Where Analysts Went Wrong
The Infosys stock lost 50 per cent of its value after the company declared its fourth quarter results and gave earnings guidance for FY04. Such a drastic reaction clearly suggests a disconnect between analysts' expectations and what the Infosys management believes.
The point of departure clearly is how pricing will behave in FY04. Some analysts claim that the management had led them to believe that the pricing pressure had eased.
"Expectations started building up after the robust volumes growth in the June quarter and gained more steam after the not-so-negative stance taken by the management in the December quarter," says Amit Khurana, senior research analyst, Birla Sunlife Securities.
Analysts obviously got added comfort from the fact that average billing rates had fallen just 0.9 per cent in the December quarter, following a 4.4 per cent sequential jump in the September quarter.
Also, much of the decline in profitability in the December quarter was explained by some one-time factors like software purchases. This led to a belief that margins would improve sequentially in the March quarter and would be maintained at those levels in FY04.
This, coupled with the assumption that the strong volume growth seen in FY03 would continue, led to a model which put Infosys's earnings growth at close to 30 per cent for FY04. The 5.1 per cent decline in average billing rates in the March quarter certainly came as a shock.
Looking back, assumptions about the continuity of strong volume growth were not unfounded - Infosys has said that it expects volume growth of around 30 per cent in FY04.
Now, what seems to have been missed in the carnage is this fact. Though the company would not have had client visits till around mid-May owing to the Iraq War and the outbreak of SARS, it has committed to grow volumes at 30 per cent.
If it sticks to the target, it will be a $1 billion company by the end of FY04. It's pricing that plays spoilsport - despite the 30 per cent growth target for volumes, the company expects revenues to grow at just 25 per cent in dollar terms.
In rupee terms, it expects the growth rate to come down to 23 per cent, as it has used the exchange rates in March for its FY04 projections, which were much lower compared to the average in FY03.
Infosys expects net margins to decline by 250-300 basis points year-on-year. Much of this is on account of the fall in its pricing power.
There are other factors like salary hikes that will also impact margins, but these are expected to be offset by cost-cutting on other fronts like selling and marketing expenses.
The company expects SG&A (selling, general and marketing) expenses to come down from 14.8 per cent of sales in FY03 to 13.9 per cent in FY04. This, however, could well be a temporary measure and the company would have to spend more on SG&A going forward, as the spend on SG&A by global peers is as much as 20 per cent of sales.
That, however, will happen only gradually and in the long-term. What's more important is to view the pressure on Infosys's margins in line with that of its global clients, many of whom are going through a rough patch.
It's only natural that Infosys would be impacted as a result of their cost-cutting initiatives. Sticking to this theory, one can assume that the company would also be a beneficiary of any gain its clients make as a result of a turnaround in business sentiment.
In sum, all is not lost for the Infosys stock. For a company that says it will grow volumes at 30 per cent despite such a huge base, it now trades at a reasonable level of under 16 times one-year forward earnings.
The hope, clearly, for investors is that the volume growth will continue beyond FY04 and that margin declines would ease.
Going by the survey results doing the rounds, it seems that IT offshoring is increasingly gaining popularity. That takes care of things on the volumes front; so it all again boils down to pricing.