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Software: Growth story on track! - Views on News from Equitymaster
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  • Apr 27, 2006

    Software: Growth story on track!

    Well, the quarterly ritual has come and gone! In fact, this time, it was even the annual results that were awaited from the software companies amidst much hype and expectations. To come straight to the point, the performance has been well in line with what we expected. The offshoring momentum continues unabated. The business outlook given by the top-tier companies is highly encouraging, leading to expectations of continued outperformance from software majors over the medium-term. In fact, the management of one of the top-tier software companies has specifically said that the demand environment now is stronger than it was at the same time last year.

    The 'Top 4' software companies continue to recruit in tens of thousands, with TCSadding a net of 20,766 employees in FY06, while the corresponding figures for Infosys, Wipro and Satyam were 15,965, 11,885 and 9,460 respectively. Undoubtedly, this suggests strong revenue and order book visibility, as also bullish expectations about business prospects for the sector.

    As regards operating metrics, the topline growth seen was a handsome 33.8% YoY. However, margin contraction was witnessed, with all the companies witnessing higher staff costs as a percentage of sales. Nonetheless, companies are witnessing some kind of leverage from selling, general and administrative expenses (SG&A). However, due to extraordinary expenses incurred in FY05 that were not there in FY06, the bottomline grew at a similar rate as the topline. Excluding these items, net profits for FY06 grew at nearly 29% YoY.

    Indian IT: FY06 performance*
    (Rs m) FY05 FY06 Change
    Net sales 285,386 381,715 33.8%
    Expenditure 204,334 276,762 35.4%
    Operating profit (EBDITA) 81,053 104,954 29.5%
    Operating profit margin (%) 28.4% 27.5%
    Other income 3,810 4,351 14.2%
    Depreciation 8,037 11,645 44.9%
    Interest 65 90 38.5%
    Profit before tax 76,761 97,569 27.1%
    Tax 11,250 13,014 15.7%
    Profit after tax/(loss) 65,511 84,556 29.1%
    Extraordinary items (2,610) (254)
    Minority interest 167 491
    Profit/(loss) in earnings of affiliates 99 230
    Net profit ** 62,833 84,041 33.8%
    Net profit margin (%) 22.0% 22.0%
    * The above numbers include the results of Infosys, Satyam, TCS and Wipro.
    ** Excluding an extraordinary item of sale of stake in associate company by Satyam.

    What has driven growth in FY06?

    Volumes power the topline: FY06 was characterised by strong volume growth for all the top-tier software companies, even as billing rates largely remained stable. Greater acceptance of the global delivery model, good efforts at client mining, strong client additions, large order wins and expansion of service lines for effective cross-selling led to the increase in business volumes in FY06.

    Billing rates were stable during the year, with all the companies indicating that new clients have been coming in at 3% to 4% higher than average rates. Contracts coming up for re-negotiation are also likely to see a pricing up-tick. Going forward, all these companies have said that billing rates are largely expected to be stable. Better billing rates could come from an increase in higher-end businesses like package implementation and consulting in the total business mix.

    A clear trend seen this year has been that of winning of larger-sized deals by Indian companies. We had the ABN Amro deal, won partly by Infosys, Patni and TCS, and then the DSG deal of US$ 330 m won by HCL Technologies, the largest-ever IT services deal won by any Indian software company. TCS also won the Pearl deal in the BPO space worth US$ 850 m spread over a period of 12 years, the largest-ever IT or BPO deal won by an Indian software company. Wipro and Satyam, on the other hand, made their presence felt in the large deals space by winning part of the General Motors contract. We believe that winning these deals is an absolute necessity in order to sustain growth rates between 25% and 30% per annum. Thus, this trend is positive for Indian software companies and lends credence to the belief that this time around, unlike the IT bubble in 2000, the growth story is more visible, stable and sustainable.

    In FY07, managements have given a strong picture through their guidance or qualitative comments on the business outlook. Infosys has actually given its highest-ever guidance for topline growth at the start of a fiscal, of 29% to 31%. Clearly, this is an indication that all these companies are more confident and bullish now about business prospects than at any other time. This is undoubtedly a positive, and the unbundling of deals ('strategic global sourcing') is expected to continue in FY07 as well.

    Margins fall: In FY06, operating margins (consolidated for all the companies) fell by nearly 100 basis points. Part of this is attributable to a stronger rupee in FY06 as compared to FY05. It is estimated that generally, for every 1% appreciation in the value of the rupee against the dollar, margins are impacted to the tune of 30 basis points. Higher employee costs also sustained the margin pressure. In fact, attrition rates were also higher for all the top-tier companies in FY06. This is a clear indication of the fact that wage inflation is here to stay, and could only intensify in times to come, given competition for talent amongst Indian incumbents as well as MNC technology companies. Going forward, we have factored in a trend of declining margins through to FY08 and beyond.

    Good bottomline performance: Despite margin pressures, the performance of these companies at the net level has also been enthusing, with net profits showing a 33.8% YoY growth in FY06. This growth is the same as the topline growth. However, it must be mentioned that there were certain extraordinary expenses for TCS in FY05 to the tune of Rs 3 bn, which, if adjusted, result in the bottomline growing at nearly 29% YoY, which, nonetheless, is impressive.

    What to expect?
    Given the robust business outlook projected by the top-tier software companies for FY07, we remain positive on the sector in general. Revenue visibility is consistently improving, as can be judged from the growth in the US$ 1 m client base of these companies. Increased client mining, greater acceptance of offshoring, expansion of service lines, a movement up the value chain and winning of larger deals are all trends that we believe are lending greater credibility and sustainability to the offshoring story.

    While fundamentals remain strong, one must take into account the risks involved. These include rupee appreciation, global competition, emergence of other cost-competitive nations for offshoring, wage inflation and employee attrition.



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