January 22, 2017 - 8:58pm EST by
2017 2018
Price: 948.70 EPS 62.85 68.05
Shares Out. (in M): 2,286 P/E 14.5 13.5
Market Cap (in $M): 32,000 P/FCF 0 0
Net Debt (in $M): 4,487 EBIT 0 0
TEV ($): 27,370 TEV/EBIT 0 0
Borrow Cost: General Collateral

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I am recommending a short in Infosys, an Indian IT outsourcer that faces rising secular business model risks, maturing revenue growth, margin pressure, and meaningful vulnerability to potential regulatory changes.

Cloud migration disrupting legacy revenue models

o Infosys and other Indian IT outsourcing “pure plays” have made a huge mark in the applications outsourcing space, successfully siphoning off huge amount of application management business from domestic providers over the last 10 years by taking advantage of favorable offshore labor arbitrage

o However, as Infosys has grown into a scale player and the IT services market has matured, revenue growth has decelerated:


o Infosys is now getting disintermediated by the transition to the cloud, and the transition is disruptive to its legacy business model. Clients can take an account and convert those applications to Amazon AWS or Microsoft Azure at a substantial cost reduction. Infosys, Tata, and Cognizant have huge revenue streams (~60% of revenues+) tied to these legacy IT models that they are desperately trying to hold on to

From industry conversation, I believe hundreds of billions in application management contracts across the industry are at a cost point that are ~40% higher than it needs to be with the presence of the cloud

“In a rebid situation, particularly, be it infrastructure management, be it application maintenance, be it testing, BPO, in all these service line which is still a big percentage for all our competition including our self, clients up front very clearly says they are looking at 30% - 40% reduction over a contract duration” (Pravin Rao, COO, 11/15/16 CLSA Forum)

o That is leading to structural pressure on pricing that only seems to be intensifying:

“Clients are looking at investing in newer areas and that means they have to figure out a way to repurpose their spending. If you look at application maintenance, infrastructure management, testing or business process outsourcing (works), there is tremendous pressure on pricing,” Praveen Rao, COO of Infosys

“The expectation from the customer is that prices have to drop and this gets more severe by the day. We have clients where all our competitors are bidding for the deals and they are saying they need lower prices” (Vishal Sikka, CEO of Infosys, 11/11/16)

o Challenges to the financial model are evident in recent financial results:

4.3% sequential (ex- RBS contract cancellation) decline in revenues from the top-10 clients is the worst quarterly change in Infosys' top-10 client revenues in the past eight years

Infosys and Cognizant both reduced full-year guidance twice in 2016

Wage inflation

o At the same time that revenue pressures are intensifying, wages for Indian IT workers are also rising 5-10% per year


o Employee wages comprise ~55% of revenues and is the most significant cost driver for the financial model

o Wage pressure will also pressure margins and diminish the Indian labor arbitrage, reducing a key driver competitive advantage and source of historical market share gains for Infosys

Regulatory risk

o Infosys generates the majority of revenues from U.S. clients and is highly dependent on the existing H1B and L1 visa programs to serve those clients. For Infosys, >50% of US headcount is on H1B or L1 visas

o There is a new bipartisan bill making its way through Congress that proposes increasing the minimum wage of a H1B visa worker from $60k to $100k. Most IT services companies pay a fully loaded wage of ~$70k - $80k to their H1B workers, implying a potential 33% labor cost headwind if the proposal passes that would regulate away a key competitive advantage for Infosys (labor arbitrage). I estimate passage of the bill could create a potential ~300-500bps of margin headwind to Infosys’s margins

o Even if the H1B bill does not pass, the new administration is likely to propose new measures that will only add pressure on companies to favor domestic workers over foreign outsourcers like Infosys (border tax adjustment, etc.)

o In addition to the margin impact, visa and other regulations would likely also have an impact on client servicing


o Pricing pressure, maturing growth, and rising wage inflation has led to ~500bps of margin compression over the past 8 years


o Pressures on their traditional business lines are forcing Infosys to invest in new digital business lines to favorably remix the revenue mix, but investments are adding further pressure to margins

o Infosys has its own initiatives to improve margins (~30% long-term margin target) involving higher utilization, automation, software content, etc., but many of these initiatives are also being pursued by competitors. I believe many of those benefits will likely get passed through to the customer rather than retained for Infosys’ financial benefit

o Over time, I believe the accelerating commoditization of their business will drive margins much lower from the rich 25% margins Infosys currently enjoys. Peers like HCL, Wipro and Cognizant already operate at 18-20% operating margins, and companies that operate in the most commoditized areas of the IT services stack operate with 5-10% operating margins. I believe Infosys margins can converge closer to these lower baselines over a longer period of time, and that the trend is already historically observable


o Infosys currently trades at ~14.5x P/E based on consensus earnings. This is not an unreasonable multiple, but forward consensus estimates are likely too high

o Consensus estimates assume a continuation of recent 9.5% revenue CAGR and flat operating margins for the next 4-5 years

o Revenue projections likely overstate the maturation of the overall IT market and the increasing pressures from the cloud on the Indian pure-play business model

o With 30-40% price reductions on contract rebids for legacy application contracts, 5-10% annual wage inflation, continuous re-investments in the business to remix the exposures, and potential disruptions from H1B regulation, I believe Infosys is unlikely to be able to defend margins over the next few years

o In total, I think there is downside risk to both consensus earnings and multiples over the next few years, leading to a favorable risk / reward and resulting in likely underperformance to broader equity indices over the next few years

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.


H1B visa / regulation

Earnings miss

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