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Software: Will ‘Bear’ bug growth? - Views on News from Equitymaster
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Software: Will ‘Bear’ bug growth?
Mar 18, 2008

The Indian stockmarkets, in line with other emerging market peers, have crash-landed, with the BSE-Sensex declining from a high of near 21,000 to 14,800 in less than 3 months. Selling of stocks has been rampant. The current situation reminds us of a very famous quote from the legendary investor, Warren Buffet. "When a bull market gets underway and it reaches a point where you find that everyone has made money, irrespective of the fact how he/she has made it, a crowd is gathered into the game. This crowd is not responding to interest rate or corporate profits but is rather thinking, ‘I cannot afford to miss the party’ and this is when prices reaches a abnormal levels."

The stock prices three months back were driven by irrational exuberance and now we believe they are driven by undue pessimism. One of the sectors, which have been the worst hit in this bout of selling across the board, is software. Software stocks were battered even before the broader markets felt the pinch. And they continue to face intense pressure in the current turmoil as well.

While the managements of Indian technology companies were not willing to believe in a slowdown in the US and its consequent impact on tech spending till a couple of months back, some of them have now raised their voices that the concerns are genuine. Considering that these top Indian software companies derive a large part of their annual sales (around 30% to 40%) from developing and maintaining software for banking and financial companies in the US, and issues there (US banking sector) was bound to impact their (IT companies) fortunes. And they seem to have done so!

In line with some of these managements are indicating, we believe that the sector is likely to witness slowing volume growth and an unstable currency situation atleast over the next few quarters. We have taken note of these genuine concerns and have revised downwards our volume growth estimations for technology companies. While we had earlier estimated volumes to grow in a range of 20% to 30% on an average for the top 4 players (TCS, Infosys, Wipro and Satyam) over the next three years, we have brought this down to a range of 15% to 20% growth annually. Though there has been no change in our estimates for billing rates, which are still expected to rise by 1% to 2% annually during the period FY08 to FY10.

Especially with news of investment banks getting bust in the US (Bear Stearns is an examples) and with some more expected to follow suit, we believe that the IT spending by the sector as a whole will be impacted. And consequently, the effect will be seen on outsourcing and offshoring contracts. This is largely because the BFS (Banking and Financial Services) sector is the largest spender in IT in the US (these companies spend around 7% to 8% of their revenues towards availing IT services).

While we do not know how big the crisis will eventually be in the US financial system, there are enough indications that the pain is here to stay for some more time in the future. What the readers also need to understand is that while in FY08 the Indian IT companies’ were working on projects, which were allocated to them in CY07 budgets, with most of the clients hinting at cuts in IT budgets in CY08, a decline in volumes is inevitable in FY09.

As we have indicated above, Indian IT companies generate over 30% to 40% of their revenues from the BFS space, volumes are likely to get impacted if the current situation prevails over the next few months or even quarters. While the fourth quarter results might be better for these companies, largely because the rupee has been rather stable against the US dollar, the real trigger for software stocks might come with the Infosys’ FY09 guidance following its FY08 results, which is likely to be released in the second week of April. Click here to read our buy/sell price limits for TCS, Infosys and Satyam

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