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Software: Back to basics!

Jul 21, 2005

As has always been the case, software companies have been first off the blocks in announcing their financial results. The results, by and large, have been mixed. However, the focus of this write-up is not to do an analysis of the same. Rather, we take a look at the kind of stock movements that have taken place with regards to these stocks before and after they have announced their results and what can the retail investor make out of it. Volatility is the middle name!
Since a number of years now, the markets have either hammered software stocks down if they did not meet 'expectations', or blasted them skywards if they exceeded 'expectations'. In this bull market, this has been even more pronounced. Who can forget the hammering markets gave to Infosys after it announced its results for 4QFY05, when the stock lost over 7% in the trading sessions after it announced guidance that was below expectations. TCS suffered even more on this count, losing as much as 16% in two trading sessions post the announcement of its 4QFY05 results.

As can be seen from the above charts, Infosys and TCS bore the brunt of the investors' ire at their 'disappointing' performances. Even during the results announcements for 1QFY06, the stocks reacted strongly. Only this time, TCS, for a change, actually went up after its results were 'as per market expectations'. However, Infosys was not so lucky and the stock took another beating after its results announcement.

As can be seen from the above charts, these stocks have reacted in a very volatile manner during their results season. This is, of course, not new and it can be remembered that Infosys, after it announced 'disappointing' guidance at the end of the March 2003 quarter in April, crashed by as much as 37% in a mere two trading sessions!

So what can the retail investor do? We have always believed that it is best for the retail investor to concentrate on fundamentals of companies, not just in the software sector, but in all other sectors as well. We take a brief look at the growth prospects of the software sector, to enable the retail investor to make an informed investment decision on companies from this sector.

What does the picture look like?
We believe that the software industry is poised for strong growth, going forward. Despite there being talks of a slowdown, we believe that the offshore outsourcing story is very much a secular trend. It was estimated that in FY04, around 300 of the Fortune 500 companies resorted to offshoring in some form or the other. In FY05, this figure increased to 400. Of these 400 global corporations around 60% offshored work in some form or the other to India. What is more, there is still plenty of scope to grow.

It has to be noted that software services exports in FY05 (excluding BPO exports) stood at US$ 12 bn. Global IT spending, as per Gartner, stood in the region of US$ 660 bn in 2004. That gives India a meager 2% of the global market share. Given India's advantages, such as low cost-high skill labour, a strong track record of execution, project management skills, the 'global delivery model' pioneered by the likes of Infosys and TCS, its unique time zone advantage, enabling 24/7 working with the client, and an enabling environment, it has to be noted that India as a destination to outsource is far too compelling to refuse.

Indian software companies are also fast moving higher up the value chain, as lower end application development and maintenance (ADM) work gets increasingly commoditised. They will now have to compete with redoubtable firms, such as IBM and Accenture to win higher-end consulting business. Other areas, like package implementation and infrastructure management services are also witnessing increasing traction and as these companies get more into such services, revenues will take a strong jump, since billing rates charged for such services are much higher than for lower-end work. For example, Infosys earns around US$ 200 an hour for consulting services, thrice its average onsite rates of US$ 65 an hour.

BPO is also emerging as an area of strong growth. Even in this space, Indian firms are starting to move higher up the value chain, into areas like network management, equity research, payroll processing, HR outsourcing, finance and accounting BPO and tax processing. BPO exports grew at a scorching pace of 44% in FY05, from US$ 3.6 bn to US$ 5.2 bn. This pace is likely to be maintained for a few years.

However, it should also be noted that employees will be the main issue at hand for software companies, going forward. Companies like Infosys, TCS and Wipro already have an employee base of around 40,000-plus and this is only going to increase as they vouch for larger deals. Thus, retention of key personnel and maintaining a manageable attrition rate is going to be a major challenge that will have to be addressed.

Another issue to be addressed is the share of revenues from the US. The US geography still accounts for a majority of revenues of most of the software companies and any shake-up in that economy could adversely affect the fortunes of the Indian software industry. Therefore, it is increasingly important for these companies to de-risk their business models away from the US, in emerging geographies like Europe, which has shown good traction of late, Japan, Australia, South East Asia, China and Eastern Europe. Currency movements will also play a part in software companies' performances.

So, what does this all mean?
As we mentioned above, we took a trip back to fundamentals for the benefit of the retail investor. We have always believed that stock market investing is a long-term commitment and playing in the short-term is highly risky and speculative in nature. Thus, investors should not worry too much about the short-term fluctuation in stocks like Infosys and TCS, as these are strong companies with excellent track records, credible management teams, strong fundamentals and good growth prospects. The examples we gave above were to highlight the market irrationality that inevitably reflects itself in such stocks, specially when expectations zoom sky-high and more particularly in the kind of bull market that we are witnessing now, where any excuse will do to push the markets up to stratospheric heights, regardless of fundamentals.

In the final analysis, we would say, at the risk of repeating ourselves that invest for the long-term, invest not in stocks but in businesses a la Warren Buffet and take advantage of market irrationality to reduce your average costs, as long as the stocks that you have invested in are fundamentally strong and more likely to give you good returns in the long term.

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