Infosys Q1 FY18 – adept driver negotiating a bumpy road well

Geographically, growth was subdued in the key market of North America, but was robust in India and the rest of the world.

Guidance maintained

Last year, Infosys' revenue grew 8.3 percent in CC terms, below the lower end of its guidance of 8.4-8.8 percent. After showing CC revenue growth of 2.7 percent in the first quarter of FY18, the company maintained its CC growth guidance of 6.5-8.5 percent for FY18 and USD revenue growth guidance at 7.1-9.1 percent.

In terms of verticals, BFSI (Banking Financial Services and Insurance) continued to be subdued. But the management expects a pick-up in the second half when the improvement coming out of the rate hike starts translating into technology spend.

New services gaining traction

As promised in the last quarter, Infosys has started reporting revenues from new services that started from April 2015. These services include Cloud Ecosystem, Big Data and Analytics, API and Micro services, Data and Mainframe Modernization, Cyber Security and IoT Engineering Services. Their share was close to 10 percent of revenue in the quarter and the management mentioned that nearly 50 percent of the incremental revenue in the past two years came from the new services. The share of digital revenue (in terms of how the peer group defines the same) stood at 23 percent.

Operating margin – positive surprise

Operating margin dipped 50 basis points (bps) to 24.1 percent, but the decline was much lower than what analysts feared. Variable compensation and visa costs shaved off 140 basis points, and rupee appreciation another 80 basis points. But these were partly offset by a 20 bps gain from cross-currency tailwinds, 90 bps from improvement in utilisation-- at a 15-year high of 84 percent -- and 50 bps from improved realisation.

The management has guided a margin band of 23 - 25 percent. While wage hikes will be effective from this quarter (average compensation increase of 6 percent) that is likely to impact margins negatively, it remains to be seen how the lever of utilisation is deployed to minimise the impact.

The transformation journey

The digital strategy of Infosys is well on track. The software plus service model of the company is gaining traction and new services and the company-wide adoption of automation is improving productivity per employee. Interestingly, while employee addition was only 0.8 percent, CC revenue growth was 6 percent, reflecting higher employee productivity. In fact in the quarter witnessed a decline in net headcount. While this isn’t music to job aspirants, it should help pacify jittery shareholders.

The company is not worried about Trump or the accompanying noise about visa restriction and feels that the ability to adopt the new technology and remain relevant to clients through innovation is what matters. Incidentally, Infosys plans to hire 10,000 people from the US in the coming years and a senior resource is re-locating to the US as well. It is also setting up four innovation hubs in the US.

While ramping up high margin business in new technologies is a key to growth strategy, the management feels that eventually the so-called legacy/commoditised services will all get upgraded into new services.

Infosys has embarked on the correct path of transformation to change into a “future ready” business and investors have to be prepared for minor hiccups in KPIs (key performance Indicators) including a slight pressure on margin as the business undergoes this reorientation.

The entire IT (information technology) sector is undergoing this transformation and interestingly there will be an inflection point where the upward movement of the new services/verticals will overpower the old. While it is difficult to put a deadline to the same, it will certainly happen in the next three to five years. IT sector will emerge in a new avatar and will be re-rated once again.

However, few will survive transition. We feel Infosys under Sikka will be one of the survivors and the new Infosys will be remarkably different in its character and offering. For long-term investors the continuity of Sikka (in light of the reported differences with the founders) remain a key investment risk.

Infosys versus TCS – which one to pick?

Infosys has clearly stolen the thunder from TCS in the quarter. While the latter is also in the middle of a transformation journey, the transition pangs will be more severe as it is perceived to be less agile and nimble-footed compared to Infosys.

It will take TCS longer to reach the inflection point where the legacy business is overpowered by the new services.

While investors looking for a re-rating of the sector will have to wait a little longer, the valuation discount that Infosys offers warrants a switch in preference from TCS. Long-term investors willing to participate in the transformation journey of Indian IT industry should consider accumulating Infosys gradually.