Infosys Q2: Looks like biz is under serious pressure, says Kotak Instl

Infosys' second quarter net profit rose by 3.5 percent, quarter-on-quarter, to Rs 2,369 crore.

In an interview to CNBC-TV18, Sanjeev Prasad, executive director and co-head of Kotak Institutional Equities says he is a little bit negatively surprised by the numbers. "The margins have actually declined compared to the previous quarter by a fairly significant number," he adds.

According to him, the business is under serious pressure. "It looks like Infosys is resorting to price competition to get some volume growth going," he adds.

He has 'reduce' rating on all the four large tier-I companies.

Below is the edited transcript of his interview with CNBC-TV18's Udayan Mukherjee and Sonia Shenoy.

Q: What is your view on Infosys’ Q2 results?

A: I am a little bit surprised, not that we were expecting anything great, but this quarter looked like, on a quarter-on-quarter basis, would have around 4 percent growth and some improvement in margins. The margins have actually declined compared to the previous quarter by a fairly significant number.

It clearly looks like the business is under serious pressure and looks like Infosys is resorting to price competition to get some volume growth going. So, I think it is a combination of what we are seeing in the industry as a whole. At the same time, it is also an Infosys specific issue. So, it clearly does not bode very well for other companies in the sector.

Q: Would you be cautious on IT as a space overall, underweight on it or would you be underweight especially on Infosys?

A: If you look at our ratings, we have ‘reduce’ rating on all the four large tier-I companies. It is only the midcap space where we find some reasonable valuation; we have some positive ratings. But, in general, our analyst has been pretty cautious on the sector. It is coming from the fact that clearly there is looking like a slowdown in the sector as a whole. It means the margins are not going to sustain.

It looks like Infosys is resorting to some sort of price competition to get volumes. Wipro is also in the same bracket. So, if you have two large players competing based on margins where is a question of other players being able to do well. So, I think this is more looking like an industry specific problem rather than just an Infosys specific problem at this point of time.

Q: Some of your peer brokerages have been talking about price levels of Rs 3,200 on Infosys. Do you think Infosys will say anything in the next couple of quarters to justify a rerating on the way up?

A: It is pretty unlikely. The company, at best, can do about Rs 165 this year and that too supported more by the rupee depreciation. Next year, I suspect, is going to be Rs 175-180 maximum. In that case, 13-14 PE is probably the maximum hope for a company that is not really growing that fast.

The bigger picture still remains very unclear whether this is just an Infosys problem or this is a larger generic problem. Our analyst’s view is this is going to spread to other companies. There is a slowdown, as far the orders or revenues from the customers are concerned. That means there is going to be price competition. Infosys is going for a price competition. Wipro will also go for price competition. Where is the question of earning numbers surprising for the others in that case?

My worry would be that this is more of a general issue for the sector as a whole. You have two companies, out of the big four, doing badly. I think that’s probably not going to be the case. So, I would be very worried about the other two (HCL Technologies and TCS) also in this kind of a scenario.

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Q: Would you worry about the fact that the CFO V Balakrishnan has stepped down? Would that lead to any kind of concerns or do you think that the market will not fret too much about it?

A: It is a cause of concern because Bala has been a senior member of the team for a fairly long time, well regarded within the industry. So, I don’t know what the internal dynamics are; whether there are internal issues between the senior management. A lot of senior people have left over the past few quarters. Bala also leaving does not leave a very good picture for an outsider.

You can only speculate as an outsider. You don’t know what the real dynamics are, what Bala’s intension is. But, to an outsider, looking at the fact that several executives have left, it doesn’t paint a very rosy picture about the internal dynamics of the company.

Q: It’s not been a great start to earning season. Do you expect to see more disappointments as we roll forward?

A: Hopefully not. We are looking at about 18.5 percent growth for the BSE 30 index as a whole, leave aside the energy sector where you have some amount of volatility depending on ONGC's numbers. That is a pretty strong growth on a year-on-year (YoY) basis. A lot of that growth is coming from two areas—Coal India and IT sector.

Coal India’s last year’s Q2 was very weak because of extended monsoons and they had a big production disappointment. So, this year we are looking at 16 percent YoY growth in volumes and pretty strong growth in net profit accordingly.

The other big driver of profit was incidentally the IT sector. It doesn’t look like that’s going to be the case. We were assuming that because of rupee depreciation we will have some margin improvement. But it doesn’t look like that’s going to be the case. So, the worry is if that pits to more stocks within the IT sector.

The other big boy, banking, how do the numbers pan out over there? HDFC Bank has been reporting very strong numbers for the past several quarters now, but incidentally the revenue growth has been lagging the earnings growth. So, if you look at loan growth and net interest income growth, it’s more in the range of around 20 percent, whereas the bottom-line growth has been somewhere about 30 percent for the last several quarters. Can this sustain for sometime? we will have to wait and see. That’s something I would be watching out for.

The other thing to watch out in the banking space would be the NPL cycle. IndusInd reported a pretty decent set of numbers, but that’s more retail oriented. But what is happening to the infrastructure space, power, and steel? We will have to wait and see over there.

Reliance presumably should have a decent quarter this time around, given the big uplift in refining margins. So, we are looking at about Rs 55 billion of net profit over there.

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Q: Where does that leaves the market at the end of this earning season? Do you think the market will have reasons to move higher from here or do you think most of the policy issues have been priced in with the move that we have seen in September?

A: The problem is grappling with the top-down view verses the bottom-up view. If you look at the top-down view, this momentum can continue based on global liquidity. Central banks continue with their monetary policy. India also some amount of positive news coming from the government and hopefully a cut from the RBI in the first quarter next calendar year.

When you look at the bottom-up view, the first problem is with the valuations itself. Things are not cheap in India. If you look at the broad market, BSE 30 free float is trading at about 14 times on the March 14 earnings. It is not cheap, not very expensive either. But when you start looking at the segregated valuations, that’s where the problems arise because consumer, pharma names, the private sector, retail oriented banks have become very expensive now. If you look at something like HUL, that is trading at 28 times March 2015 numbers. ITC is about 27 times March 2014 numbers. All the good consumer staples are north of 25 times March 2014 EPS. So, I don’t know if it is a big struggle in terms of trying to construct a portfolio on a bottom-up basis, trying to play the long-term India story.

Most of the names are becoming very expensive whether you look at the consumer staples names, the tier-I pharma names, private banks, they are all very expensive. Even media has added a good run based on digitalisation prospects so on and so forth.

I am not very convinced about NPL, as far as the PSU banks are concerned. The infrastructure pick up, which everybody is expecting, based on reform announcement, is going to really come through. My view is that, in the next six-eight quarters, infrastructure cycle is actually quite decent based on all the on going projects. But, going forward, we do see the risk of investment cliff in India. Once you complete most of the on going projects, where are the other big projects? I can go sector by sector. It looks like a pretty bleak scenario, when you look at the pipeline of projects. That’s the worry.

Valuations are not supportive at all, as far as this market is concerned. When you look at the macro economic factors, in the short term, things are worsening. If you look at the trade numbers, which came out yesterday, we have USD 18 billion trade deficit. If you look at the current account deficit, we are looking at about 4 percent plus. Definitely, it is not very positive. You look at the inflation numbers, in the short-term, based on diesel price increase, you will see inflation numbers climbing up and by November we are looking at about 8.5 percent. It will eventually come down to more like 7.7-7.8 percent by March 2013. But that’s still very high. There is not much of room for RBI to maneuver in that case.

If you look at GDP numbers, it is very unlikely that you will see a big pick-up in the GDP numbers. Finally, earnings growth, I don’t think there is much case for earnings upgrade. So, there is a big disconnect between the bullishness, which we are seeing on a top-down basis, based on whatever is happening globally and in India. On a bottom-up base when you start looking at valuations earnings fundamentals etc, that is where the problem is. It is very hard to construct a portfolio in that case.