Valuations intact even in slowdown

Valuations intact even in slowdown
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First Published: Wed, Jan 14 2009. 12 44 AM IST

Updated: Wed, Jan 14 2009. 12 44 AM IST
Infosys Technologies Ltd’s shares ended at Rs1,228 on Tuesday, at almost exactly the same level (Rs1,225) as three months ago, when the company announced its September quarter results. This is interesting because the business environment has markedly worsened in the past three months.
Indeed, although Infosys’ management had cut its annual guidance sharply in October itself, it had said that it did so out of caution, rather than any concrete change in its relationships with clients. Addressing analysts at a post-results conference call, this is how chief financial officer V. Balakrishnan had explained the cut in its guidance: “We want to be cautious even though we have not seen any impact till now. We have not seen any project cancellations. Pricing was stable even in the September quarter. We have not seen any price renegotiations for many major clients. So we believe the pricing environment is stable, even while volume growth still continues to be good. But looking at what’s happening in the environment we want to be cautious.”
Three months later, things have changed. Average billing rates have declined by 1.8% on a quarter-on-quarter basis and the company’s management is now saying that there are multiple price renegotiations going on. The outlook on volume growth has also changed. According to the Infosys CFO, given the current environment and the rate at which overall sectoral growth is coming down, if a company is able to hold volumes, that’s good; and if someone’s able to improve on volumes, they’re better off.
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That was in response to a query on the fact that the company’s guidance for the March quarter implies a mere single-digit growth on a year-on-year basis. Note that volumes grew by 14.5% in the December quarter, 17.3% in the September quarter and by 18.5% in the June quarter. Analysts normally build assumptions for the next financial year based on the outlook for the last quarter of the year. According to a fund manager, with low volume growth and pricing decline, Infosys will start financial year 2009-10 on a weak wicket.
Why then were the markets excited about Infosys’ results? The company’s share price rose 6.36% even as the 30-share Bombay Stock Exchange Sensex declined 0.42%.
To be fair to the company, it did well in the December quarter in a tough environment. Onsite operations were hit as clients took extended holidays in an attempt to cut costs in the slowdown. Besides, some billing rate cuts had to be extended because of the weak environment and price competition.
Still, the company met its guidance targets both in terms of revenues in constant currency terms and profit. The performance on the revenue front is commendable since the extra holidays and the price cuts weren’t factored in the company’s guidance for the December quarter. Besides, the company was able to assure investors that although the environment has weakened, things are still manageable and that it can sustain margins at current levels.
On the profit front, the company managed to meet its guidance due to a sharp cut in selling, general and administrative (SG&A) expenses. Infosys, on its part, has said that SG&A expenses can’t go lower than last quarter’s level of 11.75% of revenues. But most analysts feel that these low levels of SG&A spend are not sustainable and may trend higher in coming quarters. Competitors such as Tata Consultancy Services spend around 20% of revenues on such expenses.
That’s not to say that Infosys has no levers left to salvage profit margins in the coming quarters. So far, it has refrained from cutting its employees’ variable pay, which amounts to around 5% of revenues. Besides, based on the current business environment, it will be fully justified in not giving salary hikes of the nature it did in previous years. This, too, will help sustain margins.
Having said that, the outlook for FY10 is far from bright and if anything has weakened in the past three months. Revenue growth can be expected to be in single-digits and earnings growth shouldn’t be much different. Infosys’ valuation of 12.75 times trailing earnings seems disproportionately higher from that perspective.
What seems to be helping the company’s valuations is the flight to safety, which normally happens in a business downturn. The Satyam episode has only accentuated this process of reallocating capital meant for information technology investments to top-notch firms such as Infosys. From a pure business perspective, however, investors buying at current levels stand a high chance of being disappointed.
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Graphics by Paras Jain / Mint
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First Published: Wed, Jan 14 2009. 12 44 AM IST