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Software: Preview 1QFY06

Jul 7, 2005

The markets have been on fire since the past two months. After major software companies Infosys and TCS announced 'lower-than expected' guidance and results for 4QFY05, markets tanked and gave these two stocks in particular, a hammering. Infosys fell by around 7% and TCS by as much as 16% in just two trading sessions. However, since then, the BSE-Sensex and the NSE-Nifty have both hit record highs. The Sensex crossed the 7,000-mark on June 20 and managed to actually close above that level on June 21. Since then, it has stayed above that level and moved into higher and uncharted territory. Software stocks have been among the major drivers of the rally and have surged after the disappointments of the 4QFY05 results. However, one must view this with caution, as this is only the beginning of 2QFY06 and already, a few stocks have already factored in the medium to long term earning growth! Thus, there is a possibility that this almost 'secular' rise in software stocks is just an irrational exuberance and whether or not this will be proved correct will be decided by the 1QFY06 results, which are slated to begin next week. This is expected to determine the short-term trend of the indices.

As usual, it is the software companies that will be first off the blocks to announce their results. MphasiS BFL kicks off the earnings season, with the declaration of its 1QFY06 numbers on July 11. After that, the big one, Infosys, will follow on July 12. Given the battering the markets gave to the stock after 'disappointing' guidance announced by the management, it will be interesting to see if the management makes any upward revision in its FY06 guidance. PLM major, Geometric Software, is scheduled to announce its results on July 19, while Satyam will do so on July 21. Other companies are yet to announce the dates for their results.

Major drivers in 1QFY06
We attempt to analyse a few of the major operating metrics that are likely to influence the 1QFY06 results of the software companies.

Volumes: There has been concern that there is a structural shift in the industry in terms of longer time frame for decision-making on outsourcing and an actual slowdown in IT spending in the key US market, which will get reflected in the quarterly numbers. However, we believe that the markets may be too focussed on quarterly numbers and believe that it is necessary to take a long-term view on the sustainability of the business.

Given the fact that in FY05, as many as 400 out of the global 500 corporations resorted to outsourcing in some form or the other, up from 300 in FY04 and more are expected to do so in FY06 (Source: TCS management), we believe that the long-term direction is secular and are enthused by the same. Also, there is expected to be a deepening of relationships by the Indian vendors with their key clients, which will result in greater business volumes.

Billing rates By and large, the billing rate environment appears to be stable. However, getting billing rate increases from existing clients, particularly major clients, is proving to be difficult for the companies. The major rate increases are coming at the end of the new clients. However, given that the top-rung companies earn over 90% of their revenues from repeat business, this is not expected to have much of an impact. The major drivers of improved billing rates will be an increasing movement up the value chain into higher-end services like IT/business consulting and package implementation.

One must understand the billing rate changes with respect to the industry trends being followed by clients. By and large, clients are working with multiple vendors. It is more a case of working with vendors who have specific expertise in a particular area and outsourcing that work to them, rather than working with just one vendor for all the IT requirements. Therefore, clients would be working with anywhere between three to six vendors. Thus, if one vendor is offering finer rates to the client, it is likely that he will demand better rates from his other vendors. This could lead to pressures on the billing rate front. A case in point is GE, the pioneer of offshoring to India, which has started working with other vendors, such as Mindtree Consulting, apart from its traditional vendors, TCS and Patni. However, it should be understood that the depth of the relationship between the client and vendor would also play a part in determining the rates.

Exchange rates and margins: As always, the rupee-dollar exchange rate will play a part in determining margins for software companies. And clearly, there appears to be bad news on this front. The rupee, during the quarter, has appreciated not just against the US Dollar, but also against the Pound and the Euro, two other currencies in which software companies get their billings. As a result, the ultimate effect will surely be negative. Taken on a point-to-point basis, the rupee appreciated by around 0.4% against the dollar during the quarter. However, the rupee has appreciated by as much as 5% against the Pound and 6.5% against the Euro.

The effect of this will surely be negative on the software companies, which have a varying degree of billings in Pounds and Euros. Companies like Wipro, which have a larger exposure to Europe than Satyam and Infosys, will have a relatively higher proportion of billings in Euros and Pounds. While putting an exact number is difficult, the trend is very clear - the impact of the currency movements this quarter is expected to negatively impact margins. However, the hedging policies of these companies are likely to pare this pressure.

Employee costs: A number of software companies generally raise their employee salaries in April and as a result, this affects margins for the first quarter. Infosys has talked about a 15% rise in offshore salaries, while Satyam and Geometric also increase salaries in April. Wipro, however, does the same only in October. As a result, the company will not be impacted on the margins front due to this.

However, in order to mitigate the impact of higher salaries, companies like Satyam are expecting to hire an increasing number of freshers in their recruitments, while Infosys has been doing so since a while now. This will have the effect of reducing the average cost per employee. Utilisation rates are also expected to be higher and companies like Satyam and TCS are also expecting a greater shift from onsite to offshore. These are the main levers that will enable software companies to mitigate the impact of higher salaries on margins.

What to expect?
While we have given our expectations on the major operating metrics that are expected to affect software companies during 1QFY06, we believe that, as an investor, one must take a long-term view of any business, including software. Given the strong momentum expected in offshoring and the fact that Europe, traditionally conservative and a late adopter of outsourcing, has also started to increasingly adopt it, prospects appear bright.

Given a consistent move up the value chain by the software majors and a robust delivery model that enables seamless execution across geographies and better cost management, we believe that the big players will be able to compete in high-end areas such as consulting and thus, avoid getting commoditised. Overall, as regards the software sector, companies with strong management teams, solid execution skills and a good track record will benefit.

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