2023-11-30 15:20:15 ET
Summary
- Infosys is positioned at the crossroads of maturity and new growth, with legacy IT solutions and generative AI.
- The company's flagship generative AI offering, Topaz, has the potential to drive significant growth and value appreciation.
- Infosys faces competition and market saturation risks in the IT services industry, but also benefits from India's growing economy.
- We are neutral pending further developments of Topaz.
Investment Thesis
Infosys (INFY) currently waltzes at the crossroads of maturity and new growth with their legacy IT solutions and new generative AI. With a fair value finely poised at $18.41 by our analysis, INFY embodies the equilibrium of prudent investment and latent potential. A bear case pegged at $14.35 reflects cautious conservatism, while a bull scenario at $21.06 flirts with optimistic prospects. Our 'hold' recommendation echoes the rhythm of balanced growth prospects against a backdrop of moderate revenue forecasts, with a keen eye on Topaz, the generative AI beacon that could change the tempo.
Company Background/Description
Since its founding in 1981, Infosys, has been able to develop into a well-respected player in the IT sector at a global scale. They have been able to prove themselves a leader in digital transformations, tech consulting, software development and IT outsourcing; with clients in major industries such as finance, insurance, manufacturing, and healthcare. By consistently investing in R&D they have found themselves well in the mix of innovation in technologies like cloud computing, data analytics, and artificial intelligence. Their respective product lines Cobalt and Topaz are a testament to their ability to keep in line with innovation.
Diving Further into Topaz
Topaz, Infosys' flagship generative AI offering, stands out as a pivotal element in the company's technology portfolio. Topaz is designed to cater to the burgeoning demand for AI-driven solutions across various sectors. It integrates advanced AI models and algorithms to offer solutions that are both innovative and practical. They offer an impressive 150+ pre-trained models to serve their clients in all industries and in varying capacities. They have forged partnerships with several foundational model researchers, hyperscalers, and beyond.
Features and Use Cases of Topaz
Data Processing and Analysis: Topaz excels in handling large volumes of data, providing insights and predictive analytics which are crucial for decision-making in sectors like finance and healthcare.
Automated Content Generation: In industries like marketing and media, Topaz can be used to generate creative content, significantly reducing the time and effort required for content creation.
Customized Solutions for Enterprises: Topaz offers tailored solutions for businesses, enhancing operational efficiency, customer engagement, and driving innovation.
Integration with Existing Systems: One of Topaz's strengths is its ability to seamlessly integrate with a company's existing IT infrastructure, thereby enhancing the value of their current investments.
Quick Qualitative Analysis
To better understand Infosys’s potential for growth we can review expectations for the industry and how their legacy IT services and new generative AI fit in to this equation. Overall, the IT services market is moderate to highly competitive, with players like TCS, Wipro, Accenture, and IBM. Infosys competes on factors like technological expertise, pricing, quality of service, and innovation. The higher competition stems specifically from the growing AI sphere where there are numerous players ranging from tech giants to specialized AI firms that can revolutionize the IT industry. These competitors are constantly improving their offerings, leading to a highly dynamic market environment. Our view is that a lot of this competition and investment into AI is due to the fact that it is a disruptive technology and particularly disruptive to legacy IT services that INFY and their competitors thrive on. So where does this put Infosys?
To answer this question we like to think in terms of margin and revenue as they are the two paths to increasing free cash flow. The legacy IT services are undoubtedly the bedrock of INFY’s steady revenue, despite the competition, with Global IT services expected to grow at a CAGR of 7.37% into 2028 this segment will continue to generate moderate revenue growth. Unfortunately, due to the competitive nature, gaining market share in this line of services is much more difficult and comes at the price of greater expenses and offering lower cost to consumers resulting in lower margins. Generative AI sings a different tune with an expected global CAGR of 24.40% into 2030. The potential for growth here is massive and it is still early in the adoption cycle which leaves room for market capture.
Infosys's 150+ fine-tuned models is undoubtedly impressive and gives them an edge in serving a variety of client and industry's needs. This could be viewed as an early lead, however, there is more at play here, the future landscape and what adoption will look like is unknown. Centralized AI systems like Topaz could be the direction adoption takes but alternatively many companies, institutions, and sovereigns may want to design, fine-tune, and run models in house. The open-source nature of many foundational models makes this a possibility and desire for data privacy can provide the motivation for adoption to take this route. Although a partner, this is something Nvidia CEO Jenseng Huang alluded to in their earnings call last week. In our valuation section you will see that this ambiguous future is a leading reason why we are forecasting growth more in line with the CAGR of the IT industry as a whole rather than that of Generative AI and that this level of growth is already priced in.
Main Points Supporting Thesis
The company's guided revenue growth of 2.5% for fiscal year 2024, significantly lower than its 3-year CAGR of 12.94%, paints a picture of a company in a consolidation phase rather than rapid expansion. While we do forecast a return to moderate growth in line with industry growth as economic conditions ease, this growth is priced in. Additionally, there is little room for margins to widen in this competitive industry. Topaz is INFY’s wildcard that looks to change the outlook of their business. Its success in the market could be a game-changer, potentially driving significant growth and value appreciation. However, the real impact of Topaz will depend on its adoption and performance against competitors in the generative AI space. While being early in the adoption cycle can seem like an advantage we see this as a risk because we do not know where customer demand will lead adoption as noted above.
Infosys does not lack tailwinds, as a major player headquartered in India, Infosys stands to benefit from the country's rapidly growing economy. The burgeoning tech sector in India offers a fertile ground for Infosys to expand its operations and tap into new market opportunities. India has put out staggering GDP growth over the past few years outside of covid and is expected to stay steady above 6% into 2028.
Valuation Analysis
We based our model off the guided 2.5% revenue growth for 2024. From there we raised expectations to 8% and 10% for 2025 and 2026 respectively and then tapered growth back down to 6% into 2033. The result is the following Free Cash Flow to Firm:
We ran a regression over the past 500 trading days to get a beta of .60 and this leads us to our WACC.
We derive our target price from terminal value through the Perpetuity Growth Method and provide a sensitivity table based on our multiples method calculation as well.
Our DCF analysis anchors our valuation of Infosys at $18.41, a figure we deem to be its fair value. This analysis takes into account the company's current performance metrics and future growth prospects, balanced against the broader market dynamics and industry-specific trends.
We highlight our Bull case in green and Bear case red. Our bear case, with a lower terminal EV/EBITDA multiple of 11.50x, reflects the potential downside risks and aligns with competitors of a similar stature. It also reflects that we underestimated WACC, and tighter monetary policy persists longer than expected. Conversely, our bull case scenario, with a higher multiple of 15.50x, aligns with Infosys' current multiple and represents a more optimistic outlook on their business into perpetuity while also reflecting that we overestimated WACC, and macro condition improve quicker than expected. Lastly, to get our 12-month target value we subtract expected dividends from valuation to get $17.98.
Overall, our takeaway from this valuation is that INFY is priced efficiently and is in a consolidation period. The IT service industry is at a new dawn, and it is hard to say what it will look like 10 years from now with AI adoption being imminent but with different paths at hand. In theory AI should increase the margins, reach, and revenue of all businesses over time and if that is through Topaz then INFY will be rewarded. We will continue to monitor the industry and update our forecasts as future earnings reveals this vail of mystery.
Robust Discussion of Risks
When it comes to risks INFY seems safe from the more classic measures of risk such as high beta or high debt. We identify two main company specific risk, macro risk, and one risk to investors rooted in our analysis.
Market Saturation and Competition: Infosys operates in a highly competitive and rapidly evolving industry. The risk of market saturation and the intense competition from both established players and emerging entrants cannot be overlooked. This folds into technological obsolescence: In the tech industry, the risk of obsolescence is ever-present. Infosys must continually innovate to stay relevant, and any lag in this regard could significantly impact on its market position and growth prospects. Although a risk, this is an area where Infosys has persistently shown their diligence. They launched Topaz in May only 6 months after Chat-GPT’s release took the world by storm and shed light on the AI frenzy. Mitigating technological obsolescence does come at a cost though, R&D must always be heavily funded making it difficult to increase margins even with maturity.
Dependency on Topaz: Although we believe more Topaz could be a source of growth in the future and we are accounting for that uncertainty there is some level of risk here. There is no doubt that their legacy IT services will continue to anchor their revenue for the foreseeable future. However, when looking into perpetuity as we do in valuation, we should consider that a good portion of their terminal growth should stem from an AI solution to their current IT services as that is the way technology is moving. If Topaz is not that AI solution it means INFY will have to spend more money bringing a different product to market or face technological obsolescence.
Global Economic Fluctuations: Being a global player, and due to the interconnectivity of global economies, Infosys is susceptible to economic fluctuations across different geographies. Any downturn in key markets could adversely affect its business operations and financial performance. Although their home country of India looks ripe for growth, recessionary fears are still alive in geographies across the globe.
Upside Risk: This is specific to our rating of a hold. By suggesting investors wait for further clarity into Topaz’s adoption and performance it leaves the risk that Topaz overperforms in the short term and investors will have to buy in at higher values.
Conclusion and Takeaways
Infosys faces an industry with rapid changes at hand. Our 'hold' recommendation is a nod to the company's current fair valuation, coupled with the cautious optimism for its future prospects. Investors should closely monitor the progress of Topaz and the company's performance in the coming quarters, as these factors will be crucial in determining whether Infosys can transition from a stable hold.
For further details see:
Infosys: AI Prospects Not Ready To Break Consolidation