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Renewed focus on cost take out deals

Infosys (Infy) has retained its revenue growth leadership among tier-1 IT companies with healthy revenue growth of 4% QoQ CC in Q2FY23, but it was below our/consensus estimates of 5%/4.5%. Growth continued to be strong in digital, which grew 31% YoY CC. Cloud revenue crossed US$1bn for the quarter

Signs of cautious behaviour amongst clients are visible in terms of delay in decision making in select verticals. Management pointed to emerging weakness in telecom and Hi-tech verticals especially in discretionary spends apart from retail and mortgage subsegment in BFSI called out in previous quarter. Despite macro headwinds leading to weakness in certain pockets, Infy won an impressive broad-based large deal TCV of US$2.744bn, up 27.5% YoY, highest in last seven quarters. TCV comprises healthy 54% net new deals. Management alluded to increased traction in cost efficiency and automation deals. This is also reflected in an uptick in core services revenue (3% YoY CC) in Q2FY23. Higher scrutiny on spends is resulting in renewed focus on cost takeouts.

Management revised the lower end of revenue guidance band upwards to 15-16% YoY CC vs 14-16% earlier driven by strong performance in H1FY23 (20.1% YoY CC) and strong bookings. Guidance factors in slowing demand in certain verticals and seasonal weakness historically experienced by Infy in H2 mainly due to furloughs and lower working days.

Infy reported impressive improvement in EBIT margin of 150bps QoQ to 21.5%. Margins benefitted from tailwinds of 1) 70bps from currency benefit, 2) 90bps from cost optimisation (pyramid, offshore, automation, large deal optimisation, better pricing partially offset by lower utilisation), 3) 40bps from reducing sub-con costs. These tailwinds were partially offset by 40bps impact due to compensation-related headwinds rolled out on July 1, 2022 for senior and mid-level employees. Management lowered EBIT margin guidance to 21-22% (vs 21-23% earlier), in line with the earlier stated commentary of margins expected to be near the lower end of guidance. Infy reported 20.8% margin in H1FY23, guidance implies margin is likely to remain stable at ~21.5% for the next two seasonally weak quarters

Our EPS estimates increase by 1.3%/1.8% for FY23/24 largely led by an increase in US$/INR rate assumption. We note that pain due to macro headwinds is evident in the sector and our revenue estimates already bake in a possible recessionary scenario. However, we upgrade Infosys to ADD (earlier: HOLD) because we believe 1) INFY will benefit from cost-takeout deals, 2) it is likely to deliver industry-leading growth, 3) its margins have bottomed out and will likely improve hereon and 4) favourable valuations of 21x on FY24E EPS (only 12% premium to 10-year average 1-yr forward earnings multiple). We value Infy on 23x FY24E EPS to arrive at a TP of Rs1,564 (prior: 1,470). We do not estimate further material cut in EPS going forward. Infosys has underperformed NIFTY by ~17% in the last 6 months; suggest adding in dips.

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