Here‘s why Ambit cap recommends staying away from Infosys

Q: I am going to first start with Infosys because that has been the big talking point. Its increase in weightage versus ITC and the lifetime highs that it is trading at and you conversely have a sell on Infosys with a target price of sub Rs 3000. Can you just take us through the rationale and where do you see the slip between the cup and the lip coming for Infosys?

A: The broader IT sector has done very well in the last six months. In a note, we recently highlighted that about 46 percent increase that CNX-IT has seen, around 20 percent is just a PE re-rating and the rest is a combination of earnings upgrade and currency helping the sector. Infosys has clearly participated in that as well.

Specific to Infosys, the main three challenges for the firm going forward are lack of strategic clarity for the firm. For last two-three years, the firm under the leadership of Shibulal was trying to focus on moving up the value chain, Infosys 3.2.

Since Murthy has come in, they seem to have somewhat put that strategy on the back burner and are trying to move towards commoditise services. Also, you see a lot of senior level exits. So, we see lack of strategic directions that we see a lot more in competitors like Tata Consultancy Services (TCS), clearly focused on large scale commoditise or scale services. We have seen Cognizant being very close to customers.

Secondly, as Infosys makes this change from consulting which is about 35 percent of revenue towards the large infrastructure management application, managed services contract there is a change in the business mix. So, that change in the business mix implies a lowering of the realisation per head and hence a lowering of margins.

We have already seen that happen for the last one year. We think that will continue quite aggressively for the next 12 months which probably the street is not factoring in. To an extent, the margins have been weak for the last two-three quarters but because the growth has strengthened the street has ignored. It will catch up as earnings growth is not as strong as the current multiples imply.

Finally, the street is already assuming a strong recovery in organic revenue growth for FY15. We think that is a bit of a challenge for this firm; organic growth is still not very strong on a year-on-year (YoY) basis. Hence, those are the three main factors that make us still a bit bearish on Infosys and its recovery.

Q: A two part question; one is that you believe the entire PE re-rating is done in terms of the US recovery. It is factored in the best of US recovery and second, you spoke about Infosys, but what about HCL Technologies; I believe you still maintaining buy on that in terms of the large cap IT?

A: If you look at IT services in general, IT services tend to be a late cyclical sector. Suppose there is a US recovery, the IT services business will benefit from the mid to the later end of the cycle. They react a bit later; it is not an early cyclical play. To that extent, if there is a US recovery, we think it is largely priced in today given the 20 percent PE re-rating we have seen across the sector. It has been significantly higher in the larger cap names, somewhat smaller in the midacp names and extremely high on the firms that have benefited from the currency related earnings upgrades.

Now, if we just look at the strength of the US recovery, one of the things we focused on in our recent note, shrinking margin of CFT was if you look across the various factors of IT services spending or the US recovery it doesn’t seem to be very strong. One of the key areas we tend to look at is the hiring on the ground in the US. It has begun to pickup but is not very strong yet.

Secondly, we keep looking out for discretionary services spending in terms of sales of large software such as ERP software and SAP, Oracle it doesn’t look like discretionary spending has come back. So, the US recovery to that extent is already priced in. If it is significantly stronger then what we currently expect, there could be re-rating upward but will only get mixed signals and where we are in the cycle, we think it is largely priced in.

HCL Tech is our top buy idea. We think HCL Tech is among the few tier-I IT names that still has an upward re-rating potential. It trades at about 12 times – the firm has shown very strong margin recovery over the last two years, thanks to an improvement in its quality of business. It has been able to enter several large fortune 500 global 2000 accounts that have helped it expand its margins.

There is a bit of a concern among investors that a lot of growth is coming only from one service like infrastructure management. We think that probably it will change over the next 12-18 months as a lot of deal wins they have won over the last three or four quarters come to show up in the revenue number. So, the earnings upgrade is still there for HCL Tech which hasn't come through and also the possibility for growing revenues and hence, earnings that are relatively strong make us a buyer on the stock.

Q: Going back to Infosys, we did have that exit only last evening and the cultural issue that you touched upon which is a softer issue for Infosys. How have you read the spate of exits that have taken place? It is seventh in the past six months and how would you combine or maybe compare it to possibly the fact that NRN has come back and there is a management or strategy change taking place in Infosys?

A: Factually there have been several exits since Murthy's come back at the helm. There are two ways to look at it. One, whenever there is a management change or a change in view and there is a strategic change that Murthy is trying to articulate, I can say I still have my reservations about what that direction is, but there is clearly a change. When such a change happens there will be few people who do not agree with that view and want to leave.

The nature of people who have left, which is extremely high profile from the head of sales, to the head of BFSI in Americas who was one of the potential next CEO candidates, the head of consulting, someone who built up consulting for the last decade for them and more recently Subu Goparaju who was heading the labs.

The second way to look at it is that the strategic change is leading to several long time Infosys leaders to question where Infosys is heading and finding a lack of clarity wanting to depart the firm. When we talk to headhunters from Bangalore the sense we get is a lot of mid to senior level leaders are feeling jittery and looking at exit options.

We hear this about the sales team in Infosys; we hear this about mid to senior level managers. Maybe of the two explanations the second one has a slightly better weighting. As the firm undergoes change this is likely to happen. We have seen Wipro undergo this when there was a period where a lot of senior leaderships were leaving, but Wipro seems to have overcome that hump and it is in a period where it has been able to attract a lot of leaders. We are still waiting for Infosys to prove that it can attract talent and just see attrition.

Q: But you still have a sell on Wipro?

A: We have a sell on Wipro. We think it is moving towards recovery. Our preference is Wipro over Infosys. It is a valuation call.