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Software: Preview 3QFY05...

Jan 5, 2005

The euphoria in the Indian equity markets continues abated and investors now wait for India Inc. to announce results for the third quarter for FY05. Leading the pack will again be the software majors with MphasiS and Infosys announcing their results on January 11 and 12 respectively. While the past couple of quarters have been good for Indian software companies, especially the leading players from the sector, 3QFY05 might see some weakness on the revenue growth and margins front. The third quarter is usually considered to be a period of relatively sedate growth for software companies as it is marked by an elongated festival season on account of Christmas and New Year (as indicated by the managements in the past). However, if one were to see Infosys' performance on sales and profit growth in the past 10 quarters, the picture that emerges indicates otherwise. While we are not pointing to some trend, what we mean to say here is that players like Infosys have proven time and again their ability to reverse the tide. This has been made possible through their strong execution skills, ability to continuously improve their delivery model and forging long-term and fruitful relationships with clients.

Even in recent times, when several large and mid-size players from the industry have struggled to maintain volume growth, companies like Infosys and Wipro and done otherwise. Not only have these companies maintained a strong order flow, they have also witnessed a marginal increases in their billing rates for some projects. And we believe 3QFY05 to be no different. For mid-size companies, however, times are likely to be tough yet again.

A couple of factors, however, are likely to impact profitability of companies across the spectrum, however varying from company to company. One is the appreciation of the rupee vis--vis the US dollar and the second is wage inflation on account of salary hikes announced in the second quarter of FY05. The former is likely to have a greater impact on those companies that have a larger offshore cost base (like MphasiS and HCL Tech) and a greater US dollar denominated revenues (like MphasiS and Geometric). However, larger companies are likely to pare the effect through a strong growth in volumes and improvement in billing rates. Foreign exchange hedges are also likely to help companies pare some effect of the depreciating dollar in the short-term. The second factor i.e., wage inflation, is also likely to impact margins in 3QFY05. Several companies announced salary hikes for onsite employees at the end of 2QFY05, and the effect of the same will start showing from this quarter onwards.

The overall picture

If one were to take a look at the overall picture, while margins are likely to decline across the spectrum, the degree of decline is likely to be lower for large integrated players and higher for mid and small-size players. Bigger players are also likely to outperform on the volume growth side. However, valuations look stretched for most companies, at least for the medium term.

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