Sell Infosys Ahead of Earnings

NEW YORK (TheStreet) -- It's still anyone's guess when IT consulting services, which was once a dominant industry, will get back to its lofty levels.

Results from industry leaders IBM ( IBM) and Accenture ( ACN) have been less than favorable. This does not bode well for Infosys ( INFY), which is expected the report fiscal first-quarter earnings on Friday.

Indicators suggests the underlying market conditions are not stabilizing as quickly as expected. This spells doom for Infosys for several reasons. While I've always liked the company's potential, Infosys' management has made some questionable decisions causing me to rethink the company's prospects.

I don't disagree that the macro weakness in consulting services has had an impact on the company's decisions. But unlike Accenture and Cognizant ( CTSH), the moves that Infosys has made recently have been too reactionary. Nor do I believe that management has responded quickly or adequately enough to the changing market. This showed in the company's fourth-quarter earnings release in April.

Although the company posted decent revenue growth up 18% year over year, Infosys had nothing to show for it in terms of profitability. Gross margin was down nearly 6% year over year and 2% sequentially. Due to an unfavorable mix and almost a 1% drop in prices, operating income plummeted 7% year over year, missing Street estimates by roughly 9%.
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The Street showed the stock very little mercy, punishing Infosys to the extent of a 22% decline the very next day following the announcement. The bleeding didn't stop until the decline reached more than 26%. Management said the results were due to (among other things) the business being under pricing pressure, particularly the IT side of the operation, and also pointed to continued global weakness.

I'm not suggesting management is wrong. But the failure to unhinge the company from an uncertain discretionary spending environment has backfired. Now the company's ability to exploit service outsourcing if/when it does recover is in doubt. During the April conference call, management spoke about investments that the company was planning to make over the coming quarters to get Infosys back on track.

The company issued revenue guidance for full fiscal-year 2014 to come in the range of 6% to 10%, which was in line with expectations. However, I didn't see much, if any, confidence at all that the company had the formula to fix the company's eroding margins, which has been one of Infosys' biggest struggles. In that regard, management expressed difficulty in making short-term margin predictions, which suggests to me that things are not going to get better any time soon.

I'm trying to find a silver lining here somewhere, but management has stopped short of outlining how Infosys plans to overcome its lack of leverage against IBM and Accencure. Making matters worse, Accenture just issued fourth-quarter revenue and earnings-per-share guidance that were 7% and 2%, respectively, below Street expectations. This tells me that aside from trying to mitigate margin and pricing pressure concerns, Infosys may have a tougher second half of the year, too.
Read: HEADLINE

The disappointing part about all of this is, the stock price is very attractive. But I just don't have the confidence to recommend it at this point. Although I do believe that IT spending in the U.S. and across the globe will rebound, I question how much of that market Infosys will be able to secure.

Make no mistake, IBM, Accenture, Cognizant and the like, are all anticipating this same recovery.

In that regard, I don't see how it makes sense for Infosys management to maintain its current strategy. The company should look to expand into emerging markets to boost revenue.

Along those lines, it's equally important to try to assess how much profitability management can secure from the business it is able to win, regardless of which direction it takes.

There are clearly more questions than there are answers. In these scenarios, I've found that it's best to stay away from the stock until the business gives better signals.

At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

Richard Saintvilus is a private investor with an information technology and engineering background and the founder and producer of the investor Web site Saint's Sense. He has been investing and trading for over 15 years. He employs conservative strategies in assessing equities and appraising value while minimizing downside risk. His decisions are based in part on management, growth prospects, return on equity and price-to-earnings as well as macroeconomic factors. He is an investor who seeks opportunities whether on the long or short side and believes in changing positions as information changes.

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