• Revenue growth surprises positively; Pricing shows a marginal up-tick

• Select verticals/service lines drive growth; Developed geographies shine

• OPM performance below estimates on the back of continued investments

• Despite strong Q2 growth , top-end of FY14 revenue guidance unchanged 

• Improving revenue traction is encouraging; Growth differential with peers could reduce in FY15; Upgrade to BUY 

Revenue growth beats estimates; Pricing shows a marginal up-tick

Infosys reported Q2 FY14 dollar revenue performance was stronger than expected. Constant currency (cc) growth of 4.2% qoq was notably higher than our expectation of 3.4% growth. Impacted by negative cross currency (40bps), the reported dollar revenues came in at US$2.06bn (+3.7% qoq). The growth was largely offshore volume driven which grew 4.3% qoq which was further supported by increase in realisation of 0.9% qoq.  On a positive note, Infosys won five large deal wins during the quarter valued at US$450mn+. Management also alluded to improving track record in large scale outsourcing deals as compared to last year suggesting increased focus/aggression on winning its fair share of the BIT deals .

Select verticals/service lines drive growth; Developed geographies shine

The Q2 FY14 performance was driven by select verticals and service lines but was notably much more broad-based than the previous quarter. Driven by improving spending, Manufacturing and BFS verticals led the growth (+7% and +4.2% qoq respectively) amongst verticals. Within services lines, growth was led by IMS, Application development and Consulting/SI which grew 6.7%, 5.7% and 2.8% respectively.  Stabilizing macro in developed markets resulted in decent growth both in US (+3.9% qoq) and Europe (+5.5% qoq). The growth across clients was pleasantly broad-based with Top/Top 5/Top 10 clients growing 4%/4.5%/5.9% respectively.

OPM performance below estimates on the back of continued business investments

The Q2 FY14 OPM performance of Infosys came in below estimates despite multiple tailwinds. One of the key un-accounted factor that impacted Q2 FY14 OPM was the US visa issue related costs of US$35mn that were taken on books during the quarter. These costs are regarding an ongoing civil resolution of the US government’s investigation into company’s compliance with visa related processes. The company has not yet specified any further escalation of these costs. Even apart from this possibly one time charge, the OPM for Q2 FY14 came in 40bps lower qoq at 26.1% despite strong rupee depreciation, utilization expansion, absence of visa costs, higher offshoring and improved realisation (+0.9% qoq cc). The combined positive impact of these tailwinds (250bps from rupee depreciation and 150bps from the rest of the levers) was more than offset by wage hike (300bps impact), additional investments in employee related benefits (bonuses, promotions) and other business investments. On the back of the one-off visa related costs as well as lower than estimated OPM, the reported PAT of Rs24.1bn was 11% lower than our expectation. The employee additions were decent with the total employee base expanding 1.4% qoq.  

Despite strong Q2 revenue growth, top-end of FY14 revenue guidance unchanged

The FY14 dollar revenue growth guidance for Infosys was the key dampener from the Q2 FY14 result release. Management had (in Q1 FY14) guided to 6%-10% revenue growth in FY14 implying a Q2-Q4 FY14 revenue CQGR of -1% to1.5%. Despite the robust dollar revenue growth of 3.7% in Q2, the top-end full year guidance (9%-10%) remains unchanged. Considering the ~14% growth witnessed in H1 FY14, the estimated CQGR for H2 FY14 is  -1% - a highly cautious outlook. Lag in realisation the benefits of the ongoing business investments (on sales and delivery front), traditional weakness in H2 as well as anticipated sluggishness in Retail vertical (owing to US government shutdown) are the key reason alluded by the management for the cautious guidance. On the margin front too, company guided towards sustained business investments required for reviving the growth.

Improving revenue traction is encouraging; Growth differential with peers could reduce in FY15; Upgrade to BUY

We found the Q2 FY14 results of Infosys to be mixed with robust (and better-than-expected) revenues on one hand and a tepid margin performance and weak guidance on the other. While the broad contours (especially the highly cautious guidance) are not impressive, we find the notable improvement both in the management commentary and operational metrics. Management alluded to improving demand environment in US, Europe amongst geographies and BFSI, Manufacturing among verticals. Focused aggression towards earning fair share of the large deals outsourcing market has resulted in improving traction in this arena. On the profitability front, the lower than expected OPM was largely due to the operational gains from utilization, offshoring and RPP being ploughed back in the business. This, as management indicated, is essential to improve the longer term business traction for the company. We believe these factors coupled with a signs of demand improvement should support growth going forward and help reduce the differential with peers in FY15. Margin which is a function of growth is also expected to show improvement over the same period. Overall, though we remain watchful (especially on the traction in discretionary spending), we turn positive on the counter. Recommend BUY with increased 9-month TP of Rs3,744.