Software sector: Rise and fall of...

2000. What a year that was!! This is the most fitting description to the events in software sector. The year had started on positive note, which many now term as irrational exuberance. And then came February. Within 15 days Wipro touched all time high of Rs 9,800 (high) on 22nd of February (BSE at 6,009, high). Meltdown followed soon after. For most of the year there was an almost a correlation of one between NASDAQ and the Sensex.

Finally the year ended with the sector being not so "hot" anymore. The attitude towards the sector is so cold that in spite of superb results by the software companies for 3QFY01 the bourses did not react.

Macro perspective
Business Focus

If it was Y2K last year, this year it was definitely e-business. Almost all major companies including Wipro, Infosys and Satyam end the year with around 30% of revenues from e-business. Other areas that caught the attention of Indian companies were EAI (enterprise applications integration), technology solutions, ASP (application service providers) and WAP (wireless application protocol).

Telecommunications software was another segment that saw lot of new entrants. Infosys partnered with Cisco, Nortel and Lucent. This will be the area in which most of the software companies will concentrate for the next year. The sector is technology intensive. This results in to higher billing rates and entry barriers. Eager entrants into the telecom arena include Digital and Polaris (apart from long run player Wipro and Hughes).

The vertical that drove the business for most of the software companies was banking, financial services and insurance (BFSI). Online trading continued to gain popularity this year and net banking caught on. Developing solutions for B2B exchanges was another opportunity for the sector. Many companies like Satyam (through its subsidiary Sify) tied up with B2B majors like Ariba to implement Ariba's solutions.

EAI was another logical extension with brick and mortar companies extending the presence to the virtual world. Finally realizing the potential of the Internet as a brilliant delivery medium, these companies are now looking to offer their products/services through the Internet. This would call for a seamless integration of all software solutions.

WAP drew flak for not being able to match up to user expectations. The other problems that plagued the technology were high cost and reliability. Bluetooth, another wireless technology caught attention of the Indian technology companies like Wipro and HCL Technologies. Wipro recently launched Bluetooth solutions

The dot com bubble fell flat on its face by the end of this year. Executives left secure jobs to do their own thing, but by the year end all software companies were talking of reducing their dot com exposure.

Markets

The possibility of the US economic slow down caused to industry to look for other markets. Two of the most promising markets are Germany and Japan. During the year, 56% of exports were to US, 25% to Europe and followed by Japan 4% and rest of Asia 8.5%.

There are mixed feelings to the US economy slowing down. Many large companies feel that they many not be affected due to the competitive pricing (Indian software companies offer billing rates lower by 45% than their foreign counterparts.)

Also, due to the payment model for software companies, the effects of the economic slow down would be only seen after 4QFY01. A possible scenario is that the US based companies will cut down on the number of solutions providers and strengthen relations with one particular provider. This would mean that big companies like Infosys may stand to benefit from the economic slowdown. The other markets that Indian companies will look at will be Europe, Japan (embedded software markets in Japan could bring US$ 100 m in FY01), Middle East and Africa. Singapore could be another destination for the software companies.

On the inflow side, billing rates are under pressure due to a global tech squeeze i.e. companies willing to spend lesser on information technology. The IT spend is expected to grow at about 8% compared to 12% last year. Therefore, as the companies lower their IT spend the software companies may be forced to lower billing rates. But the effects of this will be seen only after the next two quarters.

Micro perspective
Acquisitions

The sector saw acquisitions by the companies to move up the value chain (i.e. to add a higher valued skill sets) and reach out to an already existing client base.

Of the acquisitions that did not fall through was that of Polaris in Data Inc. The two will now fight it out in the US courts. The companies looking for acquisitions include HCL Tech, Infosys and Wipro. These companies have a huge amount of cash lying with them raised through IPO/ADRs. Unless they deploy the cash very soon the companies will take a hit on return on employed capital.

Labour

Rising labour costs was a major concern for the industry. Due to labour shortage over the world the industry has traditionally a high attrition rate average 25%. To retain employee companies introduced ESOPs (employee stock options). But this year with all the infotech stocks crashing the companies may have to look at pay hikes. With some of the companies having high employee costs (37% for Satyam) these hike may hit the operating margins. This has already happened in companies like PSI, where wage costs rose the company took a hit on its bottomline.

However, the year ended with a superb performance in 3QFY01 by leading software companies. The concern now is not performance but valuations and growth. According to WITSA (World information technology and service alliance), the global IT industry is worth US$ 3 trillion. Assuming that the contribution of software to this is about 40%, its market size is about US$ 1,200 bn. In 2000 the size of the Indian software industry was US $ 8.3 bn (or just 0.6% of total). India has competitive advantages in terms of cost and skilled manpower. Therefore, based on the aforesaid projections, the concern over growth seems to be a trifle overdone.

However, on the flip side, these are after all just projections and if all projections were true then companies would not be talking of reducing their 'dot com' exposure. 'There is no smoke without fire'. This maxim seems apt for the Indian software industry in the short to medium term. However, even the most pessimistic would agree that the Indian software industry is here to grow in the long term.