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Software: Key drivers in FY10

Mar 31, 2009

As India Inc gears up to declare the 4QFY09 results next week, anxiety is running high amongst investors to gauge the performance in the last quarter of what has been a rather disappointing fiscal. As always, the software companies will be first off the block to announce their results and set a trend. Software stocks have clawed back some ground since 3QFY09. The likes of Infosys and TCS have gained around 13% and 5% respectively. However, cloudy issues over corporate governance and deferment of hiring plans have kept investors on the edge. In this article we take an overview of the factors that could underline the performance of software stocks in the next fiscal.

Major drivers in the next fiscal
Volumes: Once again, as has been the case in the recent past, the software companies’ volume growth is expected to be the major driver of revenue growth. The concerns about ongoing financial crisis and economic slowdown will nevertheless play its role. Companies in the US and Europe are badly affected from the slowdown and are likely to cut their technology spending. They are also reconsidering outsourcing jobs at a time when the unemployment levels in their own economies are at historic levels. Considering that these two regions contribute around 75% to the total global technology spend, a slowdown in these regions can adversely impact the volumes.

Billing rates: As has been the case in recent quarters, the billing rate environment appears to be largely under pressure. In the conference calls, managements have indicated that they are witnessing pressure on the pricing front. The pricing pressure is especially coming at the newer clients' end. However, since new clients' business does not contribute even 10% of the top tier companies' revenues, this will not have any significant impact on the topline.

It should be mentioned that although companies are not facing any significant downward pressures on their billing rates at existing client’s front, managing pricing at existing level is a challenge. Going forward, if cost pressures become acute, then companies may push harder for lower pricing.

In a recent report research firm Gartner has indicated that the billing rates are likely to decline between 5% and 20% through 2010 as the market gets more competitive. However, decline in billing rates would apply with great variability across geographies, vertical industries and client size with regard to specific deals. The success of IT firms will rely on their ability to improve business mix in favour of higher-end business like consulting and systems integration.

Exchange rates and margins: Once again, the rupee-dollar exchange rate will also play a role in determining margins of software companies. In 4QFY09, there has been a pleasant surprise on this front. The rupee has actually depreciated against the dollar. Therefore, margin upside exist to a certain extent. The rupee has lost as much as 4.5% against the dollar this quarter. However, going forward volatility in the exchange rate and its impact on the billing currency of the software companies cannot be ruled out.

What to expect?
Major levers of margin expansion in the next few quarters are expected to be depreciation of rupee against the major currencies, higher utilisation rates, increasing shift to offshore from onsite and cost efficiencies. At current levels, a number of software stocks are undervalued and in our view, while the scope for upside is immense; the downside risk is relatively capped.

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