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Software: Preview 3QFY06...

Jan 5, 2006

The markets are going up virtually every single day, even as cautious and skeptical 'market experts' caution against soaring valuations. Liquidity is as abundant as ever and, if reports are to be believed, even more money in terms of billions of dollars is expected to flow into the Indian markets, with numerous 'India-dedicated' funds being launched in places as diverse as Japan and the UK. The BSE-Sensex now trades at over 19 times trailing 12-month earnings. India Inc's 3QFY06 results are slated to begin next week. This is expected to determine the short-term trend of the indices in general. Once again, it is the software companies that will be first off the blocks to announce their results. This time around, MphasiS BFL will again kick-off the earnings season, announcing its results on January 10, 2006. Amongst the biggies, yet again, Infosys will be the first off the blocks to come out with its results on January 11, a trading holiday. TCS follows the very next day. An action-packed schedule indeed!

Major drivers in 3QFY06
We attempt to analyse a few major operating metrics that are likely to influence the 3QFY06 results of software companies.

Volumes: The demand environment for offshoring appears stronger than ever before, with no signs whatsoever of any waning interest from Fortune 1000 companies and beyond. Even as global IT spending grows at a relatively modest pace in mid-single digits, as per industry analysts like Gartner, the offshore component is on the rise, giving the IT companies much to cheer about. The strong demand environment will ensure that volume growth remains healthy for these companies.

Of course, it should be mentioned here that Infosys has said that this quarter might see slower growth due to the holiday season and lower working days, both offshore as well as onsite. But over a longer period, with order wins such as the ABN Amro deal and the Pearl deal in BPO, business appears more robust than ever before. Increasing scalability, deepening of client relationships to get a greater share of the client's wallet and greater domain expertise for tasks like consulting and package implementation will ensure that Indian IT firms continue to get an ever-increasing pie of global majors' massive IT budgets.

Billing rates:What we gather from conference calls, media reports and managements of these companies is a clear understanding that the era of strong increases in billing rates is over. Competition and greater bargaining power of the receivers of services (clients) will ensure that this does not materialise in any major way. Billing rate increases are expected to come more from the business mix in favour of higher-end business like consulting and systems integration. Annual escalation clauses may also be built into service level agreements (SLAs). Contracts coming up for review could also provide a slight rate up-tick. However, as has been the case over the past few quarters now, volume growth remains the key driver of the topline.

Exchange rates and margins: Once again, the rupee-dollar exchange rate will play a role in determining margins of software companies. This time around, the rupee's movement against the dollar has been fairly volatile, moving up and down with regularity. While in 2QFY06, the rupee depreciated against the dollar, this quarter, the overall movement on a point-to-point basis has not been that significant. If anything, a very slight appreciation was witnessed. Similar was the case with the other major currencies of billing, that is, the British Pound and the Euro, with movements being relatively flat on a point-to-point basis.

What to expect?
While we have outlined our expectations on the major operating metrics that are expected to affect software companies during 3QFY06, we remain of the belief that, as an investor, one must take a long-term view of any business, including software. One must take into account the fact that valuations are not that attractive at current levels. Any strong performance by these companies has already been factored into the current prices. As a result, there is plenty of room for disappointment and if these companies under-perform the 'market expectations' for whatever reason, there could be trouble, as we have seen so often in the past.

However, with respect to the long-term, we remain positive on the sector's prospects. More US$ 100 m-plus deals are expected to be won by the top-tier software majors. Scalability is of critical importance, more now than ever before, in order to successfully execuite such global deals. Investors can surely look forward to exciting times ahead!

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