You are welcome to try out the new site at https://beta.valueresearchonline.com
Infosys's lower valuations and improving prospects mean that it could be a multi-bagger
By Malini Bhupta | Sep 12, 2018
India's two largest IT services companies TCS and Infosys announced their quarterly numbers in July. After TCS announced its results, its stock was up by about 5.5 per cent. On the other hand, after Infosys announced its results, its stock was up by about 1.8 per cent. For long-term investors, quarterly gyrations should not matter much, but when the gap in market capitalisation between two companies in the same sector is over $60 billion, then it makes sense to go a little deeper and understand if Infosys can catch up.
TCS' market capitalisation crossed the $100 billion mark in July, while currently Infy's market capitalisation is a little over $40 billion. TCS' price-to-earnings multiple is at 28, while that of Infosys is at 18. This suggests that there's enough headroom for Infy's multiple expansion if it manages to report higher growth and bigger deal wins. Typically, maximum wealth creation happens when one catches the stock when it is fairly priced or relatively undervalued. A fully-priced stock would not deliver great returns even if it continues on its growth trajectory. From a valuation perspective, Infosys does look better placed than TCS. If Infosys catches up with TCS, then the stock could be a multi-bagger.
Before going into granularities, it makes sense to take a look at the quarterly numbers. TCS reported sequential revenue growth of 1.6 per cent in dollar terms and 4.4 per cent in constant-currency terms. The IT services major exited the June quarter with an operating margin of 25 per cent, down 40 basis points sequentially. TCS' revenue growth was led by a revival of the banking and financial-services vertical. The vertical accounted for $1.9 billion out of a total $4.9 billion in deal wins. The digital business grew at 9.1 per cent sequentially and 44 per cent annually in the June quarter and it accounts for 25 per cent of total revenues.
Infosys, on the other hand, reported revenue growth of 2.3 per cent in constant-currency terms and 0.9 per cent in dollar terms. The company had an operating margin of 23.7 per cent, down 100 basis points quarter on quarter. The financial-services vertical, which accounts for 31.8 per cent of the revenue, declined during the quarter. The total contract value of new deals during the quarter was $1.12 billion, which is the highest in eight quarters. This was split between renewals and new deal wins. Digital business accounted for 28 per cent of revenues and this segment has grown by 8 per cent in constant currency and 25 per cent year-on-year in the June quarter. The company has made two acquisitions in the UK and the US, which have enhanced its capabilities in the agile digital business.
Smart investors tend to focus on valuations and by that logic shares of Infosys appear cheaper, given its sector-leading performance in the past. But doing what it has done in the past may not be good enough to get it back on track. Even though, broadly, the market accepts that Infosys is going in the right direction, the turnaround story under promoter-chairman Nandan Nilekani is still work in progress. Interestingly, TCS was in the same spot nearly a decade and a half ago when it got publicly listed in 2004. Back then, TCS faced problems of client concentration, low-margin business clients and a higher proportion of fixed-price contracts in its kitty. Today, the tables have been turned and Infosys is attempting to break out of its risk-averse style of doing business.
So what does Infosys need to do to close the valuation gap between itself and TCS? Experts believe that Infosys has stayed away from the large multi-service deals. The company may need to make more acquisitions, like Brilliant Basics, in newer areas - cloud, data analytics, artificial intelligence, augmented and virtual reality, smart machines and IoT - where it needs to spruce up its competencies. It also has to build an ecosystem through partnerships and collaborations if it wants to bid for the large transformational deals in digital.
Today, large digital contracts require service providers to build cross-functional teams that can work with multiple vendors. These deals have to be shaped from conception at times and for this Infosys needs to invest in building new teams or retrain its existing workforce.
The market is now getting ready to move away from pilot projects to large-scale transformational engagements. For this, Infosys will need to hire fresh talent and make some sensible acquisitions. The success in digital will determine Infy's long-term growth trajectory. There is a positive uptick in the corporate profits in the US and higher outsourcing from Europe. All pointers suggest that a revenue uptick is most likely.
While Infosys has spoken about its intent to invest more in growing the business, it also needs to reset its margin band. The rupee's recent decline has given the company headroom to revise its margins despite wage hikes and higher expenses in sales and marketing. Also, the company should try to bring down the attrition.
Given that the promoter chairman is back at the helm, analysts and market believe that Infosys will underpromise and overdeliver, as it has in the past. Once seen as the poster boy of Indian IT, Infosys may not be very far from regaining its mojo.
Value Research Stock Advisor now has 37 stock recommendations and new ones are added every month. Thousands of our members are using the current market conditions to buy great stocks at low prices.
Membership of this premium service is available at a 40% to 60% discount.