At Infosys, another bastion falls

One of the reasons Infosys Ltd had been a favourite with investors was its ability to punch far above its weight when it came to both profitability and cash flow generation.

In 2007-08, for instance, even though its revenue was 25.9% lower than that of Tata Consultancy Services Ltd, its operating profit was only 9.2% lower and its free cash flow was 18% higher.

But TCS has now caught up on each of these fronts. In 2012-13, it outdid Infosys’s operating profit margin by more than 100 basis points (bps), and has since maintained the lead. In 2014-15, for the first time ever, it generated more free cash flow for every dollar of revenue than Infosys. Free cash flow is cash flow from operations after adjusting for capital expenditure and spends on acquisitions.

In 2014-15, Infosys’s free cash flow stood at $1.46 billion, or 16.8% of revenue, after adding back a one-off tax outgo of $280 million. TCS’ free cash flow amounted to $2.94 billion or 19% of revenue. One may argue that Infosys lost out on account of the much larger acquisition it made last year. But even if we were to leave acquisitions out of the calculations, i.e. deduct only capital expenditure from operating cash flow, TCS’ free cash follow still ends up higher as a percentage of revenue, albeit only just. Infosys’s loss of ground on both profitability and cash flow metrics just proves that there is no substitute for growth.

In fact, the company has been rightly criticized in the past for being overly focused on profitability metrics, and thereby losing out on growth opportunities. Interestingly, despite successive years of underperformance on revenue growth, its operating cash flow is still about 100 bps higher than that of TCS, as a percentage of revenues. One basis point is one-hundredth of a percentage point.

But this last bastion may also soon fall. It’s well-known that the company’s new chief executive officer Vishal Sikka thinks differently. According to analysts, after the change in management, Infosys has been aggressive in the marketplace on pricing, and some of this is already reflected in successive drops in average billing rates in the past two quarters. Sikka’s plans also include a far more significant role for acquisitions, which can result in continued pressure on free cash flow generation.

Investors won’t complain as long as these efforts result in growth. But as analysts at JP Morgan pointed out in a recent note to clients, “An active M&A (mergers and acquisition) strategy is risky, especially for the quantum of investments that Infosys is prepared to pay (cumulatively $7-8 billion by 2020).”

Given how far behind Infosys has fallen—its revenue, profit and free cash flow are now 44%, 46% and 50%, respectively, lower than that of TCS—it has little choice but to take some risks.