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Software: Too much euphoria?

Jul 14, 2006

With Infosys, the 'technology bellwether', having announced a sterling set of numbers for 1QFY07, there appears to be a sense of renewed optimism towards the software sector. Given the fact that Infosys is the benchmark for the sector, if it does well, the entire sector is expected to do well. Infosys recorded its strongest-ever revenue growth sequentially since 2QFY05, and its strongest net profit growth since 2QFY01. Apart from this, the company also increased its guidance on the topline by a staggering 10%, from 30.7% YoY growth in FY07 to 40.7% YoY growth (at the higher end of the guidance), and on the bottomline, from an earlier projected EPS of Rs 115 to around Rs 126. This outstanding performance, and the significant change in revenue and profit guidance, prompts one to think as to what could possibly have changed so much. The first quarter is generally the seasonally weakest quarter for Infosys and other software companies, given factors like annual salary increases and higher visa costs. Given that the company has put its foot down and confidently raised its guidance so significantly after just the first quarter of the financial year, we reason as to whether anything has changed so dramatically for the sector as a whole.

What do the fundamentals say?
Robust offshoring environment: The environment for offshoring appears to be stronger than ever before. Global corporations are showing more willingness to give their work to Indian companies. They are increasingly looking at offshoring as more than mere 'cost arbitrage outsourcing'. They now recognise the value that Indian software majors like Infosys, TCS, Wipro, Satyam and HCL Tech bring to the table. Thus, they are now looking at these companies as strategic partners in their growth. Even the political rhetoric that used to frequently come up against offshoring by the paranoid US and UK politicians has now more or less dissipated, as economics has taken the front-seat. And last, but by no means the least, MNC IT companies are themselves setting up base in India, which we believe, gives high credibility to the 'Global Delivery Model'.

Favourable industry trends: Earlier, large companies like General Motors used to hand out large, multi-billion dollar deals to the large, legacy IT players, like EDS, CSC and CapGemini. These deals used to often involve the transfer of people and assets to the IT companies, who had to make massive upfront investments. Thus, these deals used to, more often than not, be a drag on margins, while, at the same time, given the fixed agreements signed, where all time and cost overruns had to be borne by the client, rarely deliver value for them. This is now slowly but surely changing, and a trend called 'Strategic Global Sourcing', where a deal is broken up into various functions and each function is given to the 'best-of-breed' vendor in that function, is being seen. This suits Indian software majors perfectly, as they do not as yet have the expertise, scale and resources to execute huge billion-dollar deals.

Strong growth led by newer service lines: Indian software companies, particularly the top-tier companies, have recorded strong revenue growth in the region of over 30% CAGR over the past few years. A large part of this has been led by growth in new service lines that these companies have begun to offer as a method of moving higher up the value chain and away from low-end, easily commoditised application development and maintenance (ADM) work. These service lines have resulted in Indian companies developing an end-to-end offering, from plain vanilla ADM to higher-end consulting work. The revenue contribution from these newer service offerings has increased with each passing year, and now accounts for over 40% of the revenues of some companies. These service lines also enable these companies to cross-sell to clients and improve client-mining efforts, getting a larger share of the clients' wallets.

Going forward, we expect these service lines to increase their contribution to the topline, enabling the software companies to deepen the breadth of their service offerings and more effectively mine their clients. The scope of services such as testing, infrastructure management, package implementation, BPO, engineering services and consulting is significant, and in future also, these are expected to be the major growth drivers for these companies.

Other factors, such as a large base of quality engineering and management talent, the (rapidly shrinking) cost arbitrage, favourable time zone advantage, enabling 24/7 delivery and strong execution skills are also at the heart of the Indian software services industry.

Then, is the euphoria justified?
The fundamental factors that we have outlined above are nothing new - they have been in place since the past few years. What then could be the reason for such euphoria and the buoyancy that the Infosys' management team currently has towards the sector and its growth prospects? We believe that the rupee depreciation has a big role to play in the current scheme of things. In FY07, if we take the 40.7% YoY topline growth anticipated, the core volume growth expected by the management is around 34%. Thus, over 6% to 7% of the growth could be attributed to the weak rupee this fiscal, with billing rates remaining stable.

While we are positive on the sector's future growth prospects, given the fundamental drivers in place, we believe that the rupee movement is a double-edged sword. In the past, the rupee appreciation against the dollar has proved to be painful for software companies, and if the rupee does move in a manner contrary to what Infosys expects, then it could upset the applecart a bit.

That said, given the fact that, globally, clients are getting more comfortable with Indian companies and offshoring more work to them, the ever-increasing scale of these companies, geographical movement away from the US, strong execution engines, client mining efforts and top quality managements, we believe that growth of around 25% to 30% over the next three to five years is fairly sustainable. We remain positive on the sector.

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