Equity Research Report: INFY -Q4FY23

With almost $10B order in hand for FY24, Infy may beat the subdued guidance despite the chorus of an imminent recession in U.S-Europe

Company Overview, Business Model & Competitors:

Infosys (INFY) is an Indian MNC and IT services company (mainly an exporter). Infy is a global leader in next-generation digital services 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: Q4FY23 (Consolidated: INR 100 Cr. =1B)

·         Operating revenue Rs.374.41B vs 383.18B sequentially (-2.29%) and 322.76B yearly (+16.00%)

·         Operating expenses Rs.284.43B vs 289.51B sequentially (-1.75%) and 244.30B yearly (+16.43%)

·         EBITDA Rs.89.98B vs 93.67B sequentially (-3.94%) and 78.46B yearly (+14.68%)

·         Interest expenses Rs.0.82B vs 0.80B sequentially (+2.50%) and 0.50B yearly (+64.00%)

·         Core operating profit (EBTDA=EBITDA-INTT) Rs.89.16B vs 92.87B sequentially (-3.99%) and –Rs.77.96B yearly (+14.37%)

·         Core operating EPS (EBTDA/Share) 21.55 vs 22.26 sequentially (-3.21%) and 18.58 yearly (+15.97%)

·         Core operating (EBTDA) margin 23.81% vs 24.24% (-42 bps) sequentially and 24.15% yearly (-34 bps)

·         EBITDA margin 24.03% vs +24.45% sequentially (-41 bps) and +24.31% yearly (-28 bps)

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

·         Revenue growth (CC) +8.8% (y/y)

·         Large deal TCV $2.1B

·         Voluntary attrition (LTM-IT services) 39.4% VS 39.4% sequentially and 39.6% yearly

Overall, Infy reported a subdued and also below-market estimate report card for Q4FY23 amid the concern of synchronized economic slowdown/recession/banking crisis on both sides of the Atlantic (U.S.-Europe) and lower tech/digital spending by corporates/enterprises.

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

Highlights of management comments (presser and Q&A): Q4FY23/FY23 report card

·         The digital business now almost 62.9% of overall revenue

·         Thrust of leveraging generative AI capabilities both with clients and in-house to improve productivity

·         Subdued revenue in Q4 due to unplanned ramp-down of projects by some clients amid lingering macro-headwinds and banking crisis on both sides of the Atlantic (sudden change in the market environment)

·         There was some project cancellation by a specific client, which was one time

·         Although there were some signs of stabilization in March, the overall environment remains uncertain amid the chorus of synchronized recession in Europe and the U.S.

·         The pipeline of large deals remains extremely strong as several of these orders are related to cost optimization and efficiency improvement for clients coupled with vendor consolidation

·         Overall guidance (in CC) for FY24: Revenue growth of 4-7% (5.5%) and operating margin of 20-22% (21%) against FY23 guidance of 15-16% revenue growth (actual 15.4%); operating margin of 21-22% (actual 21%)

·         FY24 guidance is on the conservative side amid lingering economic uncertainty and very large deals at hand, some of which may be canceled/postponed also in the coming quarters

·         Signs of stress (unplanned project ramp downs) across various sectors in Q4FY23: Telecom, Hitech, retail, NBFC/Mortgage based/AMC (asset management company)/IB (Investment Banking)

·         Contraction in operating/EBITDA margin due to higher employee and travel expenses (onsite work after COVID), but the company is trying to improve margin by more automation (AI) and better utilization of workforce in FY24

·         Revenue guidance is being provided with TCV trend but may change in the coming quarters as clients may ramp down/up some projects (including part/complete cancellations) in an unplanned way due to lingering macro-headwinds/economic uncertainty

·         Infy is in close coordination with clients who are going for part/full cancellation of some projects due to economic uncertainty/banking crisis on both sides of the Atlantic, but the adverse economic impact in the U.S. is more than Europe

·         But the largest/robust pipeline of orders (focused on cost, efficiency, and consolidation) is also providing comfort for FY24 to meet guidance provided at least

·         Overall Infy is cautiously optimistic for FY24

·         For FY24, the management will properly utilize the existing reserve bench and fresh recruits to take care of expected volumes of work in a flexible way; the current utilization rate of the reserve bench is around 80%, which is historically on the lower side of; management is trying for more efficient utilization of bench

·         Despite some top manager-level exits recently, Infy has enough talented pool of internal leaders who can ensure a smooth transition process and delivery of services, especially digital services on automation and cost optimization; Infy has a strong leadership team within the organization and no leadership crisis even after some high profile exits

·         The management is trying to improve operating margin through higher automation, proper utilization of pyramid/workforce/bench and onsite mix related to sub-contractors, travel and also exploring higher pricing power/rates amid sticky/elevated inflation; the company is also providing necessary new skill to its employees for an adaption to changing tech

·         No guidance for freshers recruit in FY24 as the company already hired around 51K in FY23 against a target of 50K, and provided them with the necessary training/skills to be ready for projects/work in the coming days, but the company will be flexible in fresh hiring going forward while having enough talent sitting on the bench

·         The company is actively working on generative AI (GAI) tech (Chat GPT) to include it in active client projects and also owns software development libraries to improve efficiency and productivity for both (clients and self); Infy is working both on open source and proprietary GAI platform

·         Revenue growth guidance for FY24 is around 5.5% (CC) considering various pros & cons, but it may be revised in the coming quarters depending on the actual flow of work

·         The long-term revenue growth target remains 15-20% (CC) which will depend on the underlying macro environment, ongoing digital transformation to improve efficiency, cost optimization, and also consolidation

·         FCF is now almost 85% of the net profit

·         Current maco-headwinds/economic uncertainty in the U.S. is a good M&A opportunity for Infy if it finds an appropriate company that fits with the organization strategically and also culturally

·         The management is confident enough for pricing power backed by value addition; the days of a heavy discounting environment are at least over (industry-wise)

·         Some reduction in client addition in Q4FY23 was seasonal

·         Gross revenue/employee was around $53400 vs $57000 sequentially and $58000 yearly; down primarily because employee utilization comes down from 88% to 80%; the company is carrying more freshers in the bench than last year

·         Larger deals are taking additional time to convert into real revenue

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. Like TCS, 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 technology 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).

Infy does 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.

Rising investments in areas from cloud computing to cyber security and digital transformation by various corporates during the COVID pandemic have propped up demand for the $195 billion Indian IT industry. However, the demand has also led to severe attrition among employees and margins have suffered due to higher employee costs like wage hikes and additional travel and visa costs (after COVID). Thus managing employees; i.e. attrition is now a huge challenge for Indian IT service companies like Infy. But the growing trend of a hybrid model of work should also optimize operating costs and improve productivity/employee satisfaction; i.e. will eventually reduce attrition.

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.

Global techs such as Meta, Amazon, Microsoft, Alphabet (Google), and Tesla jumped on hopes of better earnings after mass layoffs. Various other big techs are also laying-off ‘unnecessary’ employees in masses to cope with the muted operating revenue as COVID-era digital spending growth fumbled after the pandemic has turned into endemic coupled with overall slowing economic activity amid higher inflation (cost of living) and higher borrowing costs. The discretionary digital spending is being affected, resulting in muted fresh digital capex. But techs are recovering now in hopes of cost optimization amid mass layoffs. Here in India, big IT firms such as TCS, INFY, and Wipro are also in the process of employee cost optimization in a prudent and calibrated manner without creating a panic.

Fair Valuation: The present fair value of Infy may be around 1170-1269-1356 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 Q4FY23 amid lingering global macro-headwinds coupled with the sudden eruption of the banking crisis on both sides of the Atlantic. Infy reported FY23 core operating EPS around 84.21 vs 74.57 in FY22 and our previous estimate of 89.49. 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 standard FY23/previous/present guidance provided by the company (15% revenue growth and 22% operating margin in CC), Infy may report at least +8% growth in core operating EPS in FY24 and +15% average CAGR in FY25-27. 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 1364 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:

The market was pricing no hike on 14^th June after renewed concern about FRC (regional bank) and a less hawkish Fed hike on 3^rd May. But now, after the FRC bailout by state-sponsored JPM buyout, and strong April NFP job report, no significant cooling of core inflation in April, and the Fed’s hawkish comments (Powell/Bullard/Williams), the market is again discounting some probability of another +25 bps rate hike on 14^th June.

Fed was already behind the inflation curve from early 2021 when the economy opens fully after the 2020 COVID disruption. Fed should have started to normalize its ultra-loose monetary policy in early 2021 rather than starting the process (telegraphing about QE ending and potential rate hikes) in late 2021. In the process, Fed created synchronized global inflation/stagflation as almost all major G20 central banks usually follow Fed policy action for currency (USD) and bond yield differential. The late action of the Fed coupled with supply chain issues and policy paralysis in the White House created synchronized elevated sticky core inflation globally (except in China).

Now (till the banking crisis emerged in 2^nd week of Feb’23), seeing inflation out of control, both Fed and ECB were engaged in ultra-hawkish jawboning to tighten monetary/financial conditions, resulting in a rapid increase in bond yields and HTM (bond portfolio) loss of mid-size U.S. regional banks, who are not so much efficient to manage interest rate increase in an efficient/professional manner.

Fed is itself now suffering from huge MTM loss (unrealized) as it’s offering trillions of dollars at higher reverse repo rates to banks; Big U.S. banks are major beneficiaries of higher reverse repo rates (risk-free return) from Fed. But small/mid-sized U.S. regional banks like SVB and FRC have a significant mismatch between asset and liability, resulting in the current failure.

Fed is now going to pause after at least one more hike as it believes banks, especially smaller ones will tighten lending norms, which will eventually tighten financial conditions more and consumer demand thereby, helping lower inflation. For the last year, Fed was too occupied with jawboning to control the market and may not have focused adequately on bank supervision/regulation; especially for vulnerable small/mid-size U.S. regional banks. Here is also Fed was far behind the curve, nearly inviting another 2008-type GFC.

But, as the immediate concern of financial stability eases, Fed may go for their planned rate hikes in a calibrated manner to ensure price and financial stability as well as credibility. Thus Fed had gone for a +25 bps rate hike on 3^rd May, and may also do the same on 14^th June for a terminal repo rate of 5.50% and then may pause depending upon the actual trajectory/outlook of core inflation. Fed will ensure financial stability with liquidity tools and price stability with interest tools as unlike during 2008-10, core inflation is still substantially higher than the +2% targets, while the unemployment rate is still near a record low of 3.5% (at maximum employment level).

In a way, while there is a question mark for June hike now in the market, there will be no rate cuts at least till mid-2024 contrary to market expectations. After mid-2024, Fed may begin talking about rate cuts (just ahead of the Nov’24 U.S. Presidential election) to boost Wall Street (risk trade) and also to ensure lower bond yields to rescue U.S. regional banks and itself. Fed has to also ensure lower borrowing costs for the U.S. government as well as businesses and households.

At the present run rate, U.S. core CPI may take another 6 months; i.e. Sep’23 to fall to around +5.0% and Sep-Dec’24 to further fall around +4.0%, still substantially higher than Fed’s +2.0% targets. Thus Fed needs to keep the real interest rate restrictive /positive enough for a longer period, so that core inflation falls towards +2% targets by Dec’25. Fed may keep the repo rate at 5.50% by June for a real positive U.S. interest rate. Fed should have communicated earlier in a clear way that a real positive interest rate is the basic requirement for ensuring price stability along with supply-side actions by the fiscal authority/government (including peaceful resolution of the Russia-Ukraine/U.S./NATO proxy war).

The average U.S. core CPI is now also running around +5.6%, almost +100 bps higher than Fed’s preferred core PCE inflation and this gap of +100 bps is running since Jan’22. The average core inflation (PCE+CPI) is now around +5.25% and thus Fed may keep the terminal repo rate at least at +5.50% till Dec’23 (real positive/zero interest rate) to curtail demand (slowing economy) and bring inflation towards +2.0% core inflation target.

As monetary/fiscal authority on both sides of the Atlantic will not allow any banks to fall in reality, both Fed and ECB may continue their rate hike plans as there will be no 2008-like GFC this time. Both Fed and ECB are now running well behind the inflation curve and are reacting to data rather than the desired opposite action. Both central banks are not confident enough to spell out the plan to keep the real rate of interest at least zero or +25/50 bps for a considerable time to manage price stability durably because of their fear of financial /stock market stability and also political/social stability. In the process, they are creating more confusion and bubbles as the market is also taking the next rate cut moves as granted.

Fed/ECB should have communicated earlier in a clear way that a real positive interest rate (wrt at least core inflation) is the basic requirement for ensuring price stability along with supply-side actions by the fiscal authority/government (including peaceful resolution of the Russia-Ukraine/U.S./NATO proxy war) to bring down inflation. AEs can’t have durable price stability only by higher borrowing costs; they have to ensure a cheap supply line source like China (DEs) without a lingering cold war mentality and appropriate supply-side reform/fiscal stimulus (to increase supply and match higher demand).

Fed may go for another +25 bps hike in June for a terminal repo rate of +5.50%, while ECB may further hike by +25 bps each in June and July. Moreover, if core inflation does not dip below +5.00% in the Eurozone by August, then ECB may have no option but to go for a further +25 bps rate hike each in September, October, and December for a terminal repo/MLF rate +5.25%.

ECB wasted at least 3 months to match Fed’s rate action and thus now scrambling to match as a consistently weaker EURUSD will also result in higher imported inflation, everything being equal. Europe may be the biggest loser of the Russia-Ukraine/U.S./NATO war/proxy war as it’s an importer of both food and fuel apart from various other commodities. The high cost of living crisis in Europe may invite bigger social and political unrest in the coming days if inflation does not come under control in the coming days.

Bottom line:

If Fed indeed goes for a pause/pivot after May-June’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 +20% CAGR from present rate 12-15%. For Infy, differentiated digital and cloud capabilities should drive broad-based growth amid robust deal momentum. There are upside valuation risks for Infy as it may even report a 15-20% growth in core operating EPS for FY24. Infy may also upgrade its revenue growth guidance from the existing +5.5% to normal +15% in FY24.

Technical view: Infy (LTP: 1261)

Looking ahead, whatever may be the narrative, technically, Infy now has to sustain over 1180 for a further rally to 1270/1300*-1350/1370*-1415/1435-1490/1535* and 1620/1675*-1790/1955* in the coming days (bullish case scenario).

On the flip side, sustaining below 1165, Infy may further fall to 1135/1020-975*/900 and 775/700*-645/500 in the coming days (bear case scenario).

Investors may accumulate Infy on dips from around 1180-975 levels or break above 1300 levels.

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