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Software: Preview FY06...

Apr 13, 2006

Well, it's that time of the year again - companies lining up to announce their quarterly results! This time, however, it is the end of the fiscal FY06, and the annual results announcements are expected to be the key factors that will drive the markets in the near-term. Sales trends, the demand environment, cost-side pressures, operating margin trends, competitive pressures and supply side issues are expected to be read into with great interest by market watchers, keen on discovering the next 'Infosys' or 'Bharti'. India Inc's FY06 results have already started trickling in, with the software companies being the first off the blocks to report their financial performances, as usual. Mid-sized companies, such as iGate and MphasiS BFL, have already announced their results. But the 'BIG ONE' is slated on Friday - Infosys. Undoubtedly, this will, as usual, be a keenly awaited day, and, more than just the numbers, the major thing to watch out for will be the management's guidance for FY07 and the industry trends being played out.

Major drivers in FY06
We attempt to analyse major factors that are likely to influence the full-year FY06 results of the software companies.

Volumes: Initial comments made by companies that have already announced their results are fairly encouraging. The demand environment for offshoring is getting stronger. With the increasing maturity of the global delivery model, more 'Fortune 1000' companies and beyond are willing to experiment with offshoring their processes. The very fact that the 'Big Six' IT majors (Accenture, ACS, CSC, EDS, HP and IBM Global Services) are themselves setting up offshore centres in low-cost destinations like India is the biggest vindication of the global delivery model.

This year, volume growth has been fairly strong for the top-tier software companies in the nine-month period ending December 2005. Encouraging signs, such as large deals wins, like ABN Amro, DSG and General Motors, are expected to maintain the volume growth momentum over the medium-term for these companies. Going forward, it will undoubtedly be such deal wins that can result in the top-tier Indian software companies sustaining volume growth in the region of 25% to 30% over the next few years.

Growth in higher-end services, such as consulting, package implementation and infrastructure management, is also expected to aid topline growth. This has been the case over the past 5 years, and building up of skills in these domains will undoubtedly enable the top-tier companies to maintain robust growth in revenues. Over the long-term, increasing scalability, deepening of client relationships to get a greater share of the client's wallet and greater domain expertise for tasks like consulting and package implementation will ensure that Indian IT firms continue to get an ever-increasing pie of global majors' massive IT budgets.

Margins: Given factors such as increasing competition, wage inflation and stagnant-to-falling billing rates, we have factored in margin depletion for the top-tier software companies in FY06 and beyond. We have mentioned above that in order to sustain revenue growth between 25% and 30% in future, the winning of large deals like ABN Amro is crucial, and is an encouraging sign. However, a point of caution here - software companies may resort to cutthroat pricing in order to win such deals. This is expected to sustain margin pressure over the longer-term. Margins in such deals generally tend to be lower-than-average.

Of course, levers to restrict margin depletion, such as leverage on sales and marketing (S&M) expenses, productivity enhancements and an optimal mix of freshers in the total hiring are always there, and to that extent, the companies can pare margin pressure.

Exchange rates: As always, the rupee-dollar exchange rate will play a role in determining margins of software companies. This time around, the rupee's movement against the dollar has been slightly positive (appreciation), resulting in possible pressures on realisations. It should be noted that in 3QFY06, software companies benefited from the dollar appreciation. However, if we take a full-year basis, there does not seem to be any sharp increase or decrease in the rupee-dollar rate.

In any case, we believe that the major factor for software companies will be volume growth, as most of these companies are adequately hedged against exchange rate movements. Infosys, in fact, has even diversified its basket of currencies for billing, shifting to the Euro and the Pound in a more meaningful way, although still, a great proportion of its revenues continues to be billed in US Dollar terms.

What to expect?

We have outlined our expectations on the major operating metrics that are expected to affect software companies during FY06. Going forward, we believe that the winning of large-sized deals in the region of US$ 100 m-plus or thereabouts is likely to intensify. As can be expected, competition is also expected to intensify. The increasing offshore presence of MNC IT majors is also likely to cause more headaches for domestic software companies.

As regards the mid-sized companies, we have always maintained that due to their relative lack of scale when compared to the top-tier firms, these companies (mid-sized) will have to either acquire other firms or get acquired themselves in order to stay relevant in the industry. We believe that the offer made by EDS, the world's second largest IT services firm, to acquire a 52% stake in MphasiS BFL, is a sign of things to come. Other global IT companies, such as Atos Origin, CapGemini and CSC, which are struggling to establish a strong offshore presence, could also make a bid for Indian mid-sized firms.

With respect to the long-term, we remain positive on the sector's prospects. As mentioned above, the winning of US$ 100 m-plus deals is expected to intensify. Scalability is of critical importance for successfully executing these deals. Let the game begin!

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