We believe the next wave of growth for large Indian IT vendors will be led by infrastructure services and business process outsourcing (BPO). These account for less than 15% of NR Narayana Murthy-led Infosys Ltd' revenue compared with 25-35% for Tata Consultancy Services (TCS) (TCS) and HCL Technologies.
Infosys is now beginning to focus on these segments, but in the next two to three years, we think Infosys’ large base (nearly 85%) in the slower growing applications segments will remain a drag on revenue growth relative to peers. With recent commentary indicating the company is having trouble jump-starting growth in its base segment as well, we think a turnaround could take longer than expected.
Excessive focus on margins in a revenue-driven model could hurt market share: We are puzzled by the company's decision to report margin increases in the past few quarters, even as revenue growth trajectory has begun to slow once again. TCS and HCL Tech had reported margin drops for at least two to three years during phases of investment, after which margins recovered as revenue growth improved.
We were very appreciative of the company's margin reset in FY13 in a bid to gain market share and view the recent reversal in that strategy and curtailment in critical areas of spending such as sales headcount as premature and potentially risky to revenue growth.
Attrition and sales growth in a vicious cycle, unlikely to reverse soon: Infosys’ attrition is very high, with the company losing nearly one-fourth of its FY13 closing employee base in FY14. TCS has announced wage hikes of 10% offshore and 2-4% onsite versus 6-7% and 1-2%, respectively, by Infosys. This, and a softer revenue outlook, could lead to further spikes in attrition for Infosys in FY15. We believe these high levels of attrition will impact revenue acceleration, limiting the company's ability to beat its revenue guidance of 7-9% y-o-y despite improving demand.
Valuation: We downgrade Infosys from Buy to Sell and lower our price target from Rs 4,050 to Rs 2,750, which values the stock at 13x FY16e EPS (earnings per share), near its three-year low. We also lower our EPS forecasts for FY15/FY16/FY17 by 4%/11%/15% to reflect our lower revenue and margin estimates than previously.
Investment summary: We believe a turnaround for Infosys will take longer than currently expected by investors