Infosys’s FY17 promises to be a roller-coaster ride

Last month, when Infosys Ltd warned investors of a bumpy ride in financial year 2016-17, no one had a roller-coaster in mind. After all, besides saying that headwinds in some segments will lead to quarterly ups and downs, chief operating officer UB Pravin Rao had also added that the company was staying with its annual revenue growth guidance of 11.5-13.5%.

But in about a month’s time, Infosys has cut its annual revenue growth target to 10.5-12%. Its performance in the June quarter was particularly weak, with revenue growing by just 1.7% sequentially in constant currency terms. Some analysts had estimated growth as high as 4.2%.

The results were shocking, to say the least. Infosys shares nosedived 10% soon after the results were announced.

There may well be some more nasty surprises awaiting investors in the rest of the year. If the June quarter had turned out as expected, Infosys would have needed average quarterly growth of 2.9-4.1% to meet its earlier stated guidance. But now, even though it has cut its annual revenue guidance, it still needs an average quarterly growth of 3.8-4.7% to meet the new target. In the backdrop of increased uncertainty in the global economy, an increase in the ask rate looks like a recipe for trouble.

Also read: Growth challenges resurface at TCS

According to chief executive officer Vishal Sikka, the company is firing on nearly all cylinders, except for a couple of areas where discretionary spending has slowed down and another couple of areas where large projects haven’t ramped up as fast as expected. But on the back of the weak June quarter results, these assurances sound hollow. As pointed out in this column earlier, a large company with a diversified portfolio just can’t blame a few pockets for dragging down overall growth. In the end analysis, investors are only interested in seeing how the entire portfolio was managed. In the June quarter, the performance was clearly poor.

And although this isn’t the first time an IT services company has revised its guidance downward after its first quarter results, it is certainly unusual. This brings to the fore questions about the credibility of the management’s statements. To think that the Brexit event is still to play out, and that the uncertainty around it may also be affecting spending by financial institutions just makes things worse.

On a year-on-year basis, Infosys’s revenue has grown by 12.1% in constant currency terms. In the March quarter, revenue had grown by 15%. Growth had fallen at Tata Consultancy Services Ltd (TCS) as well, from 11.9% in the March quarter to 10.1% last quarter. Considering that the June quarter is among the stronger ones for the industry; the signs are clearly worrying.

It appears that the shift in IT spending to digital areas is leading to a cannibalisation of traditional services. While Indian IT services have stepped up investments in the former, the pace of change is clearly not fast enough. Worse still, this is also leading to pressure on pricing in traditional areas of business. Analysts at Kotak Institutional Equities said in a note to clients earlier this year, “Constrained IT budgets and the business imperative to spend in digital imply self-funding mechanism i.e. through cost take outs in traditional services to fund digital. Vendors are achieving the desired cost savings for clients through managed services, fixed price contracts and pricing concessions. The disproportionate focus of vendors on these services has only accelerated the pricing decline.”

In this backdrop of falling returns, valuations of IT services stocks look rich. Even after Friday’s correction, Infosys shares trade at around 17 times estimated FY17 earnings, while TCS trades at 18 times forward earnings.