Just last month, N.R. Narayana Murthy asked Infosys Ltd’s shareholders for at least three years to turn around the fortunes of the company. Investors are now almost behaving as if he’s done the job in a month’s time. Shares of Infosys rose 10.9% to Rs.2,804.45 each on the back of better-than-expected results.
The company’s revenue rose 2.7% sequentially to $1.991 billion, compared with Street expectations of growth of less than 1%. Year-on-year growth looks impressive at 13.6%, especially given Nasscom’s industry growth target of 12-14%. But exclude the recently acquired Lodestone business and sequential growth falls to 1.7%, while year-on-year organic growth is just 8.5%.
More importantly, though, this is hardly the time to get excited about a percentage point or two more of sequential growth, when the company has effectively admitted it is in dire straits and needs to put its house in order. When analysts kept pestering the Infosys management with questions on why it hasn’t raised its weak guidance for the year, chief executive officer S.D. Shibulal had to remind them that “one quarter is not a secular trend”. Put simply, one needs to wait for a few more quarters of steady growth before assuming that the company is back on track.
A number of information technology analysts and investors, however, are accustomed to extrapolating the previous quarter’s performance to the full year. By this logic, revenue should expand more than 12% in the year till March 2014. But again, as Shibulal pointed out, the company’s disproportionately high exposure to business related to customers’ discretionary spending can result in volatility in growth rates. Investors shouldn’t ignore the fact that organic growth even fell into negative territory not too long ago.
Infosys shares have now risen about 27% from lows in April and done better than stocks of better-performing companies such as Tata Consultancy Services Ltd. Investors seem to have concluded that Murthy will undoubtedly turn the company around and bring it back to at least industry growth rates.
But even if he is successful in doing so, the road to recovery will without a doubt include the high cost of increased sales and marketing expenses and other investments. In short, profit margins will be under pressure, and earnings growth, if any, will be muted. Margins were flat last quarter and operating profit rose about 3% sequentially. But the company has said that the wage hikes it has given effective July will impact margins by 300 basis points. A basis point is one-hundredth of a percentage point.
An analyst with a multinational brokerage firm said his earnings estimates will not change materially after the June quarter results, primarily because of the expected pressure on margins.
Some brokerage firms, however, have raised earnings estimates by 6-8%. But it should be noted that this is also a function of resetting the rupee-dollar levels—which has nothing to do with Friday’s results announcement. Meanwhile, Infosys’s valuations have risen to nearly 17 times trailing earnings. While the rupee’s depreciation will make the growth in rupee earnings look decent, underlying growth will be much lower.