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Software: Low penetration

Mar 5, 2003

At the current market price, Infosys trades at a P/E valuation of 29x. Since, there is hardly a need to make a case for investment in Infosys, the question is whether the price is right nor not. In more technical terms, is the current valuation justified or not? Our first step is to understand, why does a valuation of 30x imply. This means, the markets are expecting a 30% growth in earnings every year over the next few years. On a more short-term basis, the markets expected the earnings guidance to be in the range of 25% to 30% for FY04. If Infosys can manage such a swift growth in earnings, the company is fairly valued and if it canít it is over-valued. Thus, if on April 10th the management announces a guidance that is significantly lower than 30%, then the stock price is likely to witness selling pressure.

Infosys: The odd man out?
Company CMP (Rs) EPS FY03E (Rs) P/E (x)
Infosys 4,138 144 28.8
Satyam 216 14 15.3
Digital 620 32 19.4
Hughes 167 11 15.3
HCL Tech* 166 17 10.0
*Consolidated numbers

However, for retail investor it would be advisable to look from a long-term perspective that is beyond one year. The Indian IT services companies are gradually making a transition to the big league. They are setting up sales and marketing infrastructure to take on global IT majors. Consequently, the operating margins have taken a hit and the earnings have grown at a much sober pace compared to the topline growth.

Once, the transition is complete, the IT service companies will graduate to the big league and be able to start tapping businesses that have been traditionally given to companies like IBM, EDS and CSC. The services offerings include information systems (IS) outsourcing, IT consulting and systems integration.

Service offering Current Share
2002
Potential share
(2008)
Custom Application Development 14-15% 30-35%
Application outsourcing 14-15% 30-35%
Packaged Software Installation and Support 1.5% 4-5%
Systems Integration 0.5% 2-3%
IS Outsourcing 0.5% 2-3%
IT Training & Education 0.5% 2-3%
IT Consulting 0.2% 1%
Source : Nasscom

Indian IT majors have started investing in developing infrastructure required in offering IS outsourcing services and have started getting smaller businesses. The fact remains that potential for business growth exists in business from new lines of service offerings, where the Indian software companies have hardly any penetration but have established themselves as the best value for money players. Exports of US$ 7.6 bn in FY02 and the global IT services markets estimated to be around US$ 370 bn, India has a roughly a 2% market share. Nasscom expects the market share to increase to 4% by FY08. Assuming that the size of the global market does not grow, the quantum of business coming to India would be US$ 14 bn in FY08. This itself translates to a 12% CAGR in exports for the next six years.

However, with offshore outsourcing gathering momentum, the growth in business could be much higher. There are concerns regarding the possible decline in margins going forward. However, the future growth will be volumes based and not price based and therefore, the margins will have to come from companies offsetting decline in realisations by volume growth. For example, if Infosysí operating margins decline to 32.5% in FY04 (35.8% in 9mFY03), the increase in net profits is 14% on the back of a 40% growth in revenues. However, if the growth in revenues is higher at 50% the growth in net profits growth will be significantly higher at 24%. The point we are trying to make is that inspite of falling margins, the company can post a strong growth in net profits on the back of higher volumes.

Thus, while the short terms concerns will continue to haunt valuations, the long-term prospects seem to justify valuations. However, we would also like to point out that considering the fact that the sector has a significant exposure to the external economics, which are affected by a vast number of factors, the element of risk is considerably on the higher side.

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