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Identifying a software stock: Do's and don'ts

Jul 19, 2003

As global economies are getting more integrated, technology companies are finding it an onerous task to align to the changing realities. In such a scenario, analyzing stocks from the technology sector require utmost caution and understanding. We will, in this article, try to elucidate the factors one should keep in mind before investing in a software sector company.Profile
Large english speaking population and low employee costs compared to developing countries have been the foundations upon which the Indian software sector has evolved over the years. Software sector sells man-hours i.e. its earnings are from billing rates (dollars/rupees earned per hour of work) multiplied by number of hours worked by an employee in a year. However, there is one critical factor here. A software company can increase revenues by adding employees and/or by increasing utilization (number of employees actually working on projects as a percentage of total employee base) and/or by charging more per hour (i.e. billing rate).

THE LEFT-HAND SIDE (Hours Worked)

Scalability
Not every software company has systems in place to manage large addition in employees per annum. A company can increase its staff strength to say 3,000 in the first three years. However, to increase the number to 6,000, the business model should be robust. Scalability therefore, is of high significance. To succeed on the scalability front, a software company needs to figure out the kind of capacity (physical infrastructure like development centres, marketing and distribution channels), people, and technology it needs to invest in. However, the most important aspect of scalability is to make sure that employees are absorbed and trained (including the understanding of the company's culture and values).

Utilisation
Another aspect of scalability is the level of utilisation. A software company needs to make sure that its capacity is utilized as effectively and fully as possible. This will result in revenue maximization and higher productivity per employee. But both the factors listed above depend on the management vision, talent and ability to foresee future industry trends.

Employee retention
Owing to increasing competition for talent, the need to reward employees for the value they create is another critical factor that determines sustainable growth. The need to attract proper talent and retain it gains utmost importance. Software companies' resort to measure like performance based incentives and ESOPs to reward their employees.

THE RIGHT-HAND SIDE (Billing Rates)

Having looked at factors that influences hours worked per annum, consider billing rates now.

The value-chain
Put simply, value chain has low-value add services like body shopping at the bottom of the chain to products at the higher-end. Moving up the value chain is delivering a service or product for which the customer is willing to pay a higher price because he perceives a higher value. However, moving up the value chain involves a whole set of issues. While marketing and branding play a key role, delivery of services is even more important. One way to measure the delivery strength of a software company is revenues from repeat business (basically, satisfied customers). Moving up the chain is an ongoing process. It takes time for a company to attain critical mass before it has the ability to bid for large value-add contracts.

Onsite and offshore
As per the outsourcing model, employees and their efforts are divided into two elements - onsite (at clients' location) and offshore (at company's premises). Although most of the Indian software majors are growing, success depends much on the way these onsite and offshore efforts are integrated in the most efficient manner to provide seamless services to clients. While onsite involves higher billing rates, offshore offers higher margins because costs are relatively lower.

Competition
Competition, both from domestic players and global players, also has a bigger say in billing rates. Since Indian companies are miniscule when viewed on the global scale, the bargaining power is on the lower side. Competition has surfaced from global majors setting up development centres in India in an effort to replicate the Indian offshoring model. Another thing to note here is, the higher a company is in the value chain, the lower the competition.

Key things to look at before investing in a software stock

  • Management: A management with vision is one of the major competitive advantages. Since the software sector is dynamic in nature, management quality has a high weightage. The ability to foresee threats/opportunities without diverting from the vision is important. Retail investor could gauge this from how the company has performed in a downturn/upturn compared to its peers in their respective competencies. Scanning the companies' annual reports or the official web site also gives an indication of the management's future vision.

  • Employee productivity: Productivity (revenue per employee divided by cost per employee) indicates how much value a company's employees are adding relative to the costs that are incurred on them. These are relative terms and have to be compared with the peer group.

  • Revenue concentration: Since this industry has a high risk-profile, it becomes important to understand from where (geographical mix), from whom (client concentration) and how (industry verticals) is the company generating its revenues. Though few clients accounting for larger share of revenue is not necessarily a negative, diversification insulates a software company from volatility. Remember, earnings visibility in the sector is relatively poor.

  • Financial ratios: Some quantitative measures evaluating a software company stock are P/E (relative to the sector), Return on Equity, Return on Assets and Return on Capital (for profitability) and Operating margins (for efficiency). Some companies command a higher premium due to subjective factors like management quality and their position on the value chain.

A final note: Global IT spending and a move towards outsourcing

Apart from the inherent features as mentioned above, there are a few external factors like the level of global IT spending and the percentage share India is likely to get from the same (simply, move towards outsourcing). At some point, the advantage of low employee costs could dry out and the sector could get commoditised. Besides, India has competition from the likes of China and South East Asia as other outsourcing destinations.

So, building a competitive advantage is very important and for that, management quality plays a vital role. Investors do need to apply great caution before investing into software stocks.

Click here to identify stocks from other sectors.

Related Links for Software Sector: Quarterly Results  NEW | Sector Analysis Report | Sector Quote | Over The Years

Equitymaster requests your view! Post a comment on "Identifying a software stock: Do's and don'ts". Click here!

1 Responses to "Identifying a software stock: Do's and don'ts"

Naresh Mehta

Jul 11, 2009

I am bulish on large cap & midcap software company in Indian market due to maintained growth in world level even worse world economy. Hence always buy in deep, the share of IT sector.

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Equitymaster requests your view! Post a comment on "Identifying a software stock: Do's and don'ts". Click here!

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