Infosys Common Equity

A report on the Indian IT Industry outlook and an estimate of the fair value of the Infosys stock through Discounted Cash Flow analysis coupled with Monte Carlo Simulation.

By NITIN R

INFOSYS COMMON EQUITY

THURSDAY, OCTOBER 17, 2013
The Indian IT Industry Outlook

RECOMMENDATION: BUY

Target Price: 3983 CMP: 3269 Potential Return: 21.85% Period: 6 Months Sector: IT Sector View: Positive Sensex: 20415 52 Week h/l (): 3362 / 2060 Market Cap ( Cr.): 187000 P/E (Infosys): 20 P/E (IT Industry): 29.4

Indias IT industrys share in the global market stands at 7%

Nasscom expects the IT services sector in India to grow by 13-14 per cent in 2013-14 and to touch US$ 225 billion by 2020 Over the last three tears, the Indian IT Industry attracted foreign direct investment (FDI) of Rs 53,757.60 crore (US$ 7.97 billion), according to data released by the Department of Industrial Policy and Promotion (DIPP). This makes the Indian IT Industry one of the main investment avenues that lure the foreign investors. In order to support and sustain growth, some of the major initiatives taken by the Government to promote IT and ITeS sector in India are: The Cabinet has recently approved the National Policy on Information Technology 2012. The policy aims to increase revenues of IT and ITES industry from US$ 100 billion to US$ 300 billion by 2020 Setting up of centers of National Institute of Electronics and Information Technology (NIELIT) in Northeast India The Government plans to set up 15 new Hardware and Software testing laboratories under public-private partnership (PPP) model India and Vietnam have signed two memorandums of understanding (MoU) during the recent APEC Summit for partnership in the field of information technology.

The Indian IT sector offers impressive growth opportunities. In a bid to reduce cost, governments across the world are exploring outsourcing and global sourcing options. The newly launched Obamacare in the US means great influx of business for all the BPOs and IT services firms in India. This brings in an additional $30 million into the IT enabled health services realm and a lot of Indian IT companies are targeting new businesses by building stronger technology to support this ramp up.

Report by Nitin Ramakoti, All the information contained here, either material or nonmaterial were collected from public sources. nitinpotter@gmail.com +91-9176546440

The new Content Digitization Act is causing a rise in IT adoption by media. Emerging technologies like BIG DATA and Cloud Services present an entire new scope of opportunities for IT firms in India. Cloud represents the largest opportunity among other technologies. Social media is the second most lucrative segment for IT firms. INFOSYS A comeback The Industry bellwether lost it to rivals such as TCS during the absence of the founder Mr. Narayana Murthy, however, reclaimed its title as India's No. 2 software services exporter after Mr. Mur thys return. It is also turned out to be the first time for Infosys to report more than $2 bn in quarterly sales. Earlier, the company sacrificed its growth for high-margin in-house developed software and consulting, but after the founders return, Infosys is more focused on winning large outsourcing, Big Data analytics and Cloud service deals. VISA IMBROGLIO Infosys received a subpoena from a grand jury in the US, which required that the company provide to the grand jury certain documents and records related to its sponsorships for, and uses of, B1 business visas. The company complied with the subpoena. The company was advised that it and certain of its employees are targets of the grand jury investigation. The company was subsequently advised that this investigation was continuing and that additional subpoenas may be issued. Following this event, the company had set aside 219 Crores or $35 million which translates into 3.84 per share to meet the necessary legal expenses. I expect that it is not necessary for the company to make any further provisions to disentangle itself from this litigation.

ROBUST BUSINESS COMBINATIONS Indian IT companies are disturbed by the uncertainty caused by the US immigration law overhaul with restrictive rules that could shoot up the costs of sending workers to US on short term visas. Many companies in the Indian IT industry are keen on diversification of revenue sources both by service offerings and by geographical dependence. The Indian IT Inc.s high reliance on the US marke t has intensified measures to enter continental Europe and other regions through acquisitions, setting up operations and hiring locally. On January 4, 2012 Infosys BPO acquired 100% of the voting interest in Portland Group Pty. Ltd. a strategic sourcing provider based in Australia. The business acquisition was conducted by entering into a share sale agreement for a cash consideration of 200 crore. On October 22, 2012, Infosys acquired 100% of the voting interests in Lodestone Holding AG, a global management consultancy firm headquartered in Zurich. The business acquisition was conducted by entering into a share purchase agreement for a cash consideration of 1,187 crore and an additional Contingent consideration of upto 608 crore, payable to the shareholders of Lodestone Holding AG over a period of 3 years. In my opinion, this is a prized acquisition by Infosys not just on the strategic outlook but also in financial terms as almost 34% of the acquisition value comes as a contingent consideration.

These business acquisitions will strengthen Infosyss consulting capabilities. Further the acquisition will enable Infosys to increase its global presence particularly in continental Europe and markets like Latin America and Asia pacific. Like most Indian IT companies, Infosys is yet to become compliant with the EU Data Privacy directive and this could be one area for investors to monitor the future developments as the non-compliance hinders some of the work to establish a strong footing in the country.

FINANCIALS & VALUATION The Discounted Cash flow method used for valuation is the Single stage / Constant Growth FCFE model. Each variable that affects the FCFE has been forecasted (in Table 1) using on the Base Case growth assumptions given in Table 2 below.

Table 1: Key Financials 2010 22742 6219 565 905 -340 57 0% 6502 2011 27501 4759 6823 1152 854 298 1428 0% 5097 2012 33734 6233 8316 1296 928 368 1419 0% 6529 2013 40352 6618 9421 1847 1099 748 1182 0% 7491 2014 E 47212 6860 10859 1888.4 1292 596.6 1940.4 0% 8322

Sales Sales g Net Income Capex Depreciation Inc. Capex WC Inv Target DR* FCFE

*Target Debt to Capital Ratio is fixed at Zero since Infosys is a Debt free company and is expected to remain the same for a foreseeable period.

Table 2 Variable FCFE g% Sales g% NI Margin Dep/Capex Capex/Sales WCInv/Sales Minimum 7.50% 16.00% 22.00% 60.00% 3.50% 3.00% Base Case 8.50% 17.00% 23.00% 68.41% 4.00% 4.11% Maximum 9.50% 18.00% 24.00% 72.00% 4.50% 5.00%

SIMULATION OF VARIABLES To obtain a better understanding about the end result of the valuation and the sensitivity of the fair value per share to the variables, a simulation was conducted where each of the six variables were modeled as a BETA distribution (The most commonly used distribution to simulate percentages). The BETA Distribution is a smoothed variation of the Triangular distribution defined by three parameters namely, The Minimum, Likeliest (Base Case) and the Maximum values. The 3 parameter values used in the simulation for each of the six variables are given in Table 2. 100,000 Trials were run and the results are given below.

Figure 1

Table 3 Statistic Trials Mean Median Mode Standard Deviation Variance Skewness Kurtosis Minimum Maximum Forecast values 100,000 3,983.72 3,941.08 3836 434.66 188,929.76 0.4195 2.72 2,926.61 5,692.22

The FCFE model, when used with the base case values (i.e., without simulation) gives a fair value per share of 3940. The Simulation results in a Mean Fair Value per share of 3983 which is used as the target price in this report. As one can see, the Simulation probabilities are normally distributed and positively skewed as measured by Kurtosis and the Skewness values reported in Table 3. A Scenario analysis was run to get an idea about the most important variable in the model and also to assess how much variation this variable could cause on the end result, the Fair value per share. Each variable is tweaked by +/- 10% of the Base case value of each input variable to gauge its impact on the per share value. Figure 2

Per Share
2000 FCFE g% 3000 7.65% 4000 5000 6000 9.35%

NI Margin

20.70%

25.30% Downside Upside

WCInv/Sales

4.49%

3.67%

Dep/Capex

61.02%

74.57%

Sales g%

15.30%

18.70%

Capex/Sales

4.40%

3.60%

Table 4 Per Share Variable FCFE g% NI Margin WCInv/Sales Dep/Capex Sales g% Capex/Sales Downside 3204.3 3427 4032.5 3880.6 3884 3970 Upside 5118.3 4455.4 3850 4002 3998.5 3912.4 Range 1914 1028.3 182.5 121.3 114.5 57.6 Downside 7.65% 20.7% 3.67% 61% 15.3% 3.6% Input Upside 9.35% 25.3% 4.49% 74.6% 18.7% 4.4% Base Case 8.5% 23% 4.08% 67.8% 17.% 4%

The chart shows that the FCFE growth rate % assumption is the most important variable affecting the fair value per share. The Base case assumption of 8.5% growth is shocked +/- 10% of the value, resulting in 9.35% and 7.65% and these values result in per share fair value of 5118.29 and 3204.28 respectively. The impact can also be assessed by looking at the Range, which is 1914.

KEY TAKEAWAYS Given the weaker currencys contribution to higher margins, Infosys has reduced its billing rates by 4%, which is healthy move, thereby passing on the benefits to the clients. Client additions have been strong in the most recent quarter, adding 68 new clients, taking the total count to 873. However, no client individually accounted for more than 10% of the revenues. There has also been an increased interest on Infosyss Cloud and Mobility offerings compared with a year back. It should be noted the recent rally in the stock price in the stock price partially factors in the markets expectations of the future growth ahead. Some of the issues such as, the increase in the employee attrition rate from 16.9% in Q1 to 17.3% in Q2 FY 13-14 and the deteriorating Net Income and EBIT Margins require improvements. Nevertheless, the stock is a good investment provided the company demonstrates a good business momentum in the remaining half of the current fiscal. Achieving the same could be a challenging task as the third and fourth quarters are usually subdued for Indian IT companies.