(Rs m) | 2QFY05 | 3QFY05 | Change |
Net sales | 52,052 | 55,438 | 6.5% |
Other income | 676 | 760 | 12.4% |
Expenditure | 37,693 | 40,313 | 7.0% |
Operating profit (EBDITA) | 14,359 | 15,125 | 5.3% |
Operating profit margin (%) | 27.6% | 27.3% | |
Depreciation | 1,622 | 1,857 | 14.5% |
Profit before tax | 13,395 | 14,002 | 4.5% |
Tax | 1,969 | 2,041 | 3.7% |
Profit after tax/(loss) | 11,413 | 11,968 | 4.9% |
Net profit margin (%) | 21.9% | 21.6% |
Increasingly, the demand for technology is likely to be more guided by the 'Return on Investment' factor, i.e., how much of cost saving or return on investment can be obtained by clients from their IT spending when quality execution capabilities is a given attribute. As such, large Indian IT companies that have provide a broad range of services and have proven capabilities in executing large and complex projects are likely to emerge winners. However, to maintain strong growth in the long-term, scalability and quality offerings would be the key.
If one is to compare the sequential growth in revenues in 3QFY05 (6.5%), it has almost been half of what was attained in 2QFY05 (13%). A major reason for this can be attributed to the sharp 4% appreciation of the rupee vis-a-vis the US dollar. We expect the dollar to remain under pressure on account of the fact that it has to support the huge US current account deficit that is to the tune of over 6% of the US GDP. While the rupee appreciation affects profits more than the topline as future realisations are hedged, revaluation of debtors usually takes some toll on revenues.
Margins under pressure from rupee appreciation: While increased hiring at the freshers' level pared pressure on margins despite continuing strong addition to employees in 3QFY05, the sharp decline in the value of dollar countered this benefit, leading to a slight decline on margins. As a matter of fact, every 1% appreciation in the value of rupee negatively affects operating margins by 30 basis points (this is assuming that, on an average, 30% of costs are in rupee terms). Some companies also witnessed a slight dip in their sales and marketing costs (as % of revenues) and this helped pare margin decline. For example, Infosys' S&M expenses were down from 7% in 2QFY05 to 6% in this quarter. This is a sign that the company is able to realise scale benefits of its S&M expenditure made in the past and we expect this to be a guiding force in paring the pace of margin decline in the future.
However, for mid-size players, who are yet to make a mark on the global platform, aggressive spending on the S&M is likely to continue and this will further affect their margins.
Margin pressure boils down to net profits: Lower sequential growth in the topline and a marginal contraction in margins led to a sedate QoQ net profits growth for the Indian software sector. Apart from these two factors, most of the players also felt the pressure on the other income front, as they reported forex losses on account of appreciation of the rupee.
As the graph below shows, the average P/E (based on P/E calculations for the companies under consideration) of the Indian software sector is 23.1 times expected EPS for FY06. This has been a marginal dropdown from the valuations of the sector as after the 2QFY05 results. However, even now, the top companies continue to trade near or above the average P/E for the sector. In fact, if one were to remove the top three players from the valuation matrix, the average P/E for the sector sharply falls to 15.5 times based on FY06 expected EPS.
Among the mid-caps, while most of them trade at discount to the average, investors need to understand that there are reasons for the same (like their small size and relatively high risks to their businesses due to their niche capabilities). However, select companies from this segment like Geometric Software and i-flex have shown their capabilities in the past and are likely to growth strongly in the future.
For the sector as a whole, the movement on the currency front is likely to be a strong factor that could affect profitability in the coming quarters. As seen in recent times, led by pressures of a huge current account deficit, the US dollar has resumed its depreciation against the Indian rupee and other major global currencies. If this were to continue in the future, and that the rupee were to strengthen further, profitability of these companies would be impacted severely.
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