Infosys - Margins disappoint despite multiple tailwinds - Centrum

Infosys' 2QFY14 results were below our expectations in terms of margins (adj. EBITDA* margins down 34bps/299bps QoQ/YoY and 141bps lower than our estimates) despite multiple tailwinds: 1) Rupee depreciation of 10.9% QoQ, 2) Utilization up 190bps to 77.8% and 3) Pyramid lever (trainees replacing part of billable attrition). We attribute the positive reaction in the stock price to optimism that revenue growth (up 3.8% QoQ to USD 2,066mn) will eventually lead to margin improvement. We believe that margin gains will lag peers, revise our margin estimates downward (to close to consensus from above consensus) and maintain our Sell rating.

Results below expectations: While rev. growth was stronger than we'd anticipated (3.8% QoQ in USD terms Vs our expectations of 3.1%) and rupee realization was a full 2% higher than we'd anticipated, we were disappointed by how little of the rupee and utilization upside flowed into margins. We expect peers like TCS, Wipro and HCLT to show substantial margin improvement this quarter. Narrowing the guidance range was only to be expected being half-way into FY14 and given revenue momentum.

Gross Margin flat/down despite sharp utilization increase: Despite a 2nd quarter of sharp uptick in utilization (up 610bps from 4QFY13 to 77.5% excl. trainees & support), banking product HC being reduced to 6,580 from 7,004 and an estimated 0.7% reduction to costs from 7K+ trainees moving to billing; gross margins were slightly down QoQ (even after steep rupee depreciation over the quarter). Salary costs were up 17% in INR terms (5.5% in USD terms). Mgmt attributed this partly to variable pay kicking in.

Sales wage bill up an eye-popping 21.9% QoQ in USD terms while G&A control limits EBITDA impact: S&M employee costs soared 21.9% in USD terms (35.2% in INR terms) to take total S&M spending to 5.8% of sales (up 66bps QoQ). G&A decreased 21bps QoQ (excl. the provision of Rs. 2,190Mn for settling claims by the US Attorney's office for Eastern Dist. of Texas and Dept. of Homeland Security) limiting adj. EBITDA* margin decline to 34bps QoQ/299bps YoY.

Cutting margin estimates, Maintain Sell: We'd anticipated significant margin expansion from rupee depreciation and utilization that hasn't materialized. We note that in 1QFY13 as well, EBITDA margins declined 201bps despite rupee depreciation of 9.7% which had provided a margin uplift of 3.7%. But pricing declines in the same quarter neutralized these benefits and onsite hiring and visa costs dragged margins down. Infosys is currently trading at 16.6x Oct'13-Sep'14 EEPS. We maintain Sell due to the lack of margin expansion despite improved utilization (we assume no large program transitions are affecting current realizations) and rupee depreciation. We are reducing EBITDA margin estimates due to: 1) lower INR realizations assumed and 2) reduced utilization headroom to arrive at a revised Sep'14 target price of Rs2,690 (12x 1-Year Fwd EPS in Sep'14).

Source : Equity Bulls

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