NASSCOM defends IT growth forecast; JPM cuts Infy EPS

Below is an edited transcript of their interview. Also watch the accompanying videos.

Q: First the big basic numbers. What have you done in terms of changes to your FY13 outlook on earnings, on EPS?

George: I think we have brought our numbers down by about 5% both for FY13 and FY14. Clearly the guidance that they have issued was way below our expectations. I suspect that the street was ahead of us, consensus was ahead of us and they might have had to cut their numbers more. But we have brought numbers down by 5% for both the years FY13 and FY14.

Q: What about the prospects of serious de-rating and switch away an ownership from Infosys to some of its other large peers because of the disappointment and the lackluster growth that they guided to? Have you brought down your target price and multiples assumed in that target price as well now?

George: Yes, we have done that. I think a de-rating from this result is certainly called for. I think Infosys missing guidance, the lower end guidance, the issue guidance in the band is not new. They have done this for the third time now in the past five quarters. But I think the magnitude they miss is really shocking. You have had more than USD 50 million miss relative to the revenues Asia reported in constant currency terms. So clearly there is something amiss there and I think it calls for a de-rating on Infosys. How much it is for anyone to guess but we have been more comfortable with mid-teen 15-16 times as opposed to be 17-18 times in that sense. So we have brought a target prices down from 2,900 to 2,750 for one year. So we are not looking for much more than 15% on your one year basis.

Q: This problem has been brewing for 3-4 quarters now. It has only come to head in the current quarter with the full year guidance of how deep-routed is the problem in your eyes. Because investors even who want to be patient and buy in this distressed phase would want to know how long it takes to fix this?

George: This has been going on for a while and I think we have brought it out in our research and we have also consistently said that there are certain things which Infosys must fix in its business models. One, how does it work the pricing versus volume trade-off. For a year they have done a fantastic job of raising pricing 4.7% in reported terms, 3.2% in constant currency terms for FY12 but in process volumes have barely registered double-digit percentage growth i.e. 10-11%. How do you get a traction in what we call the bread and butter basics of the business, infrastructure management testing BPO etc because the focus on the high-end consulting system integration etc is all welcome but in a sense environment clients are looking to cut costs and achieve efficiency to business process restructuring not necessarily to go in for consulting sort of services.

So I think there are certain issues that Infosys must sort itself out and more importantly this is not an issue that the street talks of much or the investors talk of much but it is the VISA abuse suit against Infosys also taking toll. Our customers are little bit more wary of expanding relationship with Infosys pending outcome of the suit. So it is not an angle that we have brought in to a research explicitly as the business related factors but this also could be an incremental factor in the way Infosys is seeing its growth at least for the near term.

Q: Infosys says what they are putting out is a pragmatic outlook for the rest of the year. Does your channel check show that is this a problem that is spreading to other companies as well or right now is this insulated to Infosys?

George: Our view is that issues that we have seen in Infosys are largely company specific. We do not think that USD 50 million miss that largely happened in the month of March for a company that is in control of its business. It is a kind of a miss that we have not seen for the long time now in a single month. Last we have seen that in Q4 of FY09 during the Lehman crisis or in the aftermath of the Lehman crisis. So I think this is largely company specific.

Let me take you through a couple of pointers for this. You have seen Accenture’s results recently. A couple of weeks back, they may put in some extremely strong numbers on the outsourcing side. ACPP announced yesterday and they had a slight quarter miss, it was for the reasons within the control and they have a front four year guidance which means that the coming quarter is going to be much more robust than what we initially thought. So I don’t think there are data points in the environment per se that suggest that IT spending is falling off a cliff or the environment is coming for more constructed right now. So I would like to think that right now if VISA company specific issues whether it is 80%-70%-90%, one doesn’t know we would have to wait for the other companies to report and see that.

Q: How does 15 times sit on your P/E grid? In the sense that the big 4 how are you rating it now P/E wise?

George: We are looking at 15-16 times and we think that TCS is going to command a sustainable premium of the order of 15% from here at least that much. It depends upon if TCS numbers are going to be a lot of Infosys in this quarter which we believe will be the case then I think investors would be more comfortable giving a sustainable premium of 15%. So I think we would have TCS at 18-19 times. We would have Wipro probably with a premium to Infosys at 17 times and so on and so forth. So I think it just tracks the mood of the investor at that point in time with regard to both the company and the sector.

Clearly at this point in time investors are not inclined to give higher valuation multiples to this sector also maybe because of Infosys specific issues. It becomes clear to us whether this is a company specific issue or the sector wide issues then I think the premium will adjust for the other companies. So we are comfortable with 15-16 times with Infosys, 18-19% for TCS and for Wipro somewhere in between but still at the premium to Infosys and so on and so forth. The only company we would expect to be trading at a discount to Infosys in large cap sector and rightly so is HCL Technologies because their margin profile is different even if the growth is better.

Q: They also said that there would be no wage hikes for the moment. Could attrition levels spike up once again? Could there be operational issues which will crop up during the middle of the quarter because of these kinds of defensive moves?

George: They are doing this. This move of no wage hikes or zero wage hike till as and when and take it as it comes at least takes us by surprise because we don’t think environment is so bad that we would deny wage hikes to your employees when you are already battling issues such as high inflation, etc in the day to day life.

Point two, the risk of attrition is not much now. Today the environment is not so great. So they can live with and therefore any such moves are not really going to spike up attrition because the environment is not really that great for attrition to really spike up. But what it does essentially in my view is that when the environment turns up, if the tech environment, environment for IT spending stirs up, then Infosys might find it very difficult to get people back to capitalize on the demand scenario or surge in demand. That’s one thing. So not only are you at the risk of alienating employees right now, you would probably find it difficult to get people back when spending snaps back in case you persist with these actions.

Obviously, this will depend upon what competitors do when they announce their results and give you some indication what wage hikes they intend. I think it will be in the mid to high single digit range in percentage terms. I don’t think it will be a zero wage hike situation. So I am not so much worried by what happens to attrition right now because attrition is not high for the industry, it is rather moderate. The concern is what will happen to Infosys when they want to hire people back in case or when the environment snaps back in action.

Q: I presume that when you put out your 11-14% guidance for the sector earlier, you would have polled some of the large companies which leads one to ask whether things have actually worsened for companies like Infosys in the end of fourth quarter which you could not poll when you did your survey or do you think that companies will come out with very disparate performances and therefore 11-14% might still be logical kind or believable target?

Mittal: When we had done this analysis of ours, we had factored in a fair amount of uncertainty that was in the market, the fact that Europe was in transition at that point of time. I think we had also said that there would be differentiated performance amongst companies. Earlier we used to find that most companies should take the same trajectory whether it was upwards or downwards but given the fact that they are all at various stages of their own transformation internally, there would be differentiated performance. We see that 11-14% growth rate that we had set for the sector is probably still quite achievable.

Q: The Infosys management was quite detailed and specific about the spaces from where they face pressure. There was BFSI within that banking and financial services and they said that it seems to be an offshoot of the economic environment. If that be the case, what convinces you that this is an Infosys specific issue? BFSI would impact most of the IT companies and a turn in sentiment because of economic environment surely would?

Mittal: BFSI is a very important segment and constitutes 40-41% of our business. In fact that sector is the one which probably has done well from a customer perspective. I think that those companies are doing well, they have cash on their balance but when you look at BFSI, it is very large. If you finer and segment it up, there is banking, there is insurance, there is security and I think depending upon your own customer profile you could still have a differentiated performance. But we would still believe that BFSI segment will also grow during this period.

To the point that you said what gives us confidence as I mentioned before we have two kinds of businesses. One is we run peoples operations and then there is a transformation work that we do and the right-sort business continues to happen and our growth is coming and from transformation and many new changes that these companies are making such as investing in mobile, investing in cloud, looking at new products and services that they will offer in emerging markets.

So I think we have enough drivers as well and I think the silver lining is the fact that US economy is showing recovery, the job situation there is changing. If I look at two indicators that we have which is hiring on one hand I think most companies had a good hiring spree in the campuses. I think that reflects their confidence in what they are doing. Even if we recently look at the trends and changes that people have made, they have all said that business seems to be better than the mood. So we think 11-14% still holds.

Q: JPMorgan was just pointing out that the analyst community was quite taken by surprise on Infy’s decision, not to move in terms of any further salary hikes. How did NASSCOM read it and is that you expect to be an industry wide trend that there is a halt or at least the semi-halt on salary moves?

Mittal: I believe that we had gone industry wide only when there was a generic economic downturn in 2008-09. This year, the strategies will be much differentiated. Each company would decide as to how much do they give in salary increases. What do they do through variable, how much will it be performance led. So we don’t think this would be industry wide trend. When we had polled the HR managers earlier, we had heard different numbers. But the consensus was somewhere between 8-10%. Given the inflation and so on, it probably will be in that range or maybe a percent or two more. So we think this would not be something that will be industry wide.

Q: Do you really believe that the industry will grow 4-5% more than Infosys because that would be a huge departure to a previous trend or do you think the two will converge? Either Infosys beats its guidance or NASSCOM has to bring it down in a quarter or two?

George: That’s a hard one because the industry is composed of so many players. Many of them are unlisted and many of them are capital BPOs, etc. So, one doesn’t really have a handle on the fortunes of those kinds of players - small players, capital BPOs etc. I think Mr. Som can answer that much better. But let us look at it this way - in this year if the industry is growing at 16% plus, Infosys has grown slower than the industry, marginally lower. So it is not something that is unexpected. Certainly they will grow slower. To what extent remains to be seen because in the face of it right now if 11-14% - it looks like it is going to be a clear 4-5% lower. So growing slower in industry is certainly there. This is not new also. Back in FY10 when the industry grew at 5-6%, Infosys grew at 3%. So it is not going to be the first time that Infosys is growing slower in industry but the extent of underperformance is quite marked this time we feel.