5 things to note about Infosys

Morningstar's equity analyst looks at the fair value estimate and moat of the company.
By Morningstar Analysts |  07-06-16 | 

Infosys is one of India’s most pre-eminent providers of IT services. However, the company has suffered from its slow-moving legacy past (smaller, more discretionary projects) and out-of-date go-to-market strategy, resulting in low revenue growth relative to peers, margin compression, leadership churn, and high employee attrition.

In light of these issues, Infosys has launched a number of initiatives to improve its performance. The company has some way to go before rectifying its position, but a number of signs are promising, with revenue growth, margins, client mining, and employee attrition improving.

The appointment of well-respected CEO Vishal Sikka has also reinvigorated the company’s morale and strategic direction.

Morningstar analyst Andrew Lange reviewed the stock recently. Here is an excerpt from his detailed analysis.

1) Economic Moat

Infosys’ narrow economic moat results from high switching costs (roughly 96% 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.

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.

2) Moat Trend

Infosys’ moat trend is stable. The firm’s long-dated client relationships, industry expertise, and global delivery model are not easily replicable and protect it from competitive disruption. Infosys has the ability to provide all four key industry services--consulting, systems integration, IT outsourcing, and business process outsourcing--which leads to more sticky integrated deals and reinforces our conviction in its competitive stability.

According to Gartner, Infosys’ worldwide market share (which was 1% in 2015) has remained around the low to mid-20th position for the past five years, and we do not see this changing noticeably.

3) Fair Value Estimate

The FVE of Rs 1,177 reflects one year’s worth of time value of money and an upgraded top line due to better-than-expected guidance. (The FY17 revenue growth expectation has been raised to 12.4% from 11.4%).

The FVE implies forward fiscal-year price/earnings of 17.5 times, an enterprise value/EBITDA of 12 times, and a free cash flow yield of 5.0%.

4) Growth

We forecast a 5-year revenue compound annual growth rate of 11.4% 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 already targeting larger outsourcing deals and plans to hire a raft of new salespeople, which should help improve win rates. In addition, with clients increasingly investing in compliance, infrastructure modernization, digital transformation, and analytics and cloud, 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 at current levels for the next year, and going forward, we think margins will marginally improve because of cost reduction and process optimization initiatives.

Our discounted cash flow model assumes a return on invested capital that comfortably surpasses the company's 10.5% weighted average cost of capital.

5) Financial Health

Infosys is in a strong financial position. As of March 31, 2016, the company had no debt and approximately $5 billion in cash and equivalents. The firm generates substantial free cash, averaging $1.3 billion per year over the past five years (we expect it to generate approximately $1.5 billion-$2 billion in free cash annually).

For the time being, we expect the company to use its outstanding cash balance and ample free cash generation to fund future growth opportunities; therefore, we expect it to remain unlevered.

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T M Subrahmanya Swamy
Jun 9 2016 05:41 PM
 It is interesting & assuring to know that Infosys is on the way to transform into the next level under the leadership of Mr.Vishal Sikka.Infy will stand to gain in the long run if it remains as a platform for large Ignited Indian youths.
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