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October 24, 2002
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Is Infosys better than Microsoft?


For any investor in the emerging markets and especially in India, the ability to witness the growth, wealth creation and quality of a company like Infosys Technologies is a once in a lifetime opportunity.

The company has truly demonstrated that Indian corporations can be world class in every respect and can teach their international brethren a thing or two.

Infosys will reach the distinction of a billion dollars in annual sales sometime in the next 18 months and will have multiplied its sales a hundred fold in less than 10 years, and that too entirely organically.

Its success has created self-belief in a whole generation of Indians.

Despite its awesome track record, many people, myself included question Infosys's current valuation and wonder whether the market hasn't gone overboard in its enthusiasm for the company and its future prospects.

Consider the facts, at current American depositary receipt prices, Infosys is effectively the second most valuable IT services company in the world (only after Accenture) worth more than erstwhile industry stalwarts like EDS, CSC and Cap Gemini, all of which are many multiples its size in terms of turnover, number of employees and customer relationships.

The market values each Infosys employee at roughly $800,000, when the revenue per employee is only $50,000. While for EDS each employee has a market value of only $45,000 compared to $150,000 in revenue billed.

At first glance these numbers seem a little absurd; no matter how good Infosys is, does it have the breadth of domain knowledge or quality of customer relationships to lay claim to being the second most valuable IT service company in the world?

Operating from India can any company claim global industry leadership in less than a decade?

I asked many large investors as to how they could explain the valuation of the company and justify holding it. Besides the index argument (big weight of Infosys in the benchmark) and it being a large capitalisation, well traded, high-quality proxy for Indian IT, it transpired that most investors expected Infosys to maintain revenue growth rates in excess of 20 per cent for the next 5-10 years.

They expected the company to post this growth while keeping operating margins in the 30-35 per cent range (near current levels).

Reading analyst reports one gets a sense they too have similar assumptions embedded in their models for the company. Using these assumptions, on a simple P/E basis the stock does not look outrageously expensive despite the above international comparisons.

These expectations are all fine as working assumptions and in fact even look plausible. The difficulty of actually achieving these performance goals, however, becomes clear when you look at the history of corporate performance globally.

The surprising fact is that if you look at all the major companies across industries globally, only one company has been able to maintain revenue growth rates over 20 per cent and operating margins over 30 per cent for 10 years or more once it crossed a billion dollars in sales.

That company is Microsoft which has achieved this unique feat by virtue of building a quasi monopoly, creating significant intellectual property and riding the boom in PC usage and penetration.

No other company, not even Intel or Cisco in tech land nor Disney in media, not even Wal-Mart in their heyday have achieved this combination of revenue growth and high margins for a sustained period of time.

Infosys is on the verge of hitting the magic one billion dollar revenue hurdle and thus the above comparisons start becoming far more valid as the law of large numbers starts operating.

The irony of the situation is that investor expectations of 20 per cent revenue growth and slight margin degradation look totally plausible given the company's track record and superlative handling of the current IT slowdown.

But these same expectations look totally unrealistic if compared to what other great companies have actually achieved at similar points in their growth cycle.

Infosys has to basically do what no other company except Microsoft has ever done to fulfil its investor's expectations and justify its valuations.

If Infosys were unable to deliver these types of growth rates and margins then its valuation would undoubtedly suffer.

Whether the 'India Offshore' model is robust enough, with adequate entry barriers to enable Infosys to achieve its growth objectives, will only become apparent with the passage of time; however, I am not sure investors fully appreciate the enormity of the task ahead and the headwinds of corporate history they face.

If any company in India is up to the challenge of duplicating Microsoft's performance it is Infosys and it has not paid to bet against its execution capability, but whether the India Offshore model can be compared to Microsoft's business model in terms of growth potential and margin sustainability is a moot point.

I have tremendous respect for Infosys and its management team and have only used it as an example to highlight the long-term growth and margin assumptions embedded in the current stock prices of large cap Indian IT companies and the lack of historical precedent in actually achieving these expectations.

These comments are equally applicable to all the other large Indian IT companies as they approach the billion dollar sales number.

The critical question investors have to focus on is the sustainability of the India Offshore model and its ability to continue to deliver growth and margins equivalent to Microsoft (in its heyday), for that is what investors seem to expect.

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