January 14th, 2013
The recent media hype surrounding Infosys’ Q3 results has taken on a life of its own. But the crushing feelings of doubt and confusion for brokerage analysts is very real. A recent article in the Economic Times explains why analysts are so hurt: “a lot of equity analysts, who had a not-so-cherry outlook on the stock, are licking their wounds. For a company languishing for nearly two years, Infosys’ performance was like a bolt out of the blue for them. A sense of collective hurt prevails because they say they were given to believe something else by the Infosys management.”
Infosys reported solid but not blockbuster 3QFY13 results on Friday (11/01/2013). The company reported net profit for the quarter of USD 434 mn, which was essentially flat on a q-o-q basis. The company ended up increasing full-year FY13 (Year ending March 31, 2013) revenue guidance to USD 7,450 mn, reflecting a 6.5% y-o-y increase and 150 bps improvement from their original guidance of 5%. Following the guidance upgrade the shares closed up 17%, reflecting the highest percentage daily gain since the company’s IPO in 1993. Why was the upside reaction in the share price so severe?
The simple answer is that analysts and investors were expecting a downgrade in revenue guidance. Infosys surprised by not only maintaining current guidance but actually increasing it. The concerns about a revenue guidance downgrade really took hold in December, when Cognizant filed a routine SEC filing.
Although Cognizant is a US based multinational IT services company, it was originally founded as an Indian joint-venture between Dun & Bradstreet and Satyam computers. Thus, sell-side analysts view Cognizant as being a peer of the Indian IT companies. In the SEC filing, Cognizant disclosed that top executives will receive 100% of their performance –linked shares if the company achieves 16% revenue growth in 2013. Since the target growth for performance linked shares was lower than the company’s current revenue guidance analysts became concerned that the company would cut back on its full-year 2013 revenue growth targets.Additionally, the read across was that revenue across the IT sector would be weaker than expected. Thus, the stage was set for analysts to begin downgrading their outlook for Infosys in 3Q FY13.
In November, 2012 I recommended that my Premium Access subscribers take a position in Infosys. Below is a brief summary of my long-term investment thesis:
Additionally, I found Infosys to be a compelling long candidate for the following three reasons:
1) The company has vigorously defended its margins at the cost of top-line growth. As a long-term investor I’m more interested in companies with the ability to generate strong returns on capital vs. simply grow the top-line. Revenue growth is meaningless if it’s not being converted to the bottom line. In the table below, we can see clearly that the company has maintained both high rates of returns measured by ROE and CROIC. If you’re unfamiliar with CROIC, you can find a great explanation here.
2) When I initiated my position back in November the shares were relatively cheap. Infosys was trading at a 16x TTM P/E multiple and a 14.7x FY13 multiple based on Bloomberg estimates. The company was cheap both on a historical and relative P/E multiple basis. Based on a discounted cash flow analysis, my intrinsic value for the shares at the time was INR 2,762. With the shares trading in the INR 2,300 range back in November, I thought they represented decent value.
3) Based on various data points, including the Cognizant SEC filing, analysts were expecting a revenue guidance downgrade. Infosys had very conservative revenue growth guidance of 5% for FY13 (fiscal year-ending March 31, 2013) going into the 3Q FY13 results. It was important to take a longer-term view and realize that you want to own a company that is consistently generating close to 30% in ROE. “Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” – Warren Buffett, 1992 Berkshire Hathaway Shareholder Letter
Infosys was relatively cheap and expectations were muted going into the quarterly results. I’ve seen stocks crater when expectations are too high going into the quarter and they end up missing the consensus estimate by a penny and before you know it the stock is getting slammed. All management teams guide analysts and it’s rare to see significant misses unless there is really a major deterioration in the business. I took a long-term view and was willing to buy into a business that generates significant FCF, has a reputable management team and USD 4 bn in cash on the balance sheet. Yes, I got lucky and my price target was hit in less than three months. I continue to believe that if you stay disciplined and focus on your investment process, you will eventually achieve market beating performance.
Vitaliy Katsenelson has characterized the current market environment as being neither a bull nor bear but a cowardly lion market. What does he mean? Essentially investors are facing a sideways market where brief rallies are shortly followed by crushing downdrafts. Investors are faced with high volatility but major indices will fail to make much headway over multi-year periods. In this type of market environment investors need to be especially vigilant about selectively purchasing equities when they are undervalued and selling them when they become fairly valued. This is a type of market where long-term buy and hold investing will not serve you well.
Now that Infosys has hit my original price target the question of selling discipline arises. I’ve updated my DCF model and have revised my price target higher to INR 3,000. I think a number of institutional investors were underweight the stock and will now be increasing their position sizes. As a result, we could get a continuation of positive price momentum. I would definitely advise against initiating a position at current levels. There simply isn’t a large enough of margin of safety to justify a new position.
If you didn’t catch Infosys, don’t be overly concerned. I’ve identified a number of other attractive investment opportunities in the Indian market that could provide similar upside potential, that I’ve already highlighted to my Premium Access subscribers. If you’re interested in learning more about Premium Access, please click here.