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Software: 3QFY02 ominous

Feb 6, 2002

The 3QFY02 numbers confirmed the impact of the Sep 11. tragedy on software companies. Consequently, this has once again toned down the optimism that was seen just before the results were declared. The prospects of a recovery continue to be uncertain. Also, a deeper look into the numbers reveals that the next two quarters could continue to be as tough. Weak maintenance
While the top rung software companies managed to post sequential growth in topline, the figure was subdued compared to that of 2QFY02. However, the spread was large with the top rung companies posting marginal growth (sequentially), while second rung companies like Hughes and Digital posting strong topline growth numbers. The cause for concern stems from the fact that the key revenue drivers for the software companies, development and maintenance, showed signs of weakness. The strong growth in demand for these service offerings (especially maintenance) had been fueling topline growth for the past few quarters. For example, the revenues from maintenance in 2QFY02 had shown a strong growth of 9% for Infosys. However, in 3QFY02 the revenues from the service offering declined by 3%.

Service offerings % Contribution to
revenues in 2QFY02
QoQ
Growth
% Contribution to
revenues in 3QFY02
QoQ
Growth
Infosys        
Development 31.7% 1.6% 31.7% 1.6%
Maintenance 29.4% 9.1% 28.2% -2.5%
Satyam        
Software design and development 52.2% -8.2% 49.1% -5.9%
Software maintenance 32.2% 11.9% 28.4% -11.8%
Polaris        
Maintenance 22.8% -2.8% 21.5% -5.4%

Pricing pressure
Another trend that was distinctly evident, which is a consequence of the tough economic environment, is that there is a price war raging. Almost all the companies, except Wipro, saw billing rates decline. However, even Wipro that has so far managed to avoid pricing pressure admitted to the fact that its billing rates too were under a considerable amount of strain and it might have to give in to rate cuts at some point of time in the future. In fact, the company in the past has sacrificed volumes to maintain margins.

Billing rates Onsite Offshore
US$/hr 2QFY02 3QFY02 Change 2QFY02 3QFY02 Change
Infosys 66.8 66.5 -0.4% 29.2 27.9 -4.5%
Satyam 61.3 59.5 -2.9% 24.6 24.3 -1.2%
Polaris 62.5 60 -4.0% 20 19.9 -0.5%

The revenue growth for software companies will have to be volume led as realisations are likely to remain flat if not decline. This means the companies will have to improve reach and continue to add clients. This puts the second rung software firms at a disadvantage as the dominant players have a better marketing infrastructure in place.

Fixed price
There was a marked shift towards fixed priced contracts during the quarter. Fixed price contracts ensure that the risk of projects getting delayed shifts from the client to service provider. The software companies will get only a fixed price from the project irrespective of how much time they take to complete it. While in time and material projects, the software companies bill according to the effort that has been put in the project. This is due to the fact that the clients have a upper hand when its comes to bargaining power. As expected the contribution to revenues from offshore projects increased, as clients push more and more projects offshore to avail the low cost advantage.

These are undoubtedly tough times for the software sector and considering the uncertain environment it would be safer to work with a worst-case scenario. Infy’s management is expecting a 5% to 7% decline in IT budgets for FY03. This means the sector growth rate for fiscal FY03 is likely to be lower than the expected 25% growth for FY02.

Not so surprisingly, the technology stocks and companies are not hogging the limelight any more. The media’s new darlings are the PSUs. At a recent interaction with retail investors', we were quite taken aback by the interest in these stocks.

The value proposition of the software sector continues to be as sound as ever. Though for the short-term the numbers are likely to be uninteresting. However, there is an increasing trend of corporates outsourcing larger contracts to Indian companies. And once the US economic recovery begins, the software sector will once again grab the limelight. Meanwhile, investors can be on the look out to take advantage of depressed valuations.

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