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Software: More noise than music! - Views on News from Equitymaster
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  • May 5, 2005

    Software: More noise than music!

    From the beginning of the second week of April, Indian software majors started announcing their quarterly and year-end results for FY05, a ritual that has the markets up in anticipation. The results themselves and more importantly, the picture that the companies' managements paint for the company going forward, have traditionally been the main short to medium term drivers of market direction. This April, the tone was yet again set by Infosys. While the company, like it has always done, outlined a conservative view of the future, the markets, like they have always done, took it otherwise! The rest, as they say, is history!

    In this background, we conducted a poll on our website, asking our readers what was their view towards software stocks post the 4QFY05 results announcements. Here are the results.

    Most of the respondents who responded to the poll are positive about the sector. One might not have got such a feeling after watching the market reaction to the results. Infosys announced results that fell short of market expectations and worse, a 'conservative' guidance for the next quarter that led to panic among market participants. There was more in store for the already rattled investors. TCS, the next major company to declare its results, reported a completely unexpected set of numbers, with quarterly profits falling by as much as 34%, affected largely by some extraordinary items. The markets hammered the stock mercilessly, and the stock price fell by as much as 15% in just two trading sessions! A perfect example of market irrationality is what we would say.

    However, Satyam came out with a good set of numbers to calm the markets down. Wipro too fared well and although results were below street expectations, the 1:1 bonus announcement by the company enthused the markets.

    Indian IT: 4QFY05 performance...
    (Rs m) 3QFY04 4QFY05 Change FY04 FY05 Change
    Net sales 74,652 78,445 5.1% 203,762 285,383 40.1%
    Other income 1,797 574 -68.1% 4,289 3,862 -10.0%
    Expenditure 53,504 57,221 6.9% 150,097 205,942 37.2%
    Operating profit (EBDITA) 21,148 21,224 0.4% 53,665 79,441 48.0%
    Operating profit margin (%) 28.3% 27.1%   26.3% 27.8%  
    Depreciation 1,677 2,013 20.0% 5,471 6,458 18.0%
    Profit before tax 21,242 19,776 -6.9% 52,437 76,780 46.4%
    Tax 3,228 2,687 -16.8% 7,918 11,247 42.0%
    Profit after tax/(loss) 17,983 16,676 -7.3% 44,254 62,839 42.0%
    Net profit margin (%) 24.1% 21.3%   21.7% 22.0%  
    *Consolidated to include results of Infosys, Wipro, Satyam and TCS

    On the face of it, it might appear that Infosys' flat revenues guidance for 1QFY06 implies a slowdown in business. But we believe that this is a simplistic conclusion. Wipro vice-chairman Vivek Paul has specifically mentioned that Wipro is not facing any such problems and that it is a client-specific rather than a company or industry-specific issue. Infosys has specifically mentioned that due to client-related issues like Sarbanes-Oxley compliance and salary hikes during the next quarter, revenues and margins will be flat. During the next few quarters, however, business is expected to pick up. In any case, going by past history, Infosys has a record of under-promising and over-performing and given that it has indicated a 25% growth rate in revenues for FY06, one can expect this to be achieved, along with a strong probability of over-performance!

    On an overall basis, we continue to believe that the sector will witness strong growth. The outsourcing story continues to play out and with Indian companies' inherent advantages of low cost, high skills and quality project management and execution, they will continue to be the main beneficiaries. The major changes that have taken place have been a longer sales cycle and the time taken to award an outsourcing contract to a vendor. Companies have shown a willingness to involve a greater number of people in the outsourcing decision-making process. Apart from the CIO, the CEO, CFO and technology and finance personnel are also involved in the process. The quality of the vendor, its record of execution, cost savings and other such metrics are what companies are looking out for. In fact, we believe that this only proves that outsourcing has become an increasingly strategic decision for most corporations. Thus, top-tier Indian vendors having a strong track record of execution are expected to be the major beneficiaries.

    As per our calculations, the average P/E of the top four IT companies under consideration is around 17.8 times expected EPS for FY07. This seems pretty attractive from a long-term basis. As mentioned above, while some managements have indicated a sedate growth in 1QFY06, investors should not base their decision on the expected performance of just one quarter. Looking further ahead, we expect these software services majors to continue on the path of strong growth as the improvement in the Indian offshoring story continues.

    However, there is a risk to our assumptions. For the sector as a whole, the movement on the currency front is likely to be a factor that could affect profitability in the coming quarters. As seen in recent times, led by pressures of a huge current account deficit, the US dollar has resumed its depreciation against the Indian rupee and other major global currencies. If this were to continue in the future, and if the rupee were to strengthen further, the profitability of these companies would be impacted.



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