• Revenue growth was behind expectations with pricing being the culprit 

• Asking rate to achieve annual revenue guidance becomes challenging 

• Micro growth trends reversed during Q1 FY15 as compared to Q4 FY14 

• Margin defense was better-than-expected; but headspace for operational levers limited

• Lower depreciation propel earnings; employee addition modest 

• See limited upside in the medium term; downgrade to Accumulate from Buy

Revenue growth was behind expectations with pricing being the culprit 

Versus our estimate of 2.8-3% constant currency dollar revenue growth, Infosys delivered a lowered 1.5% growth in Q1 FY15. While volume growth was near expectations at 2.9% qoq (2.2% onsite and 3.2% offshore), 0.8% qoq decline in pricing (-0.5% onsite and -0.6% offshore) surprised negatively. The sustained weakness in pricing (declined by similar extent in Q4 FY14) could be attributable to pricing pressure in commoditized service offerings and re-alignment of company’s pricing structure with the market. Better volume traction was in-line with management commentary and comes after a lackluster performance in H2 FY14 which was impacted by unanticipated project ramp downs and cancellations. IT services revenue mix continued to move towards offshore; 20bps qoq in Q1 FY15 and 280bps over preceding four quarters. Infosys won five large deals (3 in US region and 2 in Manufacturing vertical) during the quarter having combined TCV of more than US$700mn (deal win quantum has been steady for the past few quarters). As per the management, the deal pipeline has improved marginally and the company is chasing 10-12 large opportunities currently.

Asking rate to achieve annual revenue guidance becomes challenging 

Despite a muted growth performance in Q1 FY15, Infosys maintained its annual dollar revenue growth guidance of 7-9% banking on an improved performance in the remainder of the year. It will be unfair to take cue from company’s performance in the same period last year (low 1.7% CQGR over Q2-Q4 FY14); nonetheless, the task of meeting the upper end of guidance seems challenging with required CQGR of 3.5%. Especially when the company has lost a number of senior business/functional leaders and attrition at mid and lower levels is escalating. However, brisk ramp-up in new deals won could aid company in just about meeting the guided upper growth number.

Micro growth trends reversed during Q1 FY15 as compared to Q4 FY14 

Growth in IMS (12% qoq) and testing (5%+ qoq) services was ahead of the company while revenues in the BPO business and PPS (products, platforms and services) shrunk by 4.4% qoq and 6.6% qoq respectively. Revenue growth in BFSI (1.7% qoq v/s -0.4% qoq), Manufacturing (2.8% qoq v/s 0.5% qoq) and Retail & CPG (3.9% qoq v/s -3.5% qoq) bounced back after being impacted by client-specific budget cuts/ramp downs in the previous quarter. Regionally also, growth revived in the US region to 3.7% qoq and contributed almost fully to incremental revenues in the quarter. 

Margin defense was better-than-expected; but headspace for operational levers limited

On operating margin front, Infosys surprised positively once again. Despite multiple headwinds (salary hikes, higher visa cost and rupee appreciation), company managed to contain margin fall to 130bps qoq against our expectation of 190bps. Better margin defense was driven by ongoing cost optimization measures, sharp improvement in utilization (increased by 340bps qoq without trainees), sustained offshore shift and tailwinds from favourable cross currency movements. Though company expects FY15 operating margin to be similar to FY14 (27.1%), we believe it would be reasonably higher at 27.8%. Over the longer term, company may find it difficult to improve margins further as it runs-out of operational and efficiency levers (utilization near peak levels and offshore effort mix at multi-quarter high). On top, there could be pressure from pricing correction and efforts towards improving attrition. 

Lower depreciation propel earnings; employee addition modest 

The depreciation charge in the quarter was lower 36% qoq at Rs2.3bn as the remaining useful life estimates of large part of depreciable assets (primarily consisting of buildings and computers) was increased based on internal and external technical evaluation. This along with margin beat drove a much higher-than-expected PAT of Rs28.9bn. With high uncertainty around company’s long-term growth prospects and top leadership, attrition continued to escalate at worrying pace and reached 19.5% on LTM basis. This partly could be the reason behind sharp uptick in ex-trainees utilization over the past five quarters. Employee addition was marginal at 0.5% of previous quarter base slightly contradicting management’s expectation of revenue growth improvement given stretched utilization levels. 

See limited upside in the medium term; downgrade to Accumulate from Buy

Resurrecting growth amid employee/management flux has turned out to be an arduous effort for Infosys and this will likely take some more time. Therefore, at current juncture one cannot so comfortably assume that company would revert to industry growth levels in FY16. Further, margin levers apart from headroom for incremental cost optimization are fast diminishing. We expect Infosys to deliver a below peer FY14-16 earnings CAGR of 10-12% which justifies its lower valuation at 14x FY16 P/E. In the wake of very limited scope for further price appreciation over the next 9-12 months, we downgrade our rating on the stock from Buy to Accumulate.