wiLL rEmaiN mArkeT GianT :-)

Buy Infosys:

Strong balance sheet: The Company has a very strong financial position
with USD 2.5 bn of cash, despite the current weak market scenario. This, in
our view, would come handy in opening overseas business centres as well
as to fund any strategic acquisition required to strengthen its service
offerings.

Upgrade from Hold to Buy with a TP of Rs. 2,257: Factoring its recent
better-than-expected financial performance, proven execution and cost
management abilities, strong cash flow in challenging times, and 18%
valuation upside, we upgrade our recommendation to Buy.
The stock is trading at a forward P/E multiple of 20.3x and 18.8x for FY10E
and FY11E, respectively. Moreover our DCF valuation, assuming a 12% of
WACC and a 5% of terminal growth rate, gives a target price (TP) of
Rs. 2,257, an upside of 18% over the CMP.

Infosys’ revenue in Q1’10 remained stable on sequential basis at
USD 1.12 bn and was substantially higher than its guidance of
USD 1.06–1.08 bn largely on account of lower-than-expected volume decline
of 1.1% and favourable cross currency movement which contributed around
USD 23 mn to USD 24 mn. However, in INR terms, revenue declined 2.9%
qoq to Rs. 54.72 bn as rupee appreciated by 3% against the dollar.
The revenue contribution from the US and Europe has moved up in this
quarter and the trend is likely to continue as IT/ ITES sector is slowly gaining
strength in these regions with improving global scenario. Moreover, with
signals of improvement in the BFSI segment, we find Infosys well-positioned
to gain from the recovery with its well-diversified portfolio of financial
softwares and support offerings. In the telecom vertical, which consists of its
top client, British Telecom (BT), Infosys has started to diversify and bag new
clients. However, revenue from retail and manufacturing verticals is likely to
remain sluggish due to the reduction in discretionary spending. We expect
the growth in volumes to remain subdued in the first half of FY’10 and expect
it to pick up in the second half. Overall, we expect the revenue to grow at a
CAGR of 5–6% during FY09–FY12, in rupee terms.

Margin dilutive investment plan
Contrary to our expectation of weak margins, the EBITDA margin climbed up
367 bps yoy to 34.1% in Q1’10 due to a 347 bps yoy decline in software
development expenses as percentage of sales and a deferral of planned
investment in local hiring at its overseas operations.
However, we forecast a fall in FY10 EBITDA margin by around 180bps,
which implies significant margin contraction in subsequent quarters due to
the expected increase in cost per employee and sales and marketing
expenses. The cost per employee is likely to increase in the coming quarters
as the Company has elongated the training period from four months to six
months and it is planning to add more headcounts locally in all the markets
which could be expensive. The company is also planning to spend more on
sales and marketing over the subsequent quarters to increase its clientele
and win new deals.

Expiration of STPI tax holiday benefit will hit profitability margin
The Company’s effective tax rate has increased from 17% in the last quarter
to 20% in Q1’10 and is expected to remain at this level for FY10. From FY11,
it is expected to increase to the level of 24%. This is so, as the Software
Technology Parks of India (STPI) benefits for most of the facilities will expire
in the current year and the existing work cannot be shifted to tax-exempted
special economic zone (SEZ) units soon. However, the Company is actively
engaged in the process of shifting some work to SEZ to tackle this issue.
Consequently, we expect the net profit margin to decline by 220 bps to
25.4% in FY10.

Key Risk
The following factors can pose a threat to our rating:
· A prolonged recession in the developed markets
· Any adverse currency movement
· Worse-than-expected volume decline