirement in 2013 to help right the Infosys ship. His return resulted in improved financial performance, although it has been marked by numerous high-profile executive resignations.
Murthy again stepped down and re-entered retirement to make way for CEO Vishal Sikka in August 2014. Sikka is a 12-year SAP veteran and is the company’s first ever nonfounding leader. His appointment signifies a greater emphasis on proprietary software product development and a shift away from increasingly commodified outsourcing services. Sikka is expected to drive further transformational initiatives at the firm and he sees the current environment as an “opportunity to learn new skills and to develop new products and services and processes and economics.”
Given changes to management and the multiyear vision of the firm’s turnaround efforts, we are taking a conservative view on the company’s equity stewardship, which leads to our Standard rating.
The company has a prudent approach to capital allocation, with no debt on the balance sheet. The firm also generates significant free cash (averaged $1.3 billion per year over the past five years), which it can reinvest in growth opportunities. Over the past five years, the company spent approximately $600 million on acquisitions and returned $3.5 billion in dividends to shareholders. Recently, Infosys raised its dividend payout ratio to 50% of post-tax profits from 40%, and rumors of a buyback have emerged. However, the buyback remains speculation at this point and we think the funds would be better suited to organic and acquisition-related growth opportunities. We expect the firm to generate a return on invested capital in the mid- to high-20s (including goodwill) for the foreseeable future.
