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Software: What matters! - Views on News from Equitymaster
 
 
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  • Feb 7, 2005

    Software: What matters!

    The Indian Software sector is one of the most high profile and widely tracked sectors in the Indian capital markets. Not without reason! Apart from the fact that the software industry has been one of the front-runners in giving the "India" brand a global presence and recognition, it has been a key industry that, through its global growth and reach, resulted in the recognition and acknowledgement of the skills of Indian entrepreneurs and managers worldwide.

    Now, despite it being a 'high profile' sector, the volatile nature of the industry should 'not' lose relevance for investors who are invested/likely to invest in stocks from the sector. In order to understand what lies ahead for the software sector, let us understand some key aspects of the software industry.

    Global economic performance and technology spending trends
    These are two major factors affecting the fortunes of the Indian software industry. Since the industry is highly export-oriented, economic conditions in major world economies like the US, UK, Japan and those of Europe, from which a number of Indian software majors derive most of their revenues, are an important factor driving the performance of the industry. Performance of the global economy affects the way global corporations view IT spending. For example, in the heydays of late 1990s, increased investments were made in developing new technologies and spending 'excessively' towards buying the same. Then, the global slowdown of the early part of this decade led to corporations cutting down spending towards new technology initiatives, rather spending towards integrating their existing systems, which led to an overall decline in global technology spending.

    Competition is also another factor affecting global IT spending. The more the competition in a particular industry, the greater is the need to become cost conscious, improve efficiencies, have an integrated supply chain, and so on. Thus, in such an environment, companies are more likely to view IT spending as an 'investment' rather than a 'cost', which would add value in the long term, and enable them to keep pace with, and surge ahead of, competition. Thus, in these times when clients are demanding a greater return on their investments from technology spending, Indian companies that have capabilities to meet rising demand and scale up resources fast are likely to be the beneficiaries in the future.

    The 'value chain' and the competitive advantage

    The value chain is another factor that is likely to affect performance of Indian players in the long run. Industry majors like Infosys, Wipro and TCS, being relatively higher up on the chain than other Indian software companies, would subsequently enjoy a bigger balance sheet size and higher billing rates than the other companies. They are thus in a position to win and execute large-sized contracts, requiring specialised expertise (e.g. IT consulting, systems integration). Therefore, being higher up the value chain and having a large balance sheet size with scalability (ramping up operations ahead of expectations of increased business, thus being in a position to take advantage when it materializes) gives a software company an inherent advantage over its peers.

    Currency movements

    The Indian Software Industry being an export-oriented industry, currency fluctuations (read dollar depreciation / rupee appreciation) have a major role to play in determining revenues and margins of software companies. Since most of the companies' billings are in dollar terms, the movement of the dollar against the rupee plays an important role in this regard. If the dollar depreciates, or loses value against the rupee, then the company receives less rupees per dollar earned, and therefore, takes a hit on its margins. If the dollar appreciates, or gains value against the rupee, then of course, the reverse will happen, the company receives more rupees per dollar earned, and it's margins will improve. While most of the Indian software companies hedge against the volatility of currency movements, an appreciating rupee does have some impact on the profitability.

    Conclusion

    Apart from the factors mentioned above, the Indian software industry's growth is also likely to be affected by global trends with regard to outsourcing and becoming more efficient by using the principle of capitalism - "Produce where it is the cheapest, and sell where it is the most profitable." As far as company-specific factors are concerned, investors need to look at:

    1. What steps are being taken in order to build competencies to move up the value chain,

    2. How has been the focus towards de-risking business models by diversifying into new markets and new verticals (industries), and

    3. The quality of human resources.

    It clearly follows that companies which manage these issues better will be able to show better earnings visibility, and record good growth going forward, which would justify their valuations. Of course, there are a number of other factors to take into consideration while deciding to buy a software stock, but since the main focus of this article is a macro-analysis of the software industry, they are not highlighted here.

     

     

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