There's Value in Infosys' Industry Position

Infosys benefits from high switching costs, thanks to its commitment to building lasting client relationships, embedded systems and processes, and intimate knowledge of clients’ IT infrastructure. Such switching costs ensure a certain level of operational consistency, and the company’s good financial health reflects this. As a result, Infosys will look to leverage its financial stability and increase its top line while improving its competitive performance relative to peers such as Wipro WIT and Tata Consultancy Services TCS.

We expect Infosys’ performance to improve moderately through a number of initiatives. To reinvigorate revenue growth, the company is pursuing larger outsourcing opportunities rather than smaller discretionary deals. It plans to hire a raft of new salespeople to open more client opportunities, while offering greater differentiation in contract proposals and using greater process automation via partnerships such as IPsoft and internally developed platforms like Infosys Automation Platform. In terms of operating margins, management has aggressively reduced costs and launched some optimization initiatives. It will also look to increase its offshore business mix and improve utilization rates. Finally, Infosys has sought to reduce its high attrition rate by giving compensation increases, issuing employees stock, restructuring salaries, and offering more promotions. Consequently, we forecast a steadier operating performance.

High Switching Costs Ensure Operational Consistency Infosys' narrow economic moat results from high switching costs; roughly 96%-98% of revenue is from repeat business, and the proportion has been around these levels for many years. The company's commitment to building lasting relationships, embedded systems and processes, and intimate knowledge of clients' IT infrastructure means customers are averse to switching between vendors. On a gross basis, Infosys continually adds over 200 clients per year, which is an encouraging sign and cements further long-dated business given switching costs. These switching costs ensure a certain level of operational consistency, and the company's exemplary financial health reflects this. We forecast Infosys to easily generate returns on invested capital in excess of its cost of capital for the foreseeable future, and we believe its lower-cost offshore delivery model allows for this assumption.

The firm’s long-dated client relationships, industry expertise, and global delivery model are not easily replicable and protect it from competitive disruption. Infosys has the ability to provide all four key industry services--consulting, systems integration, IT outsourcing, and business process outsourcing--which leads to more sticky integrated deals and reinforces our conviction in its competitive stability. According to Gartner, Infosys’ worldwide market share has remained stable for the past five years, and we do not see this changing noticeably, barring any large M&A deals.

Working to Mitigate Internal and External Risks Infosys has highlighted issues regarding relatively low revenue growth, margin compression, leadership churn, and high employee attrition. Management has taken steps to remedy these, but it is still early and there is the risk that these problems become inflated. Poor macroeconomic conditions, competitive threats, and foreign exchange movements are external risks that could generate further downside for the company. Uncertainty exists around possible visa restrictions, and management said it has no clear understanding of what is likely to occur, although the company is expanding its onshore development center capacity to help mitigate any future pressure. Finally, the firm must differentiate itself to avoid commodification of its services; roughly 25% of the firm's revenue is exposed to a high degree of commodification, according to management.

Infosys is in a strong financial position; as of year-end 2016, it had no debt, and it generates substantial free cash. The company recently raised its dividend payout ratio to 50% of posttax profits from 40%, and rumors of a buyback have emerged. However, the buyback remains speculation at this point, and we think the funds would be better suited to organic and acquisition-related growth opportunities.