Infosys money, market share to flow into TCS: JPMorgan

Viju George, executive director at JPMorgan, says that money will start moving out of Infosys and into TCS soon because of a higher valuation premium.

“If TCS comes out today and maybe even meets expectations, it doesn’t even have to beat it very significantly, I think you will see money flow towards TCS,” he said in an exclusive interview to CNBC-TV18. He also said market share will slowly start drifting towards other players from TCS because of polarization. Infosys today shocked the street with dismal Q1FY13 numbers. Its consolidated net profit for the first quarter rose 33% year-on-year to Rs 2,289 crore, while revenue was barely in-line at Rs 9,616 crore, up 29%. Analysts on average were expecting Infosys to report a net profit of Rs 2,448 crore on revenue of Rs 9,665 crore. George, who has been tracking the stock closely, says that the IT major has disappointed on several front this time. Not only are the numbers below expectations, but the company has also gone and cut the yearly guidance for dollar revenue. The stock took a harsh beating right in the beginning, crashing 10%, and has remained around that level. Below is an edited transcript of his interview with Udayan Mukherjee and Mitali Mukherjee. Q: Take us through what the likely action on your front would be? Would you take down your rupee EPS expectations and dollar revenue expectations significantly after hearing Infosys? A: Yes I think we will be taking down our estimates at this point in time provisionally by about 3-5 %. Yes we are disappointed with the revenue outlook. It says at least 5%, but in light of the Q1 performance, it seems that even this might be bit of a challenge. So we will not be surprised if Infosys comes in below that for the year. Q: Are you surprised that there is been no second quarter guidance or do you have the numbers, because we don’t seem to have them? A: We too don’t have them. I think what Infosys probably has realized is that their track record in terms of performance versus quarterly guidance has not been really that good now for multiple quarters. In fact, in six of the last seven quarters we found that Infosys has missed expectations and therefore they might have taken the call to suspend quarterly guidance and focus on the annual picture. This need not necessarily be a very bad thing, because when you are trying to focus purely on the quarter, it can lead to counter-productive actions as well. So I am not surprised that Infosys did that because their track record in the past 6-8 quarters hasn’t really been good on this score. Q: It seems that pricing is down close to 4% on a blended basis for the company this time around. Do you have confirmation of that and that’s quite a bit of pricing pressure to be facing? A: Yes, I think there are a couple of explanations for this. One, you have to look at the mix. It seems to me that in this quarter that the mix has moved a little bit towards outsourcing or what we call bread-and-butter offerings. Consulting is down sharply, so some part of the pricing decline can be attributed to mix. Some part can also be because of pricing pressures that clients have exerted. In any case, we have always made the call that a pricing premium in this industry is something that is not going to endure and players like Infosys who may have had that in certain accounts might see greater relative risk of pricing pressure. So I guess as a combination of these two factors at play might have led to this pricing drop. _PAGEBREAK_ Q: It's also looking like utilities and telecom has been a problem vertical for them this time around. On that slippage that they are talking about on revenue growth, is it looking like a one-off in the sense that one client suddenly pull the plug and that hit them or do you think this is a deeper and more lingering problem for them? A: I think we will have to wait for management commentary on this whether it's a one client issue. But what is uncomfortable for us is that we seem to see these one-offs every quarter. The quarter before that was because of large financial services clients so time becomes large utility client and so on so forth. So there seems to be some explanation every time. I am not sure what the details are, but I am sure we will get it from the management very shortly. Q: So what do you do with the stock now, how do you value it? Do you de-rate that stock further from the kind of de-rating that we have seen already, does the valuation gap between TCS and Infosys widen further from here? A: Yes it will. This is a phenomenon called polarization; we have talked about it quite extensively. In a difficult market you will see market share gravitating towards people who are prone to take market share. Infosys’ ability to take market share from peers has been the lowest at this point in history I believe. So unless they are able to do that there will be on going polarization, and while this on going polarization in performance there will be on going polarization in valuations as well. I think it’s a matter of confidence other investors have in Infosys. So if TCS comes out today and maybe even meets expectations, it doesn’t even have to beat it very significantly, I think you will see money flow towards TCS. It will probably even increase in the valuation premier for where it is simply because of polarization and it might be a matter of confidence that investors have in Infosys or the lack of it at this point in time. Q: I was reading your pre-result report and you were alluding to rupee EPS of in the vicinity of Rs 190-195 per share. The company is just modestly increased its guidance from Rs 161 to Rs 166. What do you think should be a realistic benchmark to go with if you are trying to assign a PE multiple on a rupee EPS number? A: The problem that we have in ascribing what is a fair PE also depends on what is fair earnings growth. With every quarter we are seeing a revision downwards in the earnings numbers, and therefore it becomes difficult to ascribe a valuation. My sense is that 12 times the stock factors the worst, and if you can make a case that Infosys has bottomed out here in terms of company performance and hereon sequential growth weight should be on powered industry or powered peers, this is a good time to accumulate the stock so 12 times into maybe Rs 165 will take us closer to about Rs 2100 or so. So that might be actually a good time for longer term investors to come in. _PAGEBREAK_ Q: How do you rework this grid now in terms of what your top preference would be, whether its TCS where performance has been 10 on 10 compared to its peers, whether its HCL Tech which is already out performed a lot of IT stocks atleast in terms of stock performance, and there is Wipro that’s somewhere in the middle maybe? A: Yes we have certainly not been very constructive on Infosys stock for a while now, so we leave Infosys aside for the moment. Taking a look at the other three, TCS clearly is gaining share, that’s obvious. But at the same time we are also not very comfortable with valuations at this point in time. So it might be a good defensive bet in the next three to six months while peers like Infosys struggle and therefore the you will see gravitation towards TCS. Our sense is from a 9-12 month perspective we are not going to make more than 10-12% on this name. Therefore from a valuation perspective we are not really comfortable with TCS in making a good upside case for it. We continue to remain constructive on Wipro and HCL Tech in which we have over weight ratings in the stock. HCL Tech should not have a problem in this quarter, and given the momentum of deal winds that they have had and the fact that the execution of those deals are on track, I think we should be seeing a quarter which should not disappoint. Wipro will have its ups and downs; we just think it’s a structural story that might take a little bit of time to mend, but we are keeping the faith at this point in time. Q: What are you hearing about what people have to say with doing business with Infosys in the market, because the problem seems to be multifold? On pricing they have got a problem so margins are getting hit, volume performance is getting hit, they are obviously not moving on wages, so there will be a risk now in terms of attrition problems for Infosys. A: Yes, there is a challenge in multiple counts. They will have to figure out where they want to really play. Are they playing in the high end space where the traction is not that good or play in the volume space, the bread and butter space, where the strength is not that comparable say to a TCS. So there is little bit of an identity problem there. Then there is a problem of holding on to people. Even in this quarter, quarterly annualised attrition was 21.5. It seems very high in an environment like this. So they could be challenged in case the environment turns back and you are not ready to get people. So I think safe thing is to say that there are multiple problems that they have to grapple with. Certainly the management is seized of this issue. I think they know where they lack relative to peers. Unless we see some action which translates into results I think investors will not get comfort merely from Infosys saying that they recognise the issues. The problem gets compounded because you are talking of a company of Infosys’size. To do a little bit of a make over in a much smaller company will take less time. But to be able to bring about a transformation in Infosys’growth profile, investors have to be patient and this is something that we have been seeing. So, there is no easy way out. _PAGEBREAK_ Q: Why would EBIT margins have collapsed three percentage points in a quarter where the currency has been so favorable, can you understand that? A: Must confess that I haven’t really gone through the details of that, but I saw sales and marketing has also been cut back. So despite that you did have a margin decline. I think a lot of the decline has happened in the gross margin level - maybe it’s got to do with poor utilization. It’s got to do with the pricing cut for sure; they have lost pricing up by 4% in cross currency terms, which itself will impact margins by about 180-200 basis points. So, I think it’s lasted down to pricing, it’s probably down to also a large bench and they haven’t got the volume increase to compensate for that. Q: What do you make of that one time reversal of USD 15 million which is because of one client that the company alluded to? Do you think that market will be in a slightly less punishing mood because of that one time issue or it may not be that forgiving? A: I have to get into the details on that, whether this was assumed with Infosys guidance to begin with and maybe they had sort of factored that in. So when that was not coming, they probably took the hit now than to take the hit later. So maybe they have just sort of brought forward the hit if you will because of client not coming in. So, we will have to take a little bit of detailed look at that. But that said, for those who think that there has just been brutal revenue cut back relative to expectations, I think they should take this with a little bit of a better mood I would say. Q: Where do you see the stock stabilizing, now at Rs 2,240? A: Yes the stock seems to be settling in at lower and lower levels with every quarter and it seems it’s so important to be able to call the quarterly action that all the actions in a quarter happens only in the day after result unfortunately. So, I think the stock should stabilize between Rs 2150 and Rs 2250. I don’t see triggers for it to really go below 2150 and maybe at that level you could see some buying coming in, I would imagine.