Infosys shows the way

S. Vaidya Nathan

INFOSYS has as usual turned in an impressive performance, with revenues and earnings in the third quarter (October-December 2000) jumping more than 100 per cent year-on-year compared to the same period in 1999.

A quarter-to-quarter comparison shows a 25 per cent rise in revenues, which is a few percentage points lower than that recorded in the first two quarters of fiscal 2000-01.

Though there has been a small decline in the quarter-on-quarter growth, the growth figures -- 25-30 per cent -- are still healthy, clearly reflecting the company's success in scaling up its operations without a significant dent in profitability. Nevertheless, the stock has shed some value since the earnings announcement.

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From a long-term perspective, the stock remains an attractive pick, especially at declines. But one cannot escape the sneaking feeling that the stock price graph may have to absorb a shock (especially because the market nowadays perceives and values stocks on a quarter-to-quarter basis).

Industry-plus growth rate: And that would be in the quarter and fiscal year in which the company's growth rate of revenues and earnings slip below the 100 per cent mark. The company's top management has, over the last two years or so, indicated repeatedly that the growth rates could taper towards the industry average of around 50-60 per cent in dollar terms.

So far it has not dipped to that level, but as it gets bigger the growth may gravitate towards a largely `industry-average-plus' level with some spectacular quarters thrown in between. This may not happen in the next year, but as and when it does, it could be a significant one for long-term investors. For the early entrants into the stock, it need not be a cause for worry.

Even if it records less than 100 per cent growth, Infosys would continue to be the best exposure in the software sector -- unless, of course, by some miracle of sorts a comparable one emerges -- and also the best company in the Indian corporate firmament. It is because of sheer quality that the stock has become the favoured first destination for funds.

Compressed value creation: As a consequence, the stock has gained and sustained its value. Even at the current value of around Rs 5,500, it is almost ten-fold of what prevailed in early 1996 (see graph). This kind of gain which only a few companies can make and sustain.

But in the Infosys case, it has happened in a short span of four years. As a consequence, the gains may be more muted for some years. But long-term and early investors could gain by holding through this period and beyond. Despite the likelihood of earnings growth slipping to below 100 per cent, the company appears to be managing the risks in the business very well.

Acquisitions risk: One significant aspect of the third quarter earnings has been the Rs 13.08-crore one-time charge taken by the company for investment in EC Cubed Inc, US (see accompany story on earnings review), a company which has gone into liquidation.

The significance of the move from the standpoint of Infosys as well as the IT sector as a whole goes beyond the magnitude of the sum, which appears small. Infosys has made quite a few strategic investments and alliances. Most of them were during 1999-2000, when the company was flush (it still is) with funds from its offering of American Depository Receipts in early 1999.

Infosys could have easily invested the cash in a big buy. But it chose to be conservative in its approach towards acquisitions. This is how it ought to be, as otherwise, it could well have ended up with an EC Cubed of a bigger scale or overpaid if acquired in the big bull phase in 1999 and the first few months of 2000.

By not taking the acquisitions route blindly -- issues such as valuation, merger and attendant management/cultural integration aspects could also have posed problems -- Infosys, unlike its counterparts, has preferred to focus on strategic investments and alliances -- the less risky option. The pay-off could be high if one or two of these click; and the burden a la EC Cubed would be small even if things go wrong.

The contrast: Infosys' approach is a sharp contrast to what many second- and third-rung companies have been up to. There has been a rush to pick up companies abroad. The intent, in many cases, may well be to merely signal that the company has put through a buy in the US. Companies such as Silverline, DSQ Software, Penta Media Graphics, Mindteck, Infotech Enterprises, SSI and Subex are some of the more notable names to have gone this path. But very little is disclosed about the operations, financials and prospects of the acquired units. The risks of such acquisition are rarely, if ever, laid out before the shareholders.

There is no way of knowing whether the price paid is worth the underlying value and to what extent shareholders benefit. In the absence of such vital information, it is important for investors to view such acquisitions with a high degree of caution. If even Infosys could come unstuck with a small strategic investment -- in EC Cubed, that is -- there is no reason to believe that many other acquisitions by lesser players will not suffer such a fate. As the acquired companies are merged and few companies offer the kind of transparency Infosys does, shareholders may continue to be in the dark.

It is no surprise, therefore, that the announcements of acquisitions abroad rarely trigger improvements in stock valuation. More than the potential benefits, the risks in such deals seem to getting priced in -- and that cannot be a bad thing after all. Companies should share complete details with the shareholders to help them form more informed and well-founded opinions.