The whistleblower letters crashed the Infosys (Infy) stock by more than 16% on 21st Oct. We believe that the investors’ response was stricken with panic given the multiple corporate misgovernance episodes that have unfolded in the last couple of years where investors lost money. This is a typical example of behavioral bias – heard mindset. The price movement is the outcome of generic investors’ reaction coupled with trend-chasing traders who saw corporate misgovernance as the negative theme to ride on considering the alleged wrongdoings. Perhaps even the long-term investors did not focus much on real impact of the allegations on margins or sales growth. This type of reaction, treating everything same, is characteristic of the over-optimism and over pessimist that the market participants go through during a bull and bear phases in the market. Well, without a strong philosophical base, with strong principles and implementable rules it is a tough call to differentiate an opportunity from a trap.

We at OmniScience Capital have built and practice an investment framework called Scientific Investing that helps us make investment decisions every time, differentiating chaff from the grain. Scientific Investing framework helps us identify, label and segregate all companies that are part of our investment universe. A company depending upon its fundamentals and valuation shall be classified among the four categories. Capital Destroyers (companies with bad business operations, financials, and high debt), Capital Eroders (companies with low returns on capital), Capital Imploders (companies which are significantly overvalued, i.e. priced to perfection for high growth rates over long periods of time in the future) and Capital Compounders (SuperNormal Companies @ SuperNormal Prices).

We evaluated the accusations raised in anonymous letters to see if we need to change our investment view on Infy. Firstly, the allegations are in a relatively immature language with certain points that are not worth examining such as calling names for board members, etc. The allegation of personal expenses being paid by the company is rather weak given Salil’s background and remuneration (24.67Cr in FY2019). Allegation regarding boosting of short-term revenue and profits is crucial from corporate governance viewpoint but if this has been already been deliberated with the auditors as per the letter then it is up to the auditors to highlight this in their remarks. The allegation that the large deal approvals have irregularities with several billion-dollar deals of the last few quarters have nil margin impacts the fundamentals for the long-term investors. We believe that it could be a strategic decision to get entrenched at a large client and in new technologies. Profits can be made in later deals there. Not a big concern if there is a thought and vision behind it. Some of these details were already disclosed by the company. For instance, the Verizon deal was expected to be margin dilutive but seen as an organic growth investment and for capacity building for the emerging business models such as 5G. In the Q1 FY20 call, the management put out specifics on margin impact of 210bps due to compensation increments, salesforce ramp-up and various other heads including 20 bps due to ABN

Stater acquisition and 80bps on visa expenses. There is a further allegation that the revenue recognition matters are forced and are not as per accounting standards. The revenue recognition was explained in the last quarterly call that billing milestones are decided with the clients based on delivery dates whereas the revenue is based on the activities and efforts and hence there is a likelihood of mismatch and hence management discretion may be applicable in many engagements.

In our opinion, the overall business of Infy remains intact. A few large deals are probably at zero margins but that must be seen as investments for organic growth. These deals will bring revenue growth in the future. The digital franchise is growing and becoming a significant part of the total business. The management in last quarter’s earnings call declared that “the margin for our digital business is higher than the margin for the company overall”.

Infy has been part of our multi-cap and large-cap portfolio for more than five years now. The margin decline from mid-twenties to low twenties is a phenomenon that has been observed over a long time and has remained one of the most investigated topics in most earning calls. We believe that this being a core issue has been targeted possibly to create volatility. Further, the top management has remained an overblown concern since the early part of this decade for Infy. We have seen twice in the past a similar drop in the price, once in mid-2014 after departure of key managerial persons, especially when BG Srinivasan resigned the stock tanked around 8% and again in Aug 2017 when Sikka resigned the stock tanked 14% in two days. However, the stock proved the apprehensions wrong on both occasions by generating superior returns in the following couple of years. After the 2014 episode, it outperformed Nifty 50 and CNX IT by 48% and 61% respectively in the next two years. In two years after Sikka’s departure, the stock again outperformed Nifty 50 and CNX IT by 47% and 81% respectively, again proving the market’s anxieties to be misplaced.

Going back to the Scientific Investing framework, Infy is a well-entrenched organization with strong margins (20%+ OM), high profitability (20%+ RoE), cash-rich strong balance sheet and is available at a significant discount to its intrinsic value (Forward P/E of 18) meeting all parameters of a SuperNormal Company @ SuperNormal Price. This week the company also said that while the anonymous complaints are under investigation there is no prima facia evidence that the company has received until date to corroborate any of the allegations made. While it is up to the regulators to investigate and fix the responsibility on the large short positions created in the month of September, we still believe that if the CEO and team are found guilty, they will be replaced with a competent management to run the company.

Ashwini Kr. Shami

Executive Vice President & Portfolio Manager, OmniScience Capital


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