Tuesday, December 04, 2007

What Should Infy Do to Restore its Honor?

Take a look at the chart below. It shows something very very interesting. This is the stock price chart (adjusted for splits, bonus issues etc) of Infosys, one of India's most admired companies.

The fellow who bought the stock in March 2000 (the peak of the tech bubble) and held on to the shares in Infosys for more than seven years, essentially did not make any money!

One of the most-admired companies in one of the world's fastest growing economies - a company which is debt-free, earns super returns on capital, and is run by a management team which is renowned for its operating skills as well as integrity. And the stock earns nothing in the biggest bull market India has ever seen!

What could explain an outcome like that???

Has the company's earnings declined?

NO! See the chart below:

Infosys's earnings have grown consistently ever since it went public. Moreover, the earnings growth rate has always been well in excess of India's GDP growth rate.

Now see the chart below - it shows what really happened to Infy.
As the above chart shows, Infy's P/E Multiple chart resembles that of a speculative bubble -and indeed it was a speculative bubble.

At the peak of the tech bubble, the investment (speculative?) community was so optimistic about Infy's prospects, that every rupee of earnings was thought to be worth Rs 350 or so. Today, markets are so pessimistic about Infy that every rupee of its earnings is thought by Mr. Market to be worth no more than Rs 23.

Ben Graham's "Security Analysis" starts with Horace's observation: "Many shall be restored that are now fallen and many shall fall that are now in honor."

What can Infy do to restore its honor, given its current market value, its competitive position, and its financial strength?

What should Infy do?


Arpit Ranka said...

Dear Sir,

I think an LBO can help restore Infy's value. The reason is as follows:

At present, Infy has zero debt as compared to Rs. 11,000 cr equity and EBIT of Rs 4000 cr.

Based on the notion that equity is not free and debt doesn't cost that much, I believe that replacing 10,000 cr debt, say @ 10% (i.e while maintaining an Interest cover ratio of 4x), with equity - by paying it out as special div would result in the following things:

1) Ex-div M Cap = 80,000 cr
2) Post LBO, EV = 90,000 cr (same as before)
3) Post LBO, PAT = 2,800 cr
4) EV/Operations Cash = 25.5x (Same as before)
5) Networth = 1000 cr (as compared to 11,000 cr)
6) D/E = 10 x (10,000/1,000cr)

A D/E ratio of 10x might appear dangerously high. But considering that the business would continue to possess Rs 5,000 cr of cash & equivalents and also could repay the debt in 4-5 years time using the cash flow from business, it is not as dangerous as it appears.

As an enterprise, change in capital structure would not result in any change on the operations of the business. But infusing capital costing 10% in a business compounding capital @ 40%, not only the return on equity would improve from current 40% to 280% but also the rate of growth in Networth, over the next few years would be quite high...

And business earning 280% on equity, which can be expected to continue doing well in the future, seems like a way up from current state...


Alpha Investor said...

Dear Sir,

I believe Infy's days as a growth stock (which usually command high-to-very high P/Es) are over.

It's more a value stock now, and will therefore, more often than not, trade at a P/E that is near or less than the expected growth in its earnings.

To retain what it has lost will require it to identify new lines of businesses, say - animation, IT products, etc. something that offers more scalability and therefore more growth.

Anything else, i.e. by way of financial engineering, will push the stock up, but only temporarily.

Anonymous said...

Hello sir,

I think the previous high valuations given to IT cmpanies are thing of past and they themselves can't do much to get those astronomical valuations(P/E,P/EBIT etc). Most of the IT companies would be loosing their tax exemption shield in some years and then their earning margins would go down further.
Only things they can do is to cut down costs, explore newer domains and geographies, and develop strong competencies in some verticals so that they can get high end work giving them higher billing rates and through this they can maintain their current valuations.
Some of the examples I can think of are:

1. To cut cost, they should try to shift as much work as possible to offshore. This would result in high margins and through this they can develop long term relationships with clients. Secondly, they should not go to higher ranked colleges/B-Schools to recruit. Most of the work nowdays comprises maintenance and some enhancement with not much technical skill/aptitude required. Recruiting people from lower rung colleges and even from B.Sc/B.Com. etc would serve two purposes at a time, first the employess wont have much opportunities in colleges so they will opt to join Infy and second, once they join,they would be content to work for it and this would result in lower attrition.

2. If we see the revenues/profits as per verticals, we find that majorly BFSI, manufacturing and telecom etc generate the revenues. Infy can explore other verticals like pharma,logistics,CAD/CAM to generate revenues. They can also expand some KPO/BPO kind of work like data mining, small researches, reconcilliation etc.

3. They must develop strong expertise in some of the key areas like Finance etc. I was working for UBS in London through my company Headstrong. I met some Infy/Wipro guys there. They were doing some support kind of work and we were into development. As our company focuses only on capital markets, we were preferred partners of UBS in their domain work. Billing rates of ours were as high as by 70% from that of Infy. I think for such a big company like infy, developing strong domain expertise wont take too long. They can develop that by themselves or go for acquiring small niche companies. Getting higher margins from higher end work would compensate for the lower margins from low end work and they would be able to offer all kind of work for their clients.

4. Though Infy is already doing it and I think they should hasten their efforts of exploring newer geographies. EU,Japan,Middle East Asia can be great bets for future. Their currencies are stable wrt to $ and if Infy penetrates market earlier, they can get higher billing rates.


VISHNU said...

Debt Recap & Dividend Recap are all good in theory..But practically I dont like the idea ..though it helps me to value a company

Somehow I loath taking loan when I have cash in hand..

Infy CAN DO NOTHING or it can

1) Give dividend
2) Buy back its shares.
3) Acquire a another company
4) Invest in internal growth.

When the company returns 280% on equity.its not a good idea to give dividend.. It doesn't need to acquire another company..Because it is easy to hire 10,000 people in india at Peanut salaries than acquiring companies at mind blowing PE.

So I feel Infy can restore it honour by doing nothing or

Buy back it shares (if it feels thats share is undervalued) and Invest in internal growth


Anonymous said...

Nothing. It shouldn't do anything. The company should be worrying about the business instead of stock prices. And they seem to be doing alright by maintaining earnings despite the dollar.

If the market pushes the price even further downwards to ridiculous levels, then maybe a buyback would be in order.

Peeyush said...

Dear Professor.

I think Infy can do various things to restore its image.

1) As arpit said, it may go in for a LBO. It has zero debt, and generally while valuing such companies using a DCF, we take Cost of Equity, thereby unnecessarily penalizing someone for not taking debt, when it could have. I would not go to an extent of taking 10000 crore as debt, since that would mean more like transforming a conservative management to an ultra-aggressive one overnight. But ya, some debt can be taken for smaller buyouts in niche spaces. I do not think there is any point in buying a big company outside India, since the prices paid will be far higher than what would be required to set up similar competencies in India. However, knowing the present management, it seems unlikely that any such thing would be done.

2) If they are not buying something, they should invest the money lying idle in some higher end research or products division, rather than keeping it idle. They have more than Rs 6000 crore cash on books, and unless they show intent of using it, investors are not going to value it. They can enter products (software products) business, in order to leverage the brand they have established.

3) A buyback will restore investor confidence. Here again, the management needs to ensure that the buyback is seen in the light of using idle cash efficiently, and not because they do not think that the business will return enough on this money should this money be ploughed back into the business.

Some other thoughts about what it could do can emerge from this article, showing what IBM has done well over the last 2 years

Just looking at the global scenario now, my feeling is that the best option is number 3

Sandeep Kakkar said...

Responding to Arpit Ranka's comment, I would like to say the following:

We were discussing a similar thing among friends as to what should IT companies do in general. Infusion of debt in the balance sheet was one of the ideas but a counterpoint(which I found quite logical) was the following:

IT companies should not take much financial leverage in their business because the operating leverage in their business is already very high. It was pointed out that this cash is important for companies like these to withstand a shock like the present one. These companies have fixed costs in the form of wages which cannot be wished away in times of downturn (especially in a country like India) and thus adverse operating leverage coupled with huge financial leverage could actually kill the company.

Although we didn't reach a conclusion, I wanted to mention this point and would like to have a discussion on it.

kbs said...

I am afraid INFY can not do much. Its high valuation is no longer justified for the right reasons.

Its growth and value could be attributed to labor arbitrage. This arbitrage is being eroded after companies like IBM, HP are using some of the same models (hiring IT professionals in India). Add to this the effects of rupee appreciation, wage increases and the potential removal of tax incentives, then how do you justify current valuations at several times the revenues? Also, they do not have any significant moats. Infys, Wipros (IT group) call themselves technolgy companies - what technologies they have? They are just 'glorified head hunters'. Their market valuations are (and should be) headed further down.

Kumar A. said...

Good Evening Prof. Bakshi,

I have been a frequent visitor to your blogsite, and have always benefitted with points to ponder.

Thank you!

As for the Infosys puzzle, like everyone else who has replied to the question, i too believe that a buy-back could restore some confidence (that investors seem to be losing).

However, i would consider Infosys as a deep value stock at current levels, not only because of a possible corporate actions, but also because of the following statistics:


If the article's statistics are anywhere close to true, it opens up so many options for the management!

I don't know if Ray Kroc (McDonalds founder) inspired Infy Management, but it's surely adding a different shade to the seemingly distorted Infy picture!

Happy Investing!!

-Kumar A.

Arun said...

dear sir,
i'm not an expert in finance/stocks. but since i work in the IT industry, i would like to make my point here. From the graphs INFY's stock price and the $ vs Rs., the stock price was on a high when the dollar was very strong over rupee (March 2007). Since the Rs. appreciated the total earnings & hence the profits of Infy decreased (as they are quoted in INR). Pl. also note, the overheads for the company has not decreased. This could be the reason why the share price crashed - probable reason: lesser dividends.

Not only infosys but also many other companies whose revenue is more from USD than any other currency will face such a problem.

Anonymous said...

The service business is generating enough cash for Infy. This is the time to invest into growth by moving into products. They should invest more into developing products which will have higher margin. They have the managment, talent, resources, they should look to actively invest into product development, and it is high time that they do it more actively. Innovation will automatically lead to growth.


Anonymous said...

Infy should do nothing about its share prices. It should concentrate on new opportunities. Law of averages will correct the price of Infy share to desired P/E multiple. Nothing much has changed - Rupee will appreciate but not at the pace it has in the past one year. Subpime in US will force US companies to become more efficient i.e. more opportunity for Infy.

Anonymous said...

Although some amount of debt for INFY might be recommended, a LBO of the business would put too much risk on a business that is still expected to grow eps at 20% for the next 5 years. For eg. MSFT which is $327bn in mcap (compared to INFY's $26bn) has long been considered a utility stock but still has not put on any leverage on the balance sheet. A cursory judgement on risk of the business can be made by looking at the stock's annualized vol. MSFT's historical annualized stock volatility is 20% compared to INFY's 30%.
Furthermore, a high dividend is the touch of death for a growth stock. I would argue that with market expecting 20% eps cagr over next 5 years, INFY is still a growth stock.
Current devaluation in INFY stock is reflects the devaluation of the dollar and the risks of a recessionary environment to INFY's clients in US and Europe.
It will be interesting to see if INFY's clients increase outsourcing in a recessionary enviornment boosting INFY revenues or decrease costs dramatically enough to reduce INFY revenues.
As the company's growth and multiple decline INFY's valuation will depend on capital allocation decisions made by the management whether it is buybacks, dividends, reinvestment for organic growth or M&A.


I think this is because fundamental change of the world from brain power to commodity power, be it oil/metals/real estate price hitting all time high that make the stocks related to those field going high and high. If you observe even richest person of the world changed. Even Coca Cola has same problem its share prices are same as thats in 1998-99. Even Warren buffet invest in things ike Petrochina/ Rail roads/ PSOCO which dont have any pricing power and nobody is still nobody is asking for GM cars with POSCO steel in it. this shows the geniusness of him.
For infosys to get better valuation it has to come out of service mindset to product mindset Be it developing Videogame/WINDOWS/more Finnacle.
I dont know how feasible this things are OR wait for world to round full cirlce and again the fashion of IT start.

Krishnanand said...

If Stock Markets have overvalued Infy and over estimated its growth rates then it is not the fault of Infy .Now before we step in to understand what Infy must do , we must ask ourselves the following questions :
1) What is the business model of Infy ? Are they following the same model as they did when they started or are they shifting and diversifying their business model .
2) What are the channels through which Infy earns its revenues ? Are those channels giving proper revenues ? Are those channels insulated from the swings in the dollar rates etc ?
3) What is it that is "so special" about Infy that other Companies cant emulate or follow i.e Does Infy have "certain special characteristis" that will make Clients keep coming to them regularly or they doing just another commodity business on a large scale that any one can do ?

So unless and until we address all these business issues I do not think we can get a picture of the future of Infy .

Deepak Shenoy said...

Infy Should:

Take over client balance sheets or departments in exchange for transaction based revenues.

Buy companies that provide a serviceable component, and then scale it; for instance there are large wholesale insurance agencies in the US that could tremendously benefit from consolidation and faster execution.

Get into non-financial units. Analysis is as important for McDonalds and in a recession people don't stop eating burgers.

Take this as an opportunity to consolidate. Put your head down and focus. Build a platform which does not need more salaries to scale. Take four quarters - doesn't matter - the stock price will come back to it's original irrationality if you stick with it.

Btw, even 23 is too much. The forward growth that Infy itself has indicated is about 20% on rupee terms. (I don't remember if Infy gave guidances in 99-00) And that was with the rupee at 40+ - it's already a 100 basis points below that level. And then there's recession imminent in the US, plus financial services, which account for 50%(?) of Infy's revenue, are at the thick of negative action.

And their news flow has stopped. A company that would make deals on a daily basis announces one or two deals a quarter.

The growth business is over. Now it's going to be a commodity business. The stock market doesn't seem to care - it gives a bank a P/E of 25, and a power company a P/E of 60. So one day they'll go back to Infy, if they do something radical.

Vishal Mittal said...

I think Infy should follow the most popular way these days...it should create 2 subsidiaries - one of its hard assets - computers etc. and second of Non-US Infosys, and then list the 2 subsidiaries. First will be valued based on annuity and second would anyways get a better P/E (non dollar/ non US recession) and thus it will "unlock value". Any blue chip Investment Bank worth its salt will increase the valuation of the subsidiaries by atleast 2x and other IB firms will join the race to distribute it to me-too retail customers/(un)QIBs. Then, after 6 months, Non US Infosys can be further split into "Stable Europe Infosys" and "Emerging Market Infosys", thus creating further value. It does not really entail working hard on customer/ organizational issues, just require class IV geography and a call to any IB.

Jacob Gaddala said...

To understand this better we need to look at the background of this industry. Indian software industry mostly grew because of the labour cost arbitrage in the 1990's till recently.

The main factors contributing to the arbitrage was the cheap cost of labour and an appreciating dollar.

Cost arbitrages do not exist technically for years, with time the gap usually narrows down. Rising salaries and appreciating dollar will reduce the arbitrage going forward.

Indian companies need to move up the value chain by getting into products rather than just services. Unfortunately most Indian companies still prefer to continue with plain vanila services. Till that happens markets will value Infosys/Wipro like any other low margin commodity service with little growth.

Anonymous said...

Who says Infosys has lost its honour? How about: Infosys was overvalued in a speculative frenzy. Now it is valued at a more normal rating. As Benjamin Graham (approximately) said: in the short term, the stock market is a voting machine, in the long term it is a weighing machine. i.e. don't confuse the two. Infosys certainly has 'weight' and that will always be reflected over the long-term. This "lost its honor" business sounds like the moanings of an over-bullish investor with a long position.

Gaurav said...

Infosys should tell the world how much land it owns in Bangalore and Pune. That itself is worth $5billion. Then it will see its stock rocket.

Jokes apart, I think Infosys needs to do some serious thinking. One might argue that management should focus on operating perforamance and not stock price, company is still growing at 30%+ so what is the problem, there was a bubble in 2000 so 7yr stock price perforamce is irrelevant etc. But if we assume that the job of any management is to maximize shareholder value in the long run, there are some long-term strategic moves that Infosys can make right now to break the linear relationship between employee growth and revenue growth.

a) International Acquisitions - Those who sneer at tech M&A's need to look at Oracle. Those who think that M&A's destroy value have read too many academic papers which fail to calculate outcomes in a world where the said M&A wouldn't have occured and industry structure would have been different. A well thought out and executed M&A is the best non-linear way to turbo charge growth.

b) Domestic Acquisitions - Infy should just go and acquire all the mid-tier/small cap Indian IT companies where companies are trading at 1x-6x PE. Of course this assumes that sellers are willing to sell today and prices wont go up as Infy goes about acquiring - but even if one pays 1.5x the price, I think it is worth it.

c) R&D - Look at the number of patents Infy has and the number TCS has. This is why TCS is getting many more big deals. I dont think Infy can get into high end consulting work like Accenture till it starts investing significantly in R&D.

d) Don't do LBO - I think people who are advocating LBO havent read that credit markets are shut. Even if they weren't, I wouldn't recommend financial engineering for a 30%+ growth company.

Anonymous said...

Well guess infy should put their money in a power company or an infrastructure business and create value for the share holders ? I am sure Mr. Anil ambani would agree with me if not anybody else ? Or probably wait for Reliance Infotech to get listed , I am sure there will be some rub-off effect !!!