The Hindu Business Line : Infosys Technologies: Tender to the sponsored ADR offer

INVESTORS need to consider selling the Infosys stock. The sponsored ADR offer, which is in the offing, involves selling to overseas investors. Through this offer, shareholders get an opportunity to sell the stock at a premium to the market price. The premium may be above 10 per cent. Tendering to the sponsored offer appears attractive.

The stock would also remain locked in an escrow account for about 90 days. By the time the ADR issue is concluded, the financial performance for the second quarter would be out. Investors can verify if Infosys is revising the guidance upwards again.

That would provide a much better picture of the earnings outlook for Infosys for 2003-04. Then, as only a portion of the holdings would be accepted in the ADR tender offer, shareholders can decide to sell or hold. The valuation of the Infosys stock is now driven by factors that go beyond its numbers.

Question of belief

Do you believe in the top management of Infosys Technologies? The company recorded a 6 per cent growth in revenues and a near 3 per cent growth in operating profits for the June quarter compared to the March quarter. The Infosys management, however, still thinks that in the next three quarters, the quarter-on-quarter growth would be less than 2.5 per cent for revenues and less than 1 per cent for profits. A view can be taken that the management is deliberately setting the targets low so that they could beat it. This perception or the lack of it is a factor in driving the price trends in the stock. Where you stand in the issue could determine whether you buy, hold or sell the Infosys stock.

Reasons for optimism

The optimism of the bulls has not been due only to the cash in their hands. A few reasons can be adduced in support of such optimism. They are:

Revenue growth

: First, of course, is the June quarter's volume growth of 9.6 per cent. Important, the growth in offshore volumes has been more robust at 14 per cent. With offshore outsourcing emerging as a major trend, such volume growth could continue.

Lower productivity decline: Infosys has assumed a loss in revenue productivity, which will lead to decline in profit margins, of about 1 per cent every quarter for this year. Its experience has been better in the June quarter.

Loss in productivity in offshore business has been lower at 0.4 per cent. If offshore volumes pick up and loss in offshore revenue productivity stays lower, profit growth will be better than the estimates.

Stable rates

: Infosys has said that decline in billing rates on its incremental businesses has been arrested. In addition, the margins are slightly better because of decline in tax rates. If the decline in billing rates has been arrested, then loss in revenue productivity going forward could be lower.

Stable costs

: Salary hikes to employees have come about in the June quarter. Selling expenses are also likely to remain stable. Consequently, if revenue growth persists, profit growth could be higher.

These are only some of the factors supporting the market's optimism. There are analysts that have pegged the per share earnings of Infosys for 2003-04 at Rs 174 — about 3 per cent more than what the management thinks is possible.

Reasons for caution

There are as many reasons to be cautious, if not more. Almost all of them are applicable to the industry, in general, and not just to Infosys. They are:

Rupee appreciation: If the rupee continues to strengthen, margins will be affected. In the next two quarters, impact of rupee will be muted because Infosys has already hedged more than Rs 1,000 crore in revenues. Still, if rupee depreciates more in the last week of a quarter then impact on financial performance could be adverse.

In addition, if revenues stay flat, profits in the fourth quarter could decline from present levels. This is because fourth quarter revenues have not been hedged.

Visa regulations: The issue of visas and other regulatory issues such as possible ban on outsourcing in the US continue as major risks that can affect revenue growth.

Depreciation: Depreciation costs declined by 16 per cent in the June quarter. With Infosys planning a 100 per cent rise in capital expenditure in 2003-04 over 2002-03, depreciation costs will go up in the next few quarters.

Potential for offshore: The offshore-onsite mix in terms of revenues for Infosys is about 45:55 for Infosys now. However, in terms of efforts, offshore-onsite mix is closer to 2:1. That is for every three hours billed, two are for offshore work. So, the scope for expansion in offshore revenues alone appears modest. Growth in offshore revenues may be as muted as onsite revenue growth in the months ahead.

Decline in productivity: According to Infosys, billing rates have not been reduced to all customers. Besides, customers offer higher volumes only when price cuts are affected.

In addition, rates continue to decline. It declined in the quarter ended June and further decline has been built into the Infosys' estimates. In this situation, excessive optimism regarding profit growth appears misplaced.

Stiffly valued

Overall, it appears prudent for a retail investor to exercise caution. The Infosys management is better placed to judge and there is less reason to believe that they are managing expectations to manipulate the markets.

The ruling valuation of the stock of Infosys does not leave much room for optimism. The stock trades at about 23 times the per share earnings for the 12-month period ended June 2003. This requires robust growth beyond 2003-04 too.

However, the outlook is for the continued decline in margins in the business. If margins are likely to decline with every quarter, the profit growth will also fall.

A multiple of 20 and beyond can be justified if there is at least a perception of reduced risk going forward. However, the risk levels in the business remain high.

Reflecting the risk levels is the possibility that the stock price can move up or down by 25 per cent or more in a few trading sessions.

In this context, holding on to the Infosys stock when the multiple is about 24 does not appear justified.

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