Investor's Eye: Update - Infosys (Wait is over, Infosys' first major acquisition), IRB Infrastructure Developers (Service tax notice should not have any financial risk)

 

Investor's Eye [September 11, 2012]  Sharekhan www.sharekhan.com

Summary of Contents STOCK UPDATE   Infosys Cluster: Evergreen Recommendation: Hold Price target: Under review Current market price: Rs2,529 Wait is over, Infosys' first major acquisition  The event: acquisition of Lodestone Holding AG Infosys has acquired Zurich-based Lodestone Holding AG (Lodestone) for CHF330 million ($349 million) in an all-cash deal. Lodestone is a global management consultancy firm, which provides business transformation solutions enabled by SAP. It has strong presence in Continental Europe with 200 clients and an employee base of 858 employees. Two-third of the total cost of the acquisition is being paid upfront whereas the balance one-third would be paid after three years. The Infosys management expects the deal to be complete by end October 2012. On the earnings front, the management has indicated that the acquisition would be earnings accretive after 18 months. Business synergies for Infosys The acquisition is a strategic fit for Infosys' 3.0 strategy wherein the company is focusing on high-end consulting practice. Lodestone advises on strategy and process optimisation, and provides business transformation solutions wherein the billing rates seem to be higher. Lodestone's revenue per employee at about $306,000 is indicative of the high-end services offered by the company. It will strengthen Infosys' presence in the SAP consulting space with revenues from the practice growing to $1 billion post-acquisition. Post-acquisition, the number of total SAP consultants for Infosys will also rise to 10,000.  The company would get a deeper penetration in Continental Europe, which currently contributes about 10% of its revenues. For Lodestone about 50% of the revenues come from Switzerland and 23% from Germany. Also, Lodestone's acquisition would give Infosys access to 200 clients (minimal overlap with Infosys' client base) to whom Infosys could offer end-to-end solutions. The management has indicated that the acquisition would become earnings accretive only after 18 months. Currently, the margins of Lodestone are in single digits. The margin improvement would be a function of infrastructure integration, selling, general and administration expenses leverage, and business synergies. Nevertheless, the acquisition would provide Infosys some headroom to raise its revenue growth guidance for FY2013 from 5% guided currently.  Valuation: After a long wait, Infosys has finally resumed its long-pending inorganic growth initiatives with the acquisition of Lodestone ($349 million). The acquisition size is much larger than the historical average (Infosys has done cumulative acquisitions of around $150 million till date). We view the current acquisition as more of a strategic fit than a meaningful financial leap for the company. At least with this acquisition Infosys has managed to come out of its comfort zone to acquire a company with a single-digit margin profile. At the current juncture, it has become imperative for Infosys to accelerate its inorganic initiatives to catch up with its peers in terms of growth. We have not incorporated the financials of Lodestone in our estimates and would wait for further clarity on the numbers. At the current levels, Infosys trades at 13.6x FY2014. We maintain our Hold recommendation on the stock.    IRB Infrastructure Developers Cluster: Emerging Star Recommendation: Buy Price target: Rs175 Current market price: Rs123 Service tax notice should not have any financial risk  Event: IRB Infra receives notice from CST for penalty of Rs60 crore on toll collected by a few of its SPVs IRB Infrastructure Developers Ltd (IRB Infra) has received a notice from the Commissioner of Service Tax (CST), Mumbai, ordering the company to pay Rs60.46 crore on account of the service tax not paid on the toll collected by some of the company's subsidiaries from FY2006-07 to FY2010-11. The CST has ordered it to pay a similar amount by way of penalty and interest to be paid at appropriate rates as per provisions of the Service Tax Act. The subsidiaries include Ideal Road Builders Pvt Ltd (the Thane-Bhiwandi project), IDAA Infrastructure Pvt Ltd (the Bharuch-Surat project) and ATR Infrastructure Pvt Ltd (the Pune-Solapur project). According to the CST, these special purpose vehicles (SPVs) act as "Agents" of the National Highways Authority of India (NHAI)/state authorities instead of "Concessionaire" under the build-operate-transfer (BOT) contracts and, therefore, classify toll collection as "business auxiliary service". Though no rationale has been given as to why only three SPVs were selected, but if the logic of a 12% service tax on the aggregate toll collection is extended to all the SPVs, the total amount would come to about Rs290 crore (including the current demand for Rs60 crore) for the above mentioned period with a similar amount of interest and penalty.   However, there will be no effect on books of the company  As per the management, the demand by the service tax authorities is erroneous which takes a totally opposite stand with respect to the circular issued by the finance ministry on February 22, 2012 (circular no. 152/3/2012-ST) stating that the SPVs that themselves collect toll, without appointing any independent entity for collection, do so on their own account as concessionaires and not as agents, and hence do not attract service tax. If the liability does arise, then the company is entitled to a reimbursement of the additional cost (under the "Change in law-change in interpretation of law" provision of the concession agreement) by either direct compensation from the respective NHAI/state government authority or by seeking an extension in the concession period to recover the same. In this case the company will make an appropriate contingent liability provision in the books which will be offset by an equal amount of receivable provision from the respective authority. In all, there would be no effect on books.   Future course of action: appeal against order The company plans to file an appeal against this order over the next 90 days and seek relief on the same. It would also apply for a stay order, which it expects to receive quickly. Historically, such cases would take close to two years to get resolved, as either of the parties not satisfied with the judgment would have an option of going to a higher court and the case would ultimately be settled by the Supreme Court.   Maintain Buy with price target of Rs175 We believe this will have no financial impact on IRB Infra's books as the company has a strong case. Even in the worst case, if it loses the appeal the concession agreement provides a clause under which the company will be able to recover the above amount from the NHAI/state authority. But in case it loses the appeal and does not recover it from the NHAI/state authority, then the per share impact would be Rs8.7-17.5 (Rs8.7 for the pending service tax and a similar amount for the interest and penalty thereon). In such a scenario, even the other developers would get affected.  However, we believe IRB Infra would not face such an adverse situation. We continue to like IRB Infra and maintain our Buy recommendation on the stock with a price target of Rs175. At the current market price, the stock is trading at 8.2x and 9x its FY2013E and FY2014E earnings respectively.   Click here to read report: Investor's Eye   Sharekhan Limited, its analyst or dependant(s) of the analyst might be holding or having a postition in the companies mentioned in the article.

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