IT services is a lucrative market, as investors in IBM (NYSE:IBM), Accenture (NYSE:ACN) and Cognizant Technology Solutions (Nasdaq:CTSH) know quite well. As one of the largest players, India's Infosys (Nasdaq:INFY) has enjoyed ample growth over the years, but the question is whether the company is still well-positioned to exploit ongoing growth in service outsourcing. Although the valuation does not look especially demanding today, it's worth asking whether management can stabilize its margins and hold (or gain) share in a still-growing market.
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A Disappointing Fiscal Second Quarter
Although Infosys' reported results for its fiscal second quarter weren't too bad in objective terms, the company missed expectations and continues to sap investor confidence regarding its ability to adapt to the changing IT services industry.
Revenue rose nearly 22% from last year as reported and about 2.5% sequentially. In U.S. dollar terms, year-over-year growth was only about 3% with similar sequential performance. Volume was up about 4%, with pricing more or less flat. Although the business operations and consulting/systems integration segments did all right, the products and platforms business was weak (down almost 8% sequentially).
Margin performance continues to be problematic, as margins were down once again. Gross margin slid more than a point sequentially and operating income was down more than 3% from the prior quarter. Operating margin fell 170 basis points sequentially, hurt by higher contract support provisions and higher subcontractor expenses.
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Will Long-Term Investments Pay Off?
Some of the more charitable/supportive sell-side analysts covering Infosys seem willing to make the case that its present margin challenges are, at least in part, a product of positioning the company for better long-term growth. Perhaps so, as the company is trying to expand its capabilities with alternate delivery models and reduce its dependence upon increasingly commoditized application and maintenance markets.
On the other hand, client retention is not looking great, as the company saw 39 new clients, but only a net increase of four active clients. Along similar lines, it seems as though companies such as IBM, Cognizant, Accenture and Computer Sciences (NYSE:CSC) are doing pretty well gaining share - particularly in higher-value service offerings. So it's worth asking whether Infosys can effectively play in the higher-value sectors and/or adjust its cost structure if it cannot gain share there.
The Market Is Growing ... but also Changing
Infosys can still look forward to a fundamentally supportive environment for its core operations. Large corporations/organizations are finding it harder to recruit and retain enough skilled IT professionals, and even as Infosys is seeing the need to pay more to retain talent, Indian IT providers still offer meaningful cost advantages for companies willing to outsource their needs.
At the same time, however, it looks like there's an ongoing increase in the percentage of contracts that are fixed-price, and that presents certain challenges to margins. What's more, as I mentioned before, companies such as IBM and Computer Sciences seem to be doing pretty well when it comes to gaining higher-value contracts. That creates the risk that companies such as Hewlett-Packard (NYSE:HPQ), Xerox (NYSE:XRX) and Infosys have to compete more on the basis of price and/or content with lower-value business.
The Bottom Line
Even relatively bearish/skeptical analysts seem to believe that IT outsourcing will continue to grow at a double-digit clip for the next five years (or more), and that Infosys will continue to report low teens revenue growth and improving free cash flow margins. On a discounted cash flow basis, then, that suggests that Infosys shares may be undervalued.
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If Infosys can maintain revenue growth of around 10% and keep the free cash flow margin around 20% (its average rate over the last decade), these shares seem to be worth somewhere in the mid-$50 range. That growth certainly presumes ongoing IT services demand growth (particularly in the United States) and ongoing cost advantages for Infosys. Infosys has historically done a fairly good job of responding to changing trends within the IT market, so investors who believe that is still the case could find that this is an good time to buy shares before the company starts delivering better growth and margins.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.