2024-01-18 08:02:51 ET
Summary
- After a year of underperformance, Infosys has caught a bid recently.
- Emerging signs of a tech spending recovery bode well for the sustainability of this rally.
- Even after the latest rally, INFY stock still has ample room to grow into its valuation.
Indian IT services leader Infosys Limited ( INFY ) has traded up over the last week. Not so much on its modest Q3 FY24 P&L beat but on signs of improved deal momentum – a trend echoed across industry peers like Wipro ( WIT ) (see coverage here ). With rate cuts also set to get underway later this year (the market expects >125bps vs the Fed’s 75bps), a prolonged post-COVID hangover for discretionary IT spend may finally be at an end. Beyond a cyclical bounce, Infosys is also arguably best-positioned to navigate high-growth themes like generative artificial intelligence (>90 AI-related projects currently underway), analytics, and cloud migration over the coming years.
The stock may not screen cheaply on an absolute basis at >20x forward earnings, but relative to where the Nifty benchmark currently trades and with the prospect of further P/E multiple expansion as growth accelerates off a lower base, valuations aren’t all that demanding, in my view. Plus, Infosys’ dividend/buyback yield bonus will count for a lot more in a falling interest rate environment, cushioning any downside risks.
Reasons for Optimism Despite the Top-Line Contraction
Quarterly reporting season for India’s IT services has turned out a lot better than expected, with positive prints from industry leaders Tata Consultancy Services ( OTCPK:TTNQY ) and Infosys followed by smaller players like Wipro as well. The top-line, in particular, has been a key source of optimism – even though Infosys saw a sequential ~1% decline in constant currency terms (also down ~1% on a YoY basis), this was still well ahead of relatively downbeat consensus expectations. Key large-cap peer Tata Consultancy Services was also slightly ahead of expectations at +1% growth on the back of a more resilient IT spending backdrop.
At a more granular level, Infosys continues to lean on smaller verticals like manufacturing (+10.6% YoY) and life sciences (+6.3% YoY) to offset demand weakness in financial services (-5.9% YoY), still the company’s largest revenue source. As for client geography, Europe (+5% YoY) and the rest of the world (+7.8% YoY) have been sources of strength, cushioning revenue declines in North America (-4.9% YoY).
More importantly, Infosys’ forward-looking metrics paint an upbeat picture – the company disclosed a large deal TCV (‘total contract value’) of $3.2bn in 3QFY24, driving its highest ever year-to-date number at >$13bn. Per management , the TCV was well spread across 23 large deals (only one ‘mega’ deal win). Segment highlights include six new deals in financial services and ten in America (both major revenue generators), further adding to the optimism.
In essence, enterprise demand appears to be rotating into cost-efficiency projects and automation (vs. being cut entirely), so there are still plenty of deals to be won. Management hasn’t yet factored in potential discretionary spending upside once global central banks pivot into rate cut cycles either; thus, the current revenue guidance bar could well prove conservative.
Margins Holding Firm Through the Headwinds
Infosys’ headline profitability was similarly down – its reported EBIT margin of 20.5% for the quarter represented a ~70bps QoQ contraction. To a large extent, however, the margin compression was expected, given management’s prior guidance for year-end salary hikes (an ~70bps headwind) and a one-off ~60bps charge from a breach at its US unit Infosys McCamish. Plus, Q3 tends to be a seasonally weak quarter.
The positive surprise, on the other hand, was a hefty ~50bps gain from the firm-wide margin improvement plan, project Maximus. Also positive was that this quarter’s sizeable net headcount reduction (~2%) came without any voluntary attrition tradeoffs (down to 12.9% in Q3 FY24).
From here, there’s likely plenty more to come from margins, given management's five-point margin improvement program (comprising benefits from AI, indirect cost reductions, and procurement streamlining, among others) is still in full swing. Given key peer Tata Consultancy Services has been able to drive ~50bps of sequential margin expansion during the period, there’s clearly room for Infosys to ‘catch up’ over time. And more broadly, for IT services large-caps, a pick-up in discretionary tech spending bodes well for operating leverage gains (i.e., more revenue spread over a relatively fixed cost base), especially if digital transformation roadmaps get back on track.
Laying the Foundation for Generative AI
Adapting to new trends has long been something Infosys has excelled at; with generative AI projects ramping up at an unprecedented pace, though, there could well be winners and losers within the sector. Thus far, Infosys has sent all the right signals, having already launched an AI offering, Infosys Topaz, which integrates its Cobalt cloud and data analytics capabilities to boot. Like many of its peers, the company is expecting big things from its hyperscaler collaboration (e.g., Microsoft ( MSFT ), Google ( GOOGL ), and Amazon via AWS ( AMZN ), among others); proof of concepts thus far have spanned everything from code and text to media. In quantitative terms, Infosys’ traction places it well ahead of peers – as of Q3 FY24, ~100k of its employees have been trained, and ~90 generative AI client projects are in the works.
From here, gauging the AI impact will be tricky. On the one hand, Infosys will suffer from pricing pressure – the result of higher productivity on the client side. Whether this can be offset by project volume and how much margin can be preserved (e.g., how much productivity benefits Infosys can reap on its side) is the key question. In any case, Infosys’ scale and track record with prior themes (e.g., cloud migration and analytics) mean it's the best bet to navigate future uncertainties.
Quality Large-Cap Levered to an IT Spending Recovery
While Infosys didn’t beat expectations by a particularly big margin in Q3 FY24, its encouraging deal momentum, in line with reporting across its peer group, was likely the key reason behind its re-rating. Recall that the IT services demand backdrop has been challenged post-COVID, and the relative equity underperformance (vs. India’s benchmark Nifty 50) reflects this. Now that revenue growth is bottoming out, however, there’s a good chance that Infosys will outperform from here, particularly with monetary policy also set to loosen significantly later this year.
To be clear, Infosys isn’t the stock with the highest torque to a discretionary demand recovery (Wipro would be a far better candidate). It is, however, the safest one – key at a time when the sector is adjusting to new tech trends like generative AI. Investors willing to underwrite a relatively discounted (to peers and historicals) >20x forward earnings multiple stand to be well-rewarded, in my view. While waiting for earnings to re-accelerate, investors also get paid a nice low-single-digit % yield to wait.
For further details see:
Infosys: Quality Large-Cap Levered To An IT Spending Recovery