9 things `troubling’ Infosys

[dwarakesh]

Infosys Technologies Ltd reported a slight decrease in second quarter profit and raised its revenue and earnings forecasts -- a signal that the worst may be over for India's software services industry which has been hit hard by the global downturn.

Though the company beat analysts expectations in Q2, lately there has been some concerns regarding its performance. According to some analyst reports, Indian's IT's bellwether is likely to face increasing pressure on its operating margin due to several external and internal factors.

Here's looking into Infosys' nine `troubles'.

[dwarakesh]

Tax breaks ending

Infosys Technologies is approaching the expiration of some beneficial tax breaks and rising competition from its peers, according to a report by Barron's.

Infosys was an early adoptor of certain tax benefits, making it face expiration of these perks earlier than its peers, Barron's reported in its electronic edition.

Susquehanna analyst James Friedman told Barron's that the expiration of the tax benefits could push Infosys's tax rate toward or above 25 percent, up from 13 percent in fiscal 2009.

[dwarakesh]

Fiercer competition

The Barron's report says that competition is rising, and Infosys' profit margins could suffer if it increases wages to catch up to its peers.

Experts recently forecasted narrowing of valuation gap between Infosys and TCS, Wipro, and also raised concerns about whether India's most profitable software company can sustain its high operating margins.

According to a recent Edelweiss report, Infosys' premium pricing (especially during 2006-08), focus on the three verticals of BFSI, manufacturing and telecom, and its ability to defend industry leading margins contributed to the company's positioning.

However, the factors that helped Infosys during past few years in building its leadership position seem to be shifting. "To sum up, our long-term position is that Infosys' leadership and its 'must own stock' status in the sector will be increasingly distributed towards the others (TCS and Wipro)" Edelweiss analysts Viju George, Kunal Sangoi and Pratik Gandhi wrote in their report last month. "We believe that stock returns from both TCS and Wipro could be double that of Infosys on a 12-18 month horizon, also partly reflecting the narrowing of the valuation gap," they added.

[dwarakesh]

Rising Rupee

Falling rupee has been one of the biggest saviours of Indian IT companies during the last one year when recession was at its peak. However, a reverse swing in Rupee value is like to hurt Desi IT companies, induding Infosys.

According to Barron's report, the rise in the rupee's value and any move by India to raise benchmark interest rates to fight inflation could hurt Infosys.

The software exporter, which got 66 percent of sales from clients in North America, expects volatility in the rupee's exchange rate against the dollar to remain a "big challenge," Chief Financial Officer V Balakrishnan said recently, "It will be foolish to take a long term view. We're covering two quarters of our receivables, there is no change in our hedging policy."

A strong rupee adversely impacts the profits of IT companies as they get less rupees against every dollar earned, which in turn affects their margins

[dwarakesh]

Fall in revenue from top 10 customers

One of the top concerns for Edelweiss analysts is Infosys' falling revenues from its top ten customers (excluding BT).

"Infosys' traditional strengths have been in farming (client mining) as opposed to client acquisitions and quick ramp-up. But, till recently, the company's weakness in its core top 10 client portfolio is manifesting explicitly, spotlighting the need to focus on new client wins and quick ramp-ups ," the Edelweiss experts opined.

Many customers such as BT and BP are now seeking to outsource more work to fewer vendors, at lower rates. According to an official at one of the customer organisations based in UK who has dealt with the Indian tech vendors, "When the management is aggressively pursuing to cut costs, they question high margins of vendors, and want to get the best rates."

However, despite skepticism around Infosys' profitable growth, rivals still think that Infosys is capable of surprising the industry watchers.

[dwarakesh]

Margins under pressure

Infosys margins have been almost flat (in the September quarter) compared to the first quarter. In the next two quarters the margins could get impacted by close to 2 percentage points because of the wage increases. The company recently announced a wage increase of around 8 percent offshore and 2 percent outside India across the board with promotions.

This is likely to have some impact on margins, according to a company official. For the full year the margins could be within a narrow band of 60-100 basis points as compared to last year.

According to Edelweiss, the pressure on Infosys to sustain margins will be greater than it is for the others and, hence, the lead it has on Wipro (difference of 13 percentage points in FY09 EBIT margins) and TCS (difference of 6 percentage points in FY09 EBIT margins) could narrow over time. "Historical premiums enjoyed in the past on certain accounts such as BT by Infosys may still exist, but stand diminished today relative to where they stood even four-five quarters ago," the analysts said.

[dwarakesh]

Price cuts

India's second-largest software exporter reported second-quarter profit rose 7.7 percent, beating analysts' estimates, after winning more business from its customers.

However, the CEO, S Gopalakrishnan said that Infosys reduced prices to retain business from customers in the US and Europe, its largest markets, amid the worst recession since the 1930s.

[dwarakesh]

High unemployment rate in the US

The high unemployment rate in the US continues to worry IT firms. During Infy's Q2 results Shibulal told reporters, "Clients are still very cautious about the environment because nothing has changed dramatically -- the unemployment rate is still high and 9.8 percent in the US."

In an interview to a business daily, Gopalakrishnan said on the issue, "If you look at all analysts' expectations, the recovery is going to be a jobless recovery. Many of the jobs that were lost may not come back, because these are industries in transition and these were because of higher leverage, asset bubble created in real estate. That is the reason why people believe the recovery is protracted."

[dwarakesh]

Uncertain climate

Analysts are in agreement over the business climate showing signs of improvment. However, concerns remain. As Gopalakrishnan said, "We should remain cautious at this point. Globally, yes, there are signs of a recovery, but there is still concern."

Certain analysts too have cautioned that it's too early to say "turnaround" because revenue growth hasn't gained momentum. He doesn't expect that to happen until after March of next year.

COO SD Shibulal told a news agency, "We are seeing a positive situation in demand. Clients are starting to take decisions. We are also getting some work out of the mergers and acquisitions initiatives clients have taken. At the same time fundamentals have not changed. None of the fundamentals have changed. So we have to be cautious due to that."

[dwarakesh]

Flat budgets

Similarly, though a recover has started, companies continue to guard their purses affecting IT IT budgets. According to an Infy official, the budgets are down this year by 6 to 10 percent according to every survey one looks at. He added, "Next year budget, in our minds, would be flat ... at best, marginally high."