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Software: Powering ahead in FY07!

Jul 28, 2006

Well, it's as clear as it can get! The offshoring story remains fundamentally intact and secular, and, in fact, appears to be on an even stronger footing and poised for stronger growth in FY07. The 'quarterly ritual' of the top-tier software companies announcing their results has come and gone. This time around, the clear consensus is - higher, faster, stronger! The 1QFY07 results were totally unexpected, and comfortably exceeded 'market expectations' by a wide margin. 'Core' volume growth continues to enthuse, pricing remains stable with an upward bias, and this quarter around, the favourable movement of the rupee against major currencies has led to even stronger topline growth for these companies than what was expected. However, margin contraction was witnessed, due to most of these companies giving their annual salary hikes in April, as well as incurring higher visa costs. Nonetheless, the rupee depreciation this quarter has helped to some extent to pare the margin pressure. Due to considerably higher other income this quarter, and lower depreciation charges, the bottomline growth outperformed that of the topline and operating profits, despite the lower margins.

Indian IT: 1QFY07 performance...*
(Rs m) 4QFY06 1QFY07 Change
Net sales 107,329 117,479 9.5%
Expenditure 78,687 87,424 11.1%
Operating profit (EBDITA) 28,642 30,055 4.9%
Operating profit margin (%) 26.7% 25.6%  
Other income 1,791 3,170 77.0%
Provision for investments - 30  
Depreciation 3,521 3,067 -12.9%
Interest 24 28 18.5%
Profit before tax 26,888 30,099 11.9%
Tax 3,088 3,706 20.0%
Profit after tax/(loss) 23,800 26,393 10.9%
Extraordinary items - 60  
Minority interest 174 163  
Profit/(loss) in earnings of affiliates 88 81  
Net profit ** 23,713 26,371 11.2%
Net profit margin (%) 22.1% 22.4%  
* The above numbers include the results of Infosys, Satyam, TCS and Wipro. Wipro's numbers are consolidated, including the sales figures of its domestic IT business as well as its FMCG and lighting businesses.

What has driven growth in 1QFY07?
In 2 words - volumes and exchange rates! 1QFY07 was characterised by a general outperformance of the software companies as against general expectations. The consolidated topline of the 'Top-4' software service companies grew at an impressive 9.5% QoQ. Strong volume growth continues for these companies, leading us to continue believing in the longer-term story of the sector. This is the core business growth, and if topline growth comes from just billing rate increases, there could be cause for concern, since such a trend is not sustainable. This was certainly not the case with these companies this quarter, and we expect volumes to continue to grow in future as well.

However, this quarter, the movement of the rupee was a significant variable that helped in no small measure, the topline growth. For Infosys, the rupee movement against major currencies helped boost its topline by as much as 4.5%. As a result, the management raised its guidance for FY07 by as much as 10%, and expects both topline and bottomline to grow in the region of about 40% YoY. A large part of this (as much as 11%) is due to rupee depreciation. Satyam also revised upwards its guidance for FY07. However, we would like to caution investors, at the risk of sounding bearish, that the rupee movement is a variable that cuts both ways. In the recent past, these companies have had their margins being adversely impacted due to rupee appreciation. Thus, if the rupee does, for whatever reason, move in a manner contrary to what these companies are expecting, it could result in a downward realignment of expectations.

Billing rates, on the other hand, continue to remain stable. All these companies have been saying this for quite some time now, and newer clients are coming in at around 3% to 4% higher average rates. Also, contracts coming up for renewal are seeing some amount of upward pricing leverage as well. Over the next 2 to 3 years, we expect a stable-to-positive billing rate environment.

Margins under pressure: In 1QFY07, combined operating margins of the four companies fell by 110 basis points. All these companies, with the exception of Wipro, increased salaries of their staff in April, an annual exercise. This time around, a clear trend that has been witnessed is the increase in fresher-level salaries. In recent years, salaries at these levels have not increased in line with the growth that these companies have seen. This seems to be changing now, and is a clear pointer to intensifying competition for scarce talent in the industry. We expect this to increase wage inflation for the software companies, thus, pressurising margins further in future. Higher visa costs also did their bit in reducing margins.

Another clear trend seen this quarter, and indeed, over the past few quarter, is that attrition rates are consistently on the rise. This is yet another sign of the heightened competition for talent in the software sector. Therefore, demand and supply-side issues impacting this variable are more-than-likely to result in higher attrition rates, greater wage inflation and consequently, lower margins over the next few years. We have factored in an across-the-board decline in margins till FY09 for all the major software companies under our coverage.

Other income powers the bottomline: Despite the pressure on operating margins, considerably higher other income (up by as much as 77.0% QoQ) and lower depreciation charges resulted in the bottomline showing a strong 11.2% QoQ growth in 1QFY07. Thus, the rupee movement has benefited the top-tier software companies not only at the topline and operating margin level, but also at the bottomline level.

What to expect?
We remain positive on the sector's prospects over the medium-to-long term. We expect volume growth to be the primary driver of the topline, and this year (FY07), the depreciation of the rupee has come as a pleasant surprise. The robust business outlook projected by the top-tier software companies for FY07 gives us greater confidence in the growth prospects of the sector. Fundamentally, revenue visibility is consistently improving, as can be judged from the growth in the US$ 1 m client base of these companies. Increased client mining, greater acceptance of offshoring, expansion of service lines, a movement up the value chain and winning of larger deals are all trends that we believe are lending greater credibility and sustainability to the offshoring story.

While fundamentals remain strong, one must take into account the risks involved. These include wage inflation, employee attrition, rupee appreciation, global competition and the emergence of other cost-competitive nations for offshoring. The rupee movement, in particular, is something that one must watch closely, as, when the tide turns and the rupee starts to appreciate, things could turn the other way around for these companies!


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