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Software: Rupee volatility takes toll!

Feb 1, 2005

Performance summary
The recently concluded third quarter of FY05 saw Indian software companies reporting a slower (relative to previous quarter) growth in the topline and bottomline, much due to the strong appreciation in the value of rupee vis-a-vis the US dollar. The direct effect was also seen on the operating margins front. In this write up, we analyse the performance of the sector (through consolidation of results of key companies) and see what investors in software stocks can expect going forward.

Indian IT: 3QFY05 performance...
(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%  
* Consolidated to include results of Infosys, Wipro, Satyam, i-flex, MphasiS, Hughes and Geometric

About the sector
For Indian software companies, the past two years have marked a shift in demand from low-end services to high-end ones, like IT consulting, package implementation and systems integration. Now, while Indian software companies are increasingly facing competition from global MNCs who are replicating the Indian offshoring model, the need of the hour is to rapidly move up the software value chain.

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.

What has driven performance in 3QFY05?
Positive bias for billing rate:  While the past couple of quarters have seen billing rates stabilise for Indian technology companies, especially for major players like Infosys, Wipro, TCS and Satyam, this quarter culminated with most of the managements announcing that they have continued to get higher than average rates from this clients, especially for the work done onsite. While the change in billing rates has not been significant enough to make a major effect on the topline, volumes have continued to lead the growth in the same (the topline). For instance, offshore and onsite volumes for Infosys grew QoQ by 13% and 11% respectively, one of the highest sequential growth levels attained in the past few years.

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.

What to expect?

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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