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.

Discount Brokers Comparison: Your one-stop shop for finding the perfect broker for your investments.


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.

SEE: Understanding The Income Statement

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.

SEE: 5 Must-Have Metrics For Value Investors

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.

Related Articles
  1. Personal Finance

    A Day in the Life of an Equity Research Analyst

    What does an equity research analyst do on an everyday basis?
  2. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  3. Mutual Funds & ETFs

    ETF Analysis: iShares Morningstar Small-Cap Value

    Find out about the Shares Morningstar Small-Cap Value ETF, and learn detailed information about this exchange-traded fund that focuses on small-cap equities.
  4. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  5. Mutual Funds & ETFs

    ETF Analysis: iShares Core Growth Allocation

    Find out about the iShares Core Growth Allocation Fund, and learn detailed information about its characteristics, suitability and recommendations.
  6. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI USA Minimum Volatility

    Learn about the iShares MSCI USA Minimum Volatility exchange-traded fund, which invests in low-volatility equities traded on the U.S. stock market.
  7. Stock Analysis

    Should You Follow Millionaires into This Sector?

    Millionaire investors—and those who follow them—should take another look at the current economic situation before making any more investment decisions.
  8. Professionals

    What to do During a Market Correction

    The market has corrected...now what? Here's what you should consider rather than panicking.
  9. Mutual Funds & ETFs

    ETF Analysis: WisdomTree SmallCap Earnings

    Discover the WisdomTree Small Cap Earnings ETF, a fund with a special focus on small-cap and micro-cap stocks with positive earnings.
  10. Mutual Funds & ETFs

    ETF Analysis: iShares US Regional Banks

    Obtain information and analysis of the iShares US Regional Banks ETF for investors seeking particular exposure to regional bank stocks.
RELATED TERMS
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Profit Margin

    A category of ratios measuring profitability calculated as net ...
  3. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis ...
  4. Debt Ratio

    A financial ratio that measures the extent of a company’s or ...
  5. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing ...
  6. Net Present Value - NPV

    The difference between the present values of cash inflows and ...
RELATED FAQS
  1. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. When does the fixed charge coverage ratio suggest that a company should stop borrowing ...

    Since the fixed charge coverage ratio indicates the number of times a company is capable of making its fixed charge payments ... Read Full Answer >>
  4. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  5. What is the difference between the return on total assets and an interest rate?

    Return on total assets (ROTA) represents one of the profitability metrics. It is calculated by taking a company's earnings ... Read Full Answer >>
  6. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>

You May Also Like

COMPANIES IN THIS ARTICLE
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!