'New and Renew' has seen significant progress

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1 RESULT UPDATE Dipen Shah Summary table (Rs mn) FY15 FY16E FY17E Sales 533, , ,150 Growth (%) EBITDA 138, , ,835 EBITDA margin (%) PBT 172, , ,085 Net profit 123, , ,931 EPS (Rs) Growth (%) CEPS BV (Rs / Share) Dividend / Share (Rs) ROE (%) ROCE (%) Net cash (debt) 303, , ,679 NW capital (Days) P/E (x) P/BV (x) EV/Sales (x) EV/EBITDA (x) Source: Company, Kotak Securities - Private Client Research Analyst Holding = 200 Shares INFOSYS LTD PRICE: RS.1140 RECOMMENDATION: BUY TARGET PRICE: RS.1305 FY17E P/E: 16.9X Infosys' results beat our estimates for the third successive quarter with CC revenue growth of 1.1% (about 2%, excluding one-off of 2Q) and only a 60bps fall in EBIDTA margins. The Total Contract Value (TCV) of large orders signed was $360mn (does not include $600mn of a large renewal deal). Additional 2 deals of $150mn have been signed in January and the pipe-line remains strong at $3bn. On newer initiatives, about 70,000 employees (55000 in 2Q) have been already trained on Design Thinking with 151 engagements. The Zero Distance initiative (initiative to infuse innovation in every project) has been implemented in 8000 projects. Infosys Information PF has already been used in more than 200 (160 in 2Q) client engagements. Growth in Top clients is muted, partly due to seasonality. We believe that, these initiatives will shore up the growth rates of Infosys and sustain margins over the longer term. Annualized attrition rate has reduced sharply to 18.1% from 19.9% QoQ. FY16 guidance has been upped to 12.8% % in CC terms, which looks achievable. Our FY16E and FY17 EPS stand at Rs.58.7 (Rs.57.2) and Rs.67.5 (Rs.65.7), respectively. Our TP is Rs.1,305 (Rs.1230). We upgrade the stock to a BUY (ACCUMULATE, earlier). 'New and Renew' has seen significant progress The focus of Infosys is on renewing all existing services while introducing new products / services in an eco-system of various alliances with vendors, startups, etc. Education / training of employees on these initiatives will be the foundation of this strategy. The new strategy is aimed at improving employee productivity which currently stands at $50,500 per employee. With these new initiatives, Infosys is targeting to achieve industry growth rate by FY17 and revenues of $20bn by FY20, at margins of 30%. Infosys has already made significant progress towards these goals. Infosys has now trained about 70,000 people (55,000 in 1Q) on Design Training (DT) including work-shops for more than most senior executives. More than 90% of the sales and Consulting teams have been covered. In 1QFY16, these numbers were at and at as at FY15 end. Infosys has already implemented 150 DT projects (117 in 2Q) It is also training 2500 employees per month on open source technologies over 30 training programs. On the platforms front, Infosys has already used the Infosys Information Platforms (IIP) in more than 200 projects (160 projects by 2Q end, 127 projects by 1Q end and 100 projects by 4QFY15 end). There has been a 17% - 50% savings in efforts due to the automation platforms, which is encouraging. The Zero Distance initiative, (initiative to infuse innovation in every project) currently has more than 8000 projects (5600 in 2Q) and more than 1700 innovations have been discussed with clients already by more than 90% of the delivery organisation. The EdgeVerve business has sustained momentum during the quarter. It had 24 wins and 25 go-lives for both the Finacle and Edge suite of solutions. Kotak Securities Limited has two independent equity research groups: Institutional Equities and Private Client Group. This report has been prepared by the Private Client Group. The views and opinions expressed in this document may or may not match or may be contrary with the views, estimates, rating, target price of the Institutional Equities Research Group of Kotak Securities Limited. Kotak Securities - Private Client Research Please see the disclaimer on the last page For Private Circulation 2

2 Panaya, acquired by Infosys in FY15, is also seeing good traction and is generating 50% higher productivity in IMS projects. On the efficiency front, Infosys Automation Platform (IAP) has already been deployed across 121 engagements. There are 47 engagements under production and there has been a saving equivalent to efforts of 1,100 employees in 3Q as against 800 in 2Q. Infosys has already increased the size of its innovation fund from $100mn to %500mn. This fund will actively look at investing in or partnering with startups within and outside India. We opine that, Infosys is taking concrete and significant steps towards achieving its long-term objectives. We believe that, the strategy will have an appreciable impact on financials only over the longer term, though the initial impact has already stated being felt, we believe. Scale up in large clients and additions to large deals impacted by seasonality and spill-overs, respectively Infosys won a total of 4 large deals in 3Q with TCV of $360mn. This was lower than the TCV of $983mn won from large deals in 2Q. However, this excludes one large renewal deal of $600mn deal. Including this, TCV goes up to $960mn. The 3Q numbers was impacted by spill-over of 3 deals of which, 2 worth $150mn TCV have been signed in January already. Growth in Top 5 and 10 clients has remained muted and there was reduction in number of clients in the $75mn - $100mn brackets. However, that was largely due to the seasonality (extended furloughs, holidays). Moreover, the sharp appreciation of the AUD v/s USD impacted revenues from large clients in 3Q. Infosys added 75 clients during the quarter, on a gross basis (82 in 2Q). We believe that, Infosys will further scale up its large deal activity in the future quarters and it already has a strong pipeline. We also understand that, Infosys has become more flexible in offering terms to clients, over the past few quarters. However, we do understand that, Infosys aims to sustain margins its stated range of 24% - 26%, in the medium term. Attrition down sharply Annualised attrition for the last 12 months has fallen sharply to 18.1% in 3Q from 19.9% in 2Q. Infosys has taken various initiatives over the past few quarters in terms of promotions, selective salary increments, etc, which have had the desired impact. Reducing attrition has been one of the goals of Infosys and we believe that, the fall in attrition reflects the improved sentiments of the employees and their increased confidence in the long term prospects of Infosys. Kotak Securities - Private Client Research Please see the disclaimer on the last page For Private Circulation 3

3 3QFY16 results - above estimates (Rs mn) 3QFY16 2QFY16 QoQ (%) 3QFY15 YoY (%) Turnover 159, ,350 (1.7) 137, Expenditure 119, , ,070 EBIT 39,590 39, , Interest Other Income 8,020 7,930 8,400 PBT 47,610 47, , Tax 12,960 13,870 12,790 Minority interest PAT 34,650 33, , E. O items PAT after EO items 34,650 33,989 32,500 EPS (Rs) EBIT (%) Net Profit (%) Source : Company IT services revenues grew by 2.1% in CC terms, excluding one-offs Revenues grew by 2.1% in CC terms, excluding one offs. 2Q had one-off revenues (break-up fee) of $23mn, which were absent in 3Q. Moreover, there was an impact due to the flooding in Chennai. Thus, excluding this impact, the growth was higher. Growth was led by a 3.1% growth in volumes and a 2.1% de-growth in employee productivity in CC terms. While the manufacturing sector has larger furloughs, the current quarter did see even some other sectors resort to furloughs to curtail costs, we understand. Revenues from retail sector were also impacted by lower spending during the festive season. Energy and Insurance verticals continue to remain impacted. ECS vertical saw rise in revenues from the Utility sector. We are encouraged by the seventh successive quarter of good volume growth in IT services. The growth was secular with almost all verticals, geographies and services lines reporting higher revenues. Manufacturing vertical growth was impacted largely by the One-off revenues in 2Q. QoQ Growth in industry segments (Constant Currency terms) (%) 1QFY16 2QFY16 3QFY16 FSI Manufacturing RCL ECS Source : Company Realisations were lower by about 2.1% in CC terms. Excluding the one-time impact of 2Q, they were down by 1.1% QoQ. Realisations fell on the back of lower number of billing days during the quarter (this impacts monthly billing rates, which Infosys reports). The management has already indicated pricing pressure in non-discretionary business which is 2/3rd of its revenues. Infosys has strongly denied providing better rates to get business. However, we will be watchful of realisations in future quarters. Kotak Securities - Private Client Research Please see the disclaimer on the last page For Private Circulation 4

4 In fact, the management is confident of improving the employee productivity from the current $50,500 per employee to $80,000 per employee by QoQ Growth in geographies (Constant Currency terms) (%) 1QFY16 2QFY16 3QFY16 North America Europe ROW Source: Company Margins better than estimates EBIT margins fell by 60bps to 24.9% as against our expectations of 24.4%. While rupee and lower variable pay helped improve margins by 110bps, lower realisations (110bps), lower utilization rates / business continuity expenses (Chennai flooding) / investments in demand generating initiatives (60bps consolidated) more than set off these gains. Infosys paid out 100% of variable pay in 2Q but lower in 3Q. While there was a one-off income of separation fee in 2Q, this did not have any impact on the average realisations or on margins for the quarter, according to the management. With Infosys pushing for growth as well as training of employees, there may be higher spends towards these in the next few quarters. Infosys has margin levers to cushion the fall in profitability While the new investment may have an impact on margins in the near term, we opine that, Infosys has adequate number levers, which may offset a part of this impact. Infosys' utilization levels at about 81% (including trainees) have scope for improvement. On the other hand, the pyramid effect should also help in reducing the average cost of employees. Moreover, the increasing use of artificial intelligence (AI) and automation tools should help in better employee productivity and delivery efficiencies for the company. The recent re-organisation also lays more focus on employee productivity. Moreover, higher revenue growth, better realisations (non-linearity), higher off-shore leverage and leverage on costs should help in offsetting a part of this impact, we believe. The management expects margins to remain at around 25% in the medium term. The tax rate in 3Q was low at 27.2% largely because of a tax write back. Excluding this, the tax rate was at about 30%. FY16 revenue growth guidance increased to 12.8% % in CC terms; implies 1% - 2.5% growth in 4Q Infosys has increased its FY16 CC revenues growth guidance from 10% - 12% earlier to 12.8% %. This translates into a growth of 1% - 2.5% in 4QFY16, which is encouraging. The growth in USD terms is at 8.9% - 9.3%. The management has maintained its optimism of attaining industry growth in FY17. We believe that, if Infosys is able to achieve the 4Q guidance (especially the higher end), it will act as a strong base for a higher growth in FY17. Infosys has been winning a higher number of large deals over the past few quarters, which should scale up in future quarters. Kotak Securities - Private Client Research Please see the disclaimer on the last page For Private Circulation 5

5 We factor in 9.2% YoY growth in USD terms for FY16 and about 13.3% in FY17 We assume the exchange rate to be at Rs.64.6 / USD in FY16 and / USD in FY17. We expect margins in FY16 and FY17 to be lower than FY15. Salary hikes and increased S&M expenses will offset benefits from utilization increases, improved efficiencies, higher off-shore content and cost rationalization initiatives. Higher revenues from non-linear initiatives should help, though. Tax rates are expected to be stable v/s FY15. Consequently, PAT is expected to be at Rs.156bn in FY17 (Rs.149bn earlier). EPS works out to Rs.67.5 for FY17. We recommend BUY on Infosys Technologies with a price target of Rs.1305 Valuations and recommendations Infosys has been reporting above-expectation numbers in FY16. The consistent volume growth and order book additions from large deals have been the positive takeaways. We believe that, the new strategy should allow Infosys to improve growth rates over the long term with sustained margins. The long-term strategic plan reflects Infosys' focus on next-generation services and delivery models. Infosys has already made significant progress towards next-generation services and delivery mechanisms. We have accorded valuations to Infosys, which are at a marginal premium to those of TCS, in anticipation of improved growth rates from Infosys. Our TP stands at Rs We continue to repose faith in the prospects of Infosys and upgrade the stock to BUY from ACCUMULATE. Concerns and risks A slower-than-expected recovery in major user economies may impact our projections. A sharp appreciation of rupee beyond our assumed levels may impact our earnings estimates for the company. Kotak Securities - Private Client Research Please see the disclaimer on the last page For Private Circulation 6