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Stock Insight: Mission Infynity

Is Infosys Technologies a buy? We believe a perfect future seems to have been priced into the stock

For a non-professional investor trying to figure out whether Infosys is a good investment, the biggest psychological challenge is to keep Infosys the company separate from Infosys the stock. The company is the pride of new India symbolising everything that has gone right for this country in the last two decades. The stock, however, perpetually seems to combine the somewhat uncomfortable characteristics of appearing fully priced as well as being volatile.

Much of the investment analysis available for the company suffers from being targeted at people who are already experts. For an ordinary investor, it could be useful to have a back-to-the-basics understanding of not just the company, but the business it embodies.

The Basics
Over the last two years, any lingering doubt about the efficacy of the offshore software delivery model that companies like Infosys embody has disappeared, especially for large clients. Despite anything else you may hear, this key driver around which this business revolves is cost. As companies in the developed world try to squeeze the most out of each dollar they spent on IT, offshore firms, like Infosys, are simply much cheaper.

The key resistance has always been the psychological one of getting high-tech work done by a company from a country historically perceived as low-tech. This is a handicap that Indian companies have worked hard to overcome over the years.

It is notable that the industry and its customers' perception have evolved in such a way that the typical case is a very large client company buying IT services from a large supplier. For IT services, the psychological resistance has been overcome not so much by India as a whole but by the largest Indian IT services companies.

This makes it important for these large companies to grow not only by adding new clients, but by growing the amount of work they do for each client. For Infosys, and others like it, it is of great value to take over as much as possible of each client's IT functions. This ensures easier growth and, more importantly, provides a stickiness that is missing in piecemeal project works. A client who is dependant on a provider for most of its IT work will be loathe to undergo the cost and the pain of switching to another provider for some marginal savings. As service businesses in all kinds of industries understand, there is safety as well as profit in becoming a more and more crucial part of your clients' operations.

The Good
Of all the good news one can find about this company, we believe that the most important is the strong evidence of its ever-closer connection with its clients. Infosys continues to become a more-and-more important part of the IT operations of its strategically important large clients. The company has a total of 221 clients that bring in more than $1 million each in revenues. Of these, 167 are in the range of $1-10 million, 35 in $10-30 million and 19 in the $30 million-and-above range. Every quarter of last year saw at least 80 per cent of these 221 clients increase their billing with the company.

Moreover, clients are sticking with Infosys. Five years ago, around half of the company's revenue came from clients who had been around for more than three years; today, the figure stands at around 70 per cent. While at first sight the increased percentage appears to be a natural consequence of the company having been around longer, remember the percentage is on much higher revenue. In absolute terms, Infosys earned about Rs 930 crore from three-years-and-older clients in FY2001. In FY2006, this number was up at around Rs 6,700 crore.

Of course, the more conventional numbers are well in place. Revenue growth is at 33 per cent and will probably remain at these levels for at least two more years. Net margins are among the best in the industry at 25.6 per cent. While margins are not at the 30 per cent-plus levels of a few years ago, they have actually increased over the last two years. The balance sheet is very strong. The company now has over a billion dollars in cash. Return on capital is above 40 per cent and cash flow is around 38 per cent of sales.

The Worry
Since the cost advantage of hiring Indian engineers lies at the heart of this company's business, any erosion of this talent pool is a matter of concern.

The competition for these employees is getting tougher. Along with other Indian companies, like Wipro and Tata Consultancy Services, larger US consultants like Accenture, IBM and Cognizant are rapidly increasing their India headcounts. Net hiring has been as high as ever in FY2006. During the year, Infosys headcount grew 43%, while those of most competitors grew by comparable numbers.

Last year, revenue per employee also decreased slightly, although this is probably not important because despite higher salaries, total cost per employee was kept in check. As the competition for people intensifies, it becomes necessary for Infosys to change its business in a way that will neutralise these threats.

The increased India presence of players like Accenture, IBM and EDS (which acquired MphasiS recently) creates yet another threat for Infosys. While Infosys has strong client relationships, they can't even begin to compare with those that IBM or EDS have, and having development centres in India eliminates the one disadvantage that the foreign firms have vis-à-vis Infosys. Now, with 43,000 employees in India, IBM Global Services can present itself to its clients as an IBM with Infosys costs.

However...
So how will Infosys cope with these problems? The answer is straightforward - the company will think of something. Seriously, what exactly does an investor buy when he buys into a stock? Does he buy straight-line extensions of current trends, as some stock analysis would have you believe? Perhaps, in the short-run, yes.

But in the long-run, a large part of what you are buying is management quality. In the last 25 years, Infosys has been through many transitions in its journey from zero to Rs 9,500 crore. Each time, there was the chance of failure, but each time, the people who run this company made the right choice. And really, that's the most important thing an investor should look for.

So is this company a buy? That's a slightly tricky question. The problem with the Infosys stock is that an utterly perfect future seems to have been priced into it. A sensible course would be to not even dream of touching it for the short-term, but to buy into it steadily for a long-term, specially in times when the market is weak.