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Software: FY03 in retrospection

Apr 2, 2003

FY03 was not a good year for technology stocks in terms of market performance. The list of top gainers amongst the BSE ‘A’ Group has only five stocks. However, the list of losers amongst BSE ‘A’ group stocks is quite long. We look at some of the reasons why the technology sector took a beating and its future prospects.

Top five losers gainers over a year : BSE 'A' Group Software stocks
COMPANY Price on Mar
28, 2002 (Rs)
Price on Mar
31, 2003 (Rs)
H/L (Rs)
TRIGYN TECHNOLOGIES 9011-87.4%93 / 10
SILVERLINE TECH 537-86.4%54 / 7
DSQ SOFTWARE 427-82.4%46 / 7
PENTASOFT TECH. 235-77.7%31 / 5
SSI LTD. 17955-69.2%235 / 54

The year started on a dull note. Tamed by Infosys’ guidance for its performance in FY02 the technology stocks were already languishing. Infosys’ stock price had fallen to as low as Rs 2,900 during the year. However, then came the September quarter numbers and the company stunned the markets with a 15% sequential growth in revenues. And once again technology was back in favour. Infact the markets witnessed a brief rally between October and January 2003, led by technology stocks.

Top gainers over a year : BSE 'A' Group Software Stocks
COMPANY Price on Mar
28, 2002 (Rs)
Price on Mar
31, 2003 (Rs)
H/L (Rs)
BSE-SENSEX 3,4693,049-12.1%3,538 / 2,828
S&P CNX NFTY 1,130978-13.4%1,153 / 920
RAMCO SYSTEMS 23844888.1%615 / 118
HEXAWARE TECH 6410463.9%162 / 38
MASTEK 36251141.0%615 / 257
MPHASIS BFL SOFT. 54065420.9%775 / 345
INFOSYS 3,7364,0408.2%4,873 / 2,935

If FY03 gave a glimmer of hope for technology stocks, it was also a year of numbers reverting to reality. One of the numbers that has attracted investors in the past towards technology stocks has been high operating margins. During the year, operating margins plummeted and consequently, markets shivered.

However, there are two ways of looking at the decline in margins. Many opine that due to stiff competition software companies are witnessing pressure on margins. And therefore, prospects for the technology sector continue to be bleak going forward. This is a moot point. However, our view is that since the company is graduating up the value chain and looking at more complex tasks it is investing in sales and marketing infrastructure that is required to pitch for these mission critical projects. Thus, increase in the marketing costs is not a reason to be disappointed. This could lead to the software companies bagging significantly larger projects overseas in due course of time and the margin erosion could be offset by significant volume growth.

Our view is based on a closer look at Infosys’ margins for 9mFY03. Infosys’ operating margins have declined by 4.1%. While increased software development expenses have caused a 2.4% erosion in operating margins, the company has managed to offset the impact by cutting corners. Lower general and administrative costs have helped cushion the operating margin decline by 1.1%. Thus, net, net there has been a negative impact of 1.3%. The real blow has however come from the company stepping up its selling and marketing expenses. The figure has shot up from 4.9% of revenues in 9mFY02 to 7.6% of revenues in 9mFY03, thus shaving off 2.7% from operating margins.

Infosys Technologies
(Rs m)9mFY029mFY03Change
Software development expenses9,02012,83542.3%
% Of revenues46.9%49.3% 
Selling and marketing expenses9401,980110.7%
% Of revenues4.9%7.6% 
General and administrative expenses1,6061,89718.1%
% Of revenues8.3%7.3% 
Total expenses11,56616,71244.5%
% Of revenues60.1%64.2% 
Operating profit 7,6699,31721.5%
Operating margin39.9%35.8% 

But that is not to say that there is no margin pressure on the software companies. The point we are trying to make is that the pressure exists, but going forward the decline in margins is likely to be gradual as compared to expectations of a steep fall (as seen in 9mFY03). The Indian software industry has grown rapidly due to its ability to offer services at a much lower cost (sometimes as low as one fourth) as compared to their western counterparts thanks to the availability of cheaper manpower. Leveraging on the cost arbitrage, the companies today have operating margins in the range of 30% plus. Initially, as the Indian software industry faced the heat of downturn in the US economy, a few players began to undercut. This triggered a price war within the industry. This made life even more difficult for foreign competition. Consequently, western software companies decided to counter the cost leadership of the Indian software industry by setting up shop in India.

Not only will the Indian IT industry’s cost leadership be threatened, but it will also have to face intense competition for talent. Already staff costs for Indian software companies are as high as 40% of revenues. Increased competition from global IT services majors will be a problem for top rung IT companies that were till date the best names to work with. This will no longer be the case.

However, global IT services adopting the offshore model might not be all bad news for the Indian IT services companies. With names like IBM showing interest in offshore development the whole concept gains a lot more credibility among western clients. Going forward many companies that were apprehensive of working with Indian software companies might be more open to the idea. Considering the low penetration of Indian software companies in the global IT services market, there continues to be significant opportunity for the Indian IT services companies. Growth in the future will be volume based and therefore, those spending on infrastructure and people to get those volumes are likely to be the winners going forward. Thus, what appears to be a cause for concern right now, may just be the reason that brings in growth for the Indian IT services companies. However, not all have lost margins due to spending on marketing, but largely because they were simply unable to compete. Therefore, be very careful while making your investment decisions.

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