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Indian IT: The 1QFY05 performance

Aug 2, 2004

Introduction to results
Almost all major Indian IT companies have announced first quarter results for FY05, reporting strong performance in topline and slower rate of decline in operating margins. This quarter's performance was more of a carrying on with the good work that had been done in the last three quarters. After the pressure that these companies witnessed on the billing rates front owing to slowdown in the US economy and, thus, less spending towards fresh technology implementation, the last three quarters have witnessed stabilizing of billing rates and improved volume growth.

Consolidated** financial performance: A snapshot
(Rs m) 1QFY04 1QFY05 Change
Net sales 43,586 46,076 5.7%
Other income 480 982 104.6%
Expenditure 32,412 34,190 5.5%
Operating profit (EBDITA) 11,174 11,886 6.4%
Operating profit margin (%) 25.6% 25.8%  
Depreciation 943 938 -0.5%
Profit before tax 10,711 11,930 11.4%
Tax 1,750 1,707 -2.5%
Profit after tax/(loss) 8,961 10,223 14.1%
Net profit margin (%) 20.6% 22.2%  
** Consolidated to include results of Infosys, Wipro, Satyam, i-flex, MphasiS, Hughes and Geometric

About the sector
Global technology spending seems to be on an up-trend after the past couple of years of slowdown. However, the demand seems to be shifting from low-end services to high-end ones, like IT consulting, package implementation and systems integration. While Indian software companies are increasingly facing competition from global MNCs who are replicating the Indian offshoring model, the need of the hour for them (the Indian companies) is to rapidly move up the software value chain. For the Indian software industry, one of the biggest concerns in the medium term is the outsourcing backlash in the US. However, to grow in the long-term, scalability and quality offerings would be the key.

As per the leading IT research and consultancy firm, Gartner, total worldwide IT services spending is expected to grow from US$ 535 bn in 2002 to US$ 727 bn by 2007, a CAGR growth of 6.3%. Also, as per NASSCOM, India's software services exports grew by 25% in FY04, from US$ 9.6 bn to US$ 12.5 bn. This represents a mere 1.6% of the global IT services market. NASSCOM also expects Indian IT services exports to cross the US$ 56 bn mark by FY08, which would mean CAGR of over 45% in the four-year period (FY04-FY08). Both these factors combine to signal Indian software sector's huge growth potential going forward.

Stable rates and robust volumes drive performance in 1QFY05
Sales: Initiatives on moving up the value chain gained speed during the quarter and have helped companies like Infosys, Wipro and Satyam increase contribution from high value services (like package implementation and systems integration) to their total revenues. This move towards high-end services has not only helped these software majors cap the decline in overall billing rates, it has, more importantly, brought their managements more closer to the clients (as these services have a higher onsite component, at least to start with), which is a long-term positive. For niche players like Geometric and Hughes, the fact that they are diversifying into newer related areas and improving quality of offerings, it seems just a matter of time before they move into the next higher orbit of companies.

Operating margins: The margin improvement is despite the continued additions to the employee base and salary revisions that usually take place in the first quarter. This, therefore, seems a result of most of these companies benefiting from scale advantages from the investments that they have already made. Also, the companies' continued initiatives in moving work offshore have helped in the improvement of overall margins.

Net profits: Apart from the strong topline growth, sequential net profit growth in 1QFY05 has been aided by a strong rise in other income. And this growth has been largely due to lower exchange losses that have seemingly been a result of depreciation of the rupee. It must be noted that since a large part (almost 95%) of Indian software companies' revenues are received in US dollar terms and expenditures are made in rupee terms, any depreciation in the rupee value benefits earnings growth (because companies get more rupees when they convert their dollar revenues).

What to expect?
At the current valuations, the average P/E multiple for the Indian software sector stands at 9.6x estimated FY06 earnings. As far as valuations of specific companies are concerned, most of them are trading at attractive valuations, but from a 2-3 year (FY06 onwards) perspective.

While valuations might be affected in the short term due to eventualities (read, outsourcing backlash) like those we have just witnessed, fundamentals are likely to play a more important role in the long-term. Thus, the need of the hour for investors (and those waiting to be) in Indian software companies is to invest with a long-term horizon. Also, they need to invest in only those companies that have visionary managements and sound business models. Returns then will, take care of themselves.

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