The Hindu Business Line : Infosys: Buy

In our view, the post-earnings announcement weakness in the stock represents a buying opportunity for investors who have returns expectations in the 15 per cent range over the next three quarters.

Our earlier `buy' recommendation in the stock was at around Rs 1,950. Investors, however, will have to gear up for more volatility in the stock price.

A few key variables such as competitive challenges from global and Indian top-tier peers, growth in the top-ten client accounts and changes in contribution from its broadbased portfolio of services, are slated to exert greater influence on the company's earnings card.

For once, Infosys Technologies' well-established credo of "under promise and over deliver" has not worked in the latest quarter, as it has in the past.

The flat revenue and post-tax earnings guidance for the first quarter ended June 30, 2005 has turned out to be in line with forecasts. It, however, fell short of market expectations.

If we ignore the sharp growth in Progeon (its business process outsourcing subsidiary) and Finacle (its banking product solution), the core IT services business has recorded muted revenue growth in the latest quarter.

The key highlights of the first quarter performance are:

The revenue growth from the top client, top five and top ten clients has declined in the latest quarter, as projected by the management in the fourth quarter.

A combination of internal restructuring and compliance issues among select clients in the top five-client bracket appears to have bogged down the overall revenue growth. This is also partly reflected in the revenue productivity that has declined by 1.7 per cent on onsite and 0.3 per cent on the offshore front.

Among verticals, telecom and manufacturing have witnessed sluggish growth in relation to the previous quarter. The largest impact was on telecom whose contribution declined by 2.2 percentage points to 17.4 per cent.

This was attributed largely to the slow growth among a couple of its large telecom clients. The BFSI (banking, financial services and insurance) vertical, however, has turned in a strong performance, aided by a strong performance from Finacle.

The operating margins have dipped by 1.50 percentage points to 32 per cent on account of the onsite/offshore salary hike and higher visa costs. But if we take out Finacle's licensing fee revenues from overall revenues, the margin decline may be of a higher order.

Over the next couple of quarters, three positive factors are poised to rev up the company's performance:

Client momentum: Even though the top five client growth slowed down in the first quarter, Infosys was able to counter it, to some extent, with strong client growth in the $20 and $30 million bracket. For instance, 14 clients fall under the $20 million-plus bracket in the latest quarter, up from 11 clients in the previous quarter.

If the contribution from the top five and top ten clients stabilise, it can provide a leg-up to revenue growth in the coming quarters.

The company is also regaining the momentum in $1 million client additions, with 31 clients added in the last year. On top of this, there are also about half a dozen mega offshoring deals that are also doing the rounds, in different verticals such as BFSI, automotive and aerospace.

Broadbased portfolio: Nearly 35-40 per cent of Infosys's revenues accrue from new services that range from packaged implementation, testing, engineering services to consulting.

Not only do these services help Infosys derisk its overall business model, some of these services also command higher realisation and will have a positive impact on margins in the coming quarters.

Since development/maintenance contracts remain exposed to multi-vendor relationships, higher contribution from new services will leave them less vulnerable to sustained volume growth.

Geographic diversification: Infosys has been steadily increasing its contribution from Europe. For the latest quarter, out of 24 per cent of revenues from Europe, 12 per cent accrued from the UK. Since concerns stemming from the recent terrorist strike in the UK are overdone, Europe's share is set to rise sharply over the next few quarters.

On the flip side, the earnings of Infosys will be dictated by a couple of crucial elements:

Competition from global peers: Multinationals such as IBM and Accenture have stepped up their recruitment engine over the past few quarters and are talking in terms of employee additions that are almost in line with that of Indian peers. Increasingly, they are also building the offshore component into their application development/maintenance contracts.

While the tussle for quality talent at the entry level/freshers may not be high, there is a possibility of greater churn in the middle management of established companies such as TCS, Infosys and Wipro.

Uptick in billing rate: If these competitive pressures intensify, the uptick in billing rates that have been on the cards for the past few quarters may not materialise in the latter part of the year.

Since the multi-vendor situation remains a risk, Indian companies may not have the latitude to renegotiate contracts with existing clients. Though new clients may come in a higher price point, they may not alter the revenue and margin picture significantly.

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