Equity Research Report: INFY (Q1FY24)

Infy won the large deal for around $2.3B in Q1FY24, up 9.5% sequentially and 35.3% yearly; may report at least 8% growth in core operating EPS in FY24

Company Overview, Business Model & Competitors:

Infosys (INFY) is an Indian MNC and IT services company (mainly an exporter; provides end-to-end business solutions). Infy is a global leader in next-generation digital services, generative AI, and business consulting firms. Infy’s end-to-end business solutions include consulting, systems integration, enterprise solutions, and advanced technologies (AI, cloud computing, enterprise mobility). Infy’s business IT services comprise application development and maintenance, independent validation services, infrastructure management, engineering services comprising product engineering and life cycle solutions, and business process management. Infy helped global enterprises to navigate their digital transformation powered by cloud technology (backed by AI-powered core).

Infy’s products, business platforms, and solutions accelerate intellectual property-led innovation, including Finacle (banking product/software), which offers solutions to address the core banking, mobile banking, and e-banking needs of retail, corporate, and universal banks worldwide. Infy has a presence/office in more than 50 countries with over 300K workforces, having 40 years of experience in managing the system and workings of global enterprises. Infy also provides outsourcing services and it’s the 2^nd largest Indian IT outsourcing/service company after TCS. Some of the other big IT service exporters, which may be termed as competitors of Infy are Wipro, HCL Tech, Tech Mahindra, Accenture, and Cognizant etc.

Over 85% of INFY’s revenue comes from North America/U.S. and Europe and BFSI (banking & financial service) is Infy’s bread & butter, followed by retail, communication, energy/utilities, manufacturing, and Hi-Tech. Generally, around 68% of Infy revenue is in USD ($), while 32% is in other currencies.

Key management: Salil Parekh (CEO/MD) and Nilanjan Roy (CFO)

Board Members: Key Person: Nandan Nilekani and Salil Parekh

Key Shareholders:

Summary of latest report card: Q1FY24 (Consolidated: INR 100 Cr. =1B)

·         Operating revenue Rs.379.33B vs 374.41B sequentially (+1.31%) and 344.70B yearly (+10.05%)

·         Operating expenses Rs.288.69B vs 284.43B sequentially (+1.50%) and 266.06B yearly (+8.51%)

·         EBITDA Rs.90.64B vs 89.98B sequentially (+0.73%) and 78.64B yearly (+15.26%)

·         Interest expenses Rs.0.90B vs 0.82B sequentially (+9.76%) and 0.56B yearly (+60.71%)

·         Core operating profit (EBTDA=EBITDA-INTT) Rs.89.74B vs 89.16B sequentially (+0.65%) and –Rs.78.08B yearly (+14.93%)

·         Core operating EPS (EBTDA/Share) 21.68 vs 21.55 sequentially (+0.60%) and 18.61 yearly (+16.49%)

·         Core operating (EBTDA) margin 23.66% vs 23.81% (-16 bps) sequentially and 22.65% yearly (+101 bps)

·         EBITDA margin 23.89% vs +24.03% sequentially (-14 bps) and +22.81% yearly (+108 bps)

·         Digital growth (CC) +15.0% (y/y)

·         Revenue (CC/$): $4617M vs 4554M sequentially (+1.38%) and 4444M yearly (+3.89%)

·         Operating Profit (CC/$): $961M vs 957M sequentially (+0.42%) and 4444 yearly (+0.22%)

·         Operating margin ($): +20.81% vs 21.01% sequentially (-20 bps) and 19.98% yearly (+83 bps)

·         TCV Large deal TCV: $2.3B vs. $2.1B sequentially

·         Number of active clients 1883 vs 1872 sequentially and 1778 yearly

·         Total number of employees 336294 vs. 343234 sequentially and 335186 yearly

·         Total number of S/W professionals 317611 vs. 324816 sequentially and 318447 yearly

·         Voluntary attrition (LTM-IT services) 39.5% vs. 39.4% sequentially and 39.3% yearly

·         Reported FCF Rs.57.49B vs 58.44B sequentially and 51.06B yearly; ECF conversion at 96.6% of net profit

·         Fresh Guidance for FY24 (in CC): Revenue growth 1.0-3.5% (+2.25%) vs earlier 4-7% (+5.5%); operating margin 20-22% (21%) vs earlier 20-22% (21%)

·         FY23 guidance of 15-16% revenue growth (actual 15.4%); operating margin of 21-22% (actual 21%)

Overall, Infy reported a subdued and also below-market estimate report card for Q1FY24 and also issued lower guidance for revenue growth in FY24 amid the concern of synchronized economic slowdown/recession/higher borrowing costs/elevated inflation/macro-headwinds/banking crisis on both sides of the Atlantic (U.S.-Europe) and lower tech/digital spending by corporates/enterprises. Subsequently, Infy stumbled from around 1500 to almost 1300 levels.

Highlights of management comments (presser and Q&A): Q1FY24

·         One Large/mega-deal for $2.3B in Q1FY24 and another mega deal of $2B in July days before the concall

·         Building well for the future amid consistent wins of large deals in almost every quarter/regularly

·         Generative AI platform Topaz is being used as an open-source tool for software development

·         Additional thrust on generative AI technology for a new deal and better employee productivity

·         Aiming to improve operating margin in the coming years, although FY24 guidance remains unchanged at 20-22% (CC)

·         Subdued performance and guidance amid lingering macro-headwinds and reassessment of discretionary tech spending by clients, although continues to focus on cost & efficiency programs

·         The operating margin was dragged by higher employee costs despite higher utilization and automation

·         Client metrics remain strong, while the company is providing them with multiple relevant services

·         Reported ROE at 32.8%, up by +180 bps y/y

·         Signed 16-large deals in Q1FY24; 11-in America and 4-in Europe

·         BFSI (Banks & Financials) continues under softness in a loan providing amid credit norms tightening (higher borrowing costs and recent banking crisis due to elevated bond yields/MTM loss); also overall AMC, investment banking operating under stress

·         But big U.S. banks and large regional banks are resilient, although they are focusing on vendor consolidation, and various cost-cutting initiatives including outsourcing various non-core operations that take away existing employees across tech and operations, hampering decision-making process; Infy has won some recent deals and has a strong pipeline of deals, supporting future growth

·         In retail, the focus continues on cost efficiency, vendor consolidation, and leveraging AI to enhance the digital experience for enhanced customer and employee experience, predictive analytics, and real-time insights; although the decision-making process is lengthy, large deal pipelines remain healthy in infra, apps, process modernization, cloud, and workload migration

·         The communication sector is witnessing continued impact from budget cuts, delayed decision-making for newer spending, and a slow ramp-up. Growth challenges for the clients persist due to increasing OPEX pressures. Cost optimization and vendor consolidation are top priorities for clients who are open to innovative solutions and are asking for AI to amplify productivity. OEM clients are showing greater interest in revenue-generating services, decreased time to market, increased product quality, and improved customer experience. Large deal pipeline in this vertical remains very healthy

·         Outlook for the energy, utilities, resources, and services vertical continues to be positive, though there slowdown in decision-making. Energy clients are coming to us for large-scale transformation programs such as digital capabilities for energy transition and journey to net zero. Utility clients are focused on in-flight transformation programs or those required for regulatory compliance. Service clients are focused on consolidation and M&A, cloud cost optimization, and legacy transformation. Infy’s investment in industry cloud and solutions in the energy transition area had helped us differentiate in these sectors to win multiple deals and build a very strong pipeline

·         Manufacturing clients are focusing on controlling spend and awarding deals that are focused on differentiation. Despite the volatile environment, the deal pipeline is strong. Areas like engineering, IoT, supply chain, cloud, ERP, and digital are gaining traction. There is a need to increase paper migration to the cloud, increasing productivity by transforming to smart factories and transitioning to smart products. We are seeing opportunities across auto, aerospace, and industrial

·         Lower revenue growth guidance of 1.00-3.50% for FY24 (in CC) is due to lower-than-expected volumes amid ramp-down in discretionary spending, coupled with lower mega deal volumes arising from delayed timing and longer ramp-up times due to regulatory approvals and transition

·         Margin guidance remained at 20% to 22% for FY24

·         Infy continues to aspire for higher margins over the medium term with a razor-sharp focus on cost optimization and efficiency improvements

·         Infy launched a new margin maximization program across the five pillars comprising over 20 tracks involving pricing, cost optimization, automation/generative AI and portfolio rejig

·         Many deals involving cost efficiency, automation, consolidation, and transformation of clients

·         Revised guidance based on actual Q1 performance and outlook

·         Overall subdued performance/guidance due to lingering macro-headwinds and cut/delay in discretionary tech spending; but companies are eager to spend on AI for transformation, cost efficiency, and consolidation

·         Generally, all large/mega deals generate actual revenue more toward the latter part of the year

·         The salary hike cycle is under active consideration in FY24 too

·         Europe, especially U.K., Germany, and the Nordics are doing well compared to the U.S.

·         But some macro-headwinds are also affecting certain sectors in Europe (like BFSI telecom and retail)

·         The management is cautiously optimistic overall

·         Overall employee utilization/productivity is improving while headcount is reducing

·         Most of the large/mega deals involving cost efficiency or consolidation are not affected due to lingering macro-headwinds, but smaller deals involving discretionary tech spending or transformation projects are getting delayed, especially in affected sectors (like BFSI, telecom, and retail)

·         A client-specific slowdown, but broad sector specific

·         The high base in Q1FY23 is also one of the reasons behind subdued revenue growth in Q1FY24

·         Now Infy is emphasizing generative AI, and cloud/digital tech for the next leg of growth

·         Higher variable pay in Q1FY24 is the main reason for higher employee costs despite lower headcount and lower 3^rd party costs; management consciously upped variable pay and promotion to balance everything (to retain talent)

·         Infy is emphasizing employee lateral hiring, reskilling, and better utilizing existing employees for higher volumes and attrition

Finally, concluding comments by Parekh:

“In summary, for us, we have had a solid Q1, very good Q-on-Q growth, solid margins, excellent large deals and mega deal wins. This sets us up very nicely, with some of the delays and the volume slowing more for the later part of the year. We have also got incredible traction in generative AI with 80 projects and the Topaz work resonating with clients. We now put in place a stronger program for margin expansion, which is in play. Putting all of that together, we see this is a year, where we will make that difference translating to mega deals and large deals, and as we come towards the later part of the year, showing the realization of all of those.”

Highlights of FY23 report card: (Consolidated-INR 100 Cr. =1B)

·         Operating revenue Rs.1467.67B vs 1216.41B (+20.66%) vs 1004.72B (+21.07%)

·         Operating expense Rs.1116.37B vs 901.50B (+23.83%) vs 725.82B (+24.20%)

·         EBITDA Rs.351.30B vs 314.91B (+11.56%) vs 278.90B (+12.91%)

·         Net interest paid Rs.2.84B vs 2.00B (+42.00%) vs 1.95B (+2.56%)

·         Core operating profit (EBTDA=EBITDA-INTT) Rs.348.46B vs 312.91 (+11.36%) vs 276.95B (+12.98%)

·         Core operating EPS (EBTDA/Share) Rs.84.21 (FY23) vs 74.57 (+12.92%) vs 65.20 (+14.38%)

·         EBTDA margin 23.74% vs 25.72% (-198 bps) vs 27.76% (-187 bps)

·         EBITDA margin 23.94% vs 25.89% (-195 bps) vs 27.76% (-187 bps)

·         Interest/EBITDA ratio 0.81% vs 0.64% (+17 bps) vs 0.70% (-6 bps)

·         Constant Currency (CC) revenue growth +25.4%; digital growth +25.6%

·         Large deal TCV $9.8B

Conclusions:

Overall report card of Infy was subdued and the management also issued materially lower guidance/revenue growth for FY24 amid lingering macro-headwinds/economic uncertainty. Infy is also a key beneficiary of higher tech/digital transformation spending on enterprise growth & transformation (G&T) initiatives. Infy is cautiously optimistic about demand and ongoing discretionary tech spending by big corporates as they have to stay competitive, more productive, and relevant amid the chorus of the synchronized recession on both sides of the Atlantic (U.S.-Europe).

Previously (during the Q4FY22 concall), Infy did not see any meaningful softness in demand/new prospects or delay in the decision-making process by big corporates despite the uncertain macro environment and the chorus of synchronized global recession/stagflation amid adverse geopolitical situation (Russia-Ukraine/NATO), economic sanctions, elevated inflation, and faster tightening by Fed, ECB, BOE, and small banking crisis. But Infy is now more cautious than 3 months ago.

For Infy, the operating margin should improve in FY24 amid the normalization of salary hikes, moderation in attrition, higher automation, and better pricing & utilization. This coupled with higher USDINR may support all IT service exporter earnings including Infy in FY24. Infy is also aiming for double-digit growth of around +15% of its revenue in the next few years on a sustainable basis and partnering with various big corporates in U.S. and Europe for their digital transformation journey.

Infy has a strong, debt-free, and cash-rich company. Looking ahead it can grow multifold through various organic and inorganic expansions and also growing digitalization theme in India (both at government and private levels). It also seems that Infy has some regional/small U.S. banks as clients, but the overall exposure may be not much significant.

Overall, Infy may be a major beneficiary of global inflation/macro headwinds as companies are now embarking on cost-cutting/optimization by adopting greater automation and digital and cloud adaption. The market was already skeptical about Infy’s performance amid the synchronized economic slowdown in U.S. and Europe, the primary market for almost all Indian software service exporters. Infy said although there are some concerns about discretionary long-term high-tech spending, most companies are now upgrading their techs for cost optimization, better productivity, consolidation and to stay ahead of the curve/competitors.

Fair Valuation: The present fair value of Infy may be around 1356 and TCS may scale Rs.1534 by FY24, Rs.1736 by FY25, and Rs.1965 by FY26

Overall, Infy delivered a subdued report card in Q1FY24 amid lingering global macro-headwinds. But Infy reported core operating EPS of 21.68 vs 21.55 sequentially (+0.60%) and 18.61 yearly (+16.49%); going by the trend, Infy may deliver +8.00% growth in core operating EPS for FY24. Infy reported FY23 core operating EPS around 84.21 vs 74.57 in FY22. In any way, Infy clocked a growth of around +12.92% in FY23 vs +14.38% in FY22 vs +25.27% in FY21 and +11.98% in FY20. The average growth rate of core operating EPS is around +17%.

Now considering various pros & cons, current & past run rates, and guidance provided by the company, Infy may report at least +8% growths in core operating EPS in FY24 and +15% average CAGR in FY25-27 after considering higher USDINR and normalization of global macro from CY2024. This will translate to a projected core operating EPS of around Rs.90.95-104.59-120.28-138.32 from FY24-27.

Further, if we consider BVPS/PB (Book Value/share) and OCFS (Operating Cash Flow/share) valuation metrics along with traditional EPS/PE, then the average valuation of Infy may be around Rs.1356-1534-1736-1965 for FY: 24-27. As the financial market usually discounts 1Y projected earnings in advance, the present fair value of Infy may be around 1356 and Infy may scale Rs.1534 by FY24, Rs.1736 by FY25, and Rs.1965 by FY26.

Infy and also other big Indian IT service companies (exporters) are big beneficiaries of digital transformation by global corporates to stay ahead of the competition, productivity, and inflation curve (higher input costs). Indian IT exporters are also benefitting from the weak Rupee despite some cross-currency headwinds and higher employee & travel expenses (post-COVID).

Impact of Fed rate action on Techs:

As highly expected Fed goes for a +25 bps hike on 26^th July with a less hawkish stance; the Fed repo rate is now at +5.50%, the highest in 22 years. The U.S. labor market and core inflation trajectory are still hot enough for another Fed hike. Fed never surprised the market with its rate action and by mid-October (after core inflation and labor/wage data for July-September); it will be clear whether Fed will go for another +25 bps hike in 2023 before going for a final pause in 2024. In any way, Fed is now preparing the market for another hike and then a possible end of the tightening cycle by Dec’23.

Fed may go for a pause in September after the 26^th July hike, but may hike another +25 bps on 2^nd November, if core inflation does not fall significantly. Fed may go for a long pause to assess the underlying core inflation trend and outlook along with the labor market for July-Sep’23 economic data. Fed may project at least another hike in 2023 in its September dot-plots (SEP) depending upon the actual economic data and outlook. If there is no significant easing of core inflation, especially core service inflation, then Fed may go for another +25 bps hike in Nov’23 and possibly the end of a tightening cycle.

Fed goes for a less hawkish hike on 26^th July; Fed may go for a long pause, at least till 1^st November’23, to assess the underlying core inflation trend and outlook along with the labor market for July-September’23 economic data. If core CPI inflation indeed eased further to around +4.0% by Oct’23, then Fed may refrain from any further rate hike in 2023 and may also indicate some rate cuts in Q2CY24 in the Dec’23 SEP (ahead of the US Presidential Election in Nov’24) to keep real repo rate around +1.00% levels. 

Bottom line:

If Fed indeed goes for a pause/pivot after Nov-Dec’23 and prepares the market gradually for any rate cuts from mid-2024 itself, U.S./global bond yields (borrowing costs) will slump, which will be positive for Wall Street/techs including all Indian IT service providers like Infy in FY: 25-27 and core operating EPS may grow around +15-20% CAGR from present rate 12-15%. For Infy, differentiated digital, generative AI and cloud capabilities should drive broad-based growth amid robust deal momentum. Infy may also upgrade its revenue growth guidance from the existing +2.5% to normal +15% in FY24 (CC).

Technical view: Infy (LTP: 1340)-EOD: 28/07/23

For short/medium-term trading levels:

Looking ahead, whatever may be the narrative, technically, Infy now has to sustain over 1400 for a rebound to 1425/1460-1500/1525* and further rally to 1585/1675*-1790/1955* in the coming days (bullish case scenario). On the flip side, sustaining below 1380, Infy may further fall to 1330/1300*-1260/1215* and 1185*/1095-950/900* in the coming days (bear case scenario).

Investors may accumulate Infy on dips from around 1300-1215* levels.

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