Infosys’ fourth-quarter results were in line with our expectations. In what was a disruptive year from a board and management perspective, we were pleased with the firm’s overall financial performance. However, the stock declined notably after the result. We believe the reaction followed management’s new fiscal 2019 guidance, which called for a lower than historical range for its closely followed operating margin.
The company expects its operating margin to be 22%-24% for fiscal 2019, which continues a recent trend of management resetting market expectations for this metric. Strategically, the margin outlook reflects the firm’s need to focus on growing its digital business, reskill its workforce, and expand its localization efforts. We think this focus makes long-term sense and believe that the digital and localization efforts are required to be a leading IT services provider in the future.
In the short term, we think this will keep margins slightly depressed, but a midterm margin outlook of 23%-25% is appropriate, particularly as localization efforts moderate.
After accounting for management’s new outlook and rolling our model forward one year, we reiterate our fair value estimate and narrow economic moat rating.
Economic Moat: Narrow
Infosys’ narrow economic moat results from high switching costs (roughly 96%-98% of revenue is from repeat business and has been around these levels for many years). The company’s commitment to building lasting relationships, embedded systems and processes, and intimate knowledge of clients’ IT infrastructure means customers are averse to switching between vendors.
On a gross basis, Infosys continually adds over 200 clients per year, which is an encouraging sign and cements further long-dated business given switching costs. Such switching costs ensure a certain level of operational consistency and the company’s exemplary financial health reflects this.
We forecast Infosys to easily generate a return on invested capital in excess of its cost of capital for the foreseeable future, and we believe its lower-cost offshore delivery model allows for this assumption.
Fair Value Estimate: Rs 1,100
Our FVE implies forward fiscal-year price/earnings of 15 times, an enterprise value/EBITDA of 11 times, and a free cash flow yield of 6%. We forecast a 5-year revenue compound annual growth rate of 8.6% and expect a broad-based contribution from the company's four major industry segments.
We think the firm will actively pursue top-line growth and use its significant financial flexibility to achieve this. Infosys is targeting larger outsourcing deals and has hired a raft of new salespeople to assist with these endeavors.
In addition, with clients increasingly investing in compliance, infrastructure modernization, digital transformation, analytics and cloud, and cyber security, Infosys has established the Center of Innovation for Tomorrow's Enterprise to help develop relevant next-generation products and services.
Furthermore, the acquisition of Lodestone signifies a bigger focus on European growth, and we think the firm will attract more business from this region. Operating margins are forecast to remain around the low to mid-20s in the short term, and going forward, we think margins will marginally improve because of cost reduction, process optimization initiatives, and significant emphasis on automation.
Our discounted cash flow model assumes a return on invested capital that comfortably surpasses the company's 10.5% weighted average cost of capital.
Consider Buy: Rs 660 / Consider Sell: Rs 1,705
Yesterday, April 23, the stock’s closing price on BSE was Rs 1,183.35. With the stock trading close to our fair value, we’d seek a wider margin of safety before considering investment.
