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Software: Where to, now?

Aug 4, 2005

Well, it's come and gone! No, we are not talking about the flood of torrential rains that hit Mumbai and left everyone (that is, everyone except the stock market!) in a daze. Indeed, that was a highly unfortunate event that exposed the poor state of the infrastructure in the country's financial capital. But in this case, we are talking about the quarterly ritual of the software companies' results. As usual, they were among the first to announce their results and the 'general feeling' has been that they were 'disappointing'. We analyse the macro picture, through consolidation of the results of the top four IT majors and attempt to find any clear trend emerging, either positive or negative and see what investors can expect, going forward.

Indian IT: 1QFY06 performance…
(Rs m)4QFY051QFY06Change
Net sales78,445 81,115 3.4%
Other income520 740 42.3%
Expenditure56,650 58,647 3.5%
Operating profit (EBDITA)21,795 22,468 3.1%
Operating profit margin (%)27.8%27.7% 
Depreciation2,522 2,381 -5.6%
Interest8 12  
Profit before tax19,785 20,815 5.2%
Tax2,687 3,069 14.2%
Profit after tax/(loss)17,098 17,746 3.8%
Extraordinary items(527) (1) 
Minority interest (99)86  
Profit/(loss) in earnings of affiliates8 27  
Net profit 16,678 17,686 6.0%
Net profit margin (%)21.3%21.8% 
* Consolidated to include results of Infosys, Wipro, Satyam and TCS

About the sector

For Indian software companies, the past few years have marked a shift in demand from low-end services to high-end ones, like IT consulting, package implementation and systems integration. Now, while Indian software companies are increasingly facing competition from global MNCs who are replicating the Indian offshoring model, the need of the hour is to rapidly move up the software value chain.

Increasingly, the demand for technology is likely to be more guided by the 'Return on Investment' factor, i.e., how much of cost saving or return on investment can be obtained by clients from their IT spending when quality execution capabilities is a given attribute. As such, large Indian IT companies that provide a broad range of services and have proven capabilities in executing large and complex projects are likely to emerge winners. However, to maintain strong growth in the long-term, a highly credible and visionary management team, long-term relationship building with major clients, scalability and quality offerings would be the key.

So, how do 1QFY06 results stack up?

Driven by volume growth:  Revenues for the top four grew at a relatively sedate 3.4% QoQ. The major driver of revenue growth during the quarter was volume expansion. Billing rates, by and large, were flat, with a slight positive bias. Companies like TCS and Wipro actually managed to get price increases, TCS particularly due to improvements in the execution of fixed price projects (FPPs). But, by and large, the billing environment has stayed relatively stable, without any notable downward bias. Going forward, the managements have indicated that they expect billing rates to remain stable with a slight upward bias. Companies have managed to get higher rates at the newer clients' end. However, given that new clients have contributed to well below 10% of revenues in the quarter, this is not expected to have any major impact and volumes are expected to continue to drive growth. Higher billing rates will be a function of the business mix. Companies that move faster up the value chain into areas like consulting and package implementation will get better billing rates for these services and will thus, improve their average billing rates.

The growth seems subdued at first glance, but if we take only Wipro's global IT services business into consideration, the growth improves to a healthier 5.3%. TCS and Satyam were the standout performers, particularly Satyam, which grew by a healthy 9.0% sequentially. The package implementation business seems to be the major business leading the way for all the major companies. It has been this business that has shown the strongest growth for the top companies, except Infosys. For Infosys, it was its products business line, Finacle, which grew at a strong pace, mainly due to the receipt of license fees. In fact, Infosys appears to be witnessing good traction in this business, with new order wins in overseas geographies, such as Singapore, where earlier, it was mainly focussed on the domestic market. We believe that these trends are a positive for the IT sector as a whole, as it is imperative for Indian companies to move higher up the value chain and this is a step in that direction.

Margins flat overall:  As can be seen from the table above, margins for the four companies combined have been virtually unchanged, declining by just 10 basis points. However, taking a company-specific view, both Infosys and Satyam faced margin pressure, due in part to the salary hikes carried out by them in April, a yearly event. TCS, however, despite raising salaries, actually expanded margins by 110 basis points, due to improvement in billing rates, better volumes, lower communication costs and productivity improvements, leading to better cost management. Wipro, on the other hand, did not increase salaries, as it does this in October. Even though revenues were lower on a sequential basis, due to savings on the raw material front, margins actually expanded. However, margins for Wipro's global IT services were lower by 130 basis points.

However, a common factor for all these companies has been an appreciation in the rupee against major currencies, like the Euro and Pound, which has affected them to a varied extent, depending upon the percentage of revenues and billings in these particular currencies. Higher visa costs also resulted in margin depletion to some extent. Going forward, for companies like Infosys and Satyam, margins could see an upward trend due to the impact of the salary increases being factored in and better leverage on the S&M front. Business is also expected to improve and the increase in volumes could also aid this upmove.

Bottomline growth misleading:  On the face of it, it appears that bottomline has shown a healthy 6.0% QoQ growth. However, it must be understood that TCS' profit grew at 31.7% QoQ, due to the impact of the extraordinary item of EVA-based compensation costs in 4QFY05, which reduced profits abnormally and lowered the base considerably. If we strip off the effect of the extraordinary items, the sequential net profit growth comes to a mere 0.2%! Satyam, in particular, saw sequential net profit dwindle by 7.7%, while Wipro's net also fell by about 1.2%. Thus, it does appear that the net profit growth is lacklustre.

However, going forward, given a pick-up in business, leverage on various cost fronts, the impact of salary hikes being factored in and also room for improvement in margins of companies like TCS, which saw an improvement in margins despite the above-mentioned factors, net profit growth could improve.

What to expect?

At current valuations, these companies appear to be fairly valued from a medium-term perspective. Given the recent run-up in stock prices, purely on the basis of liquidity flow from Foreign Institutional Investors (FIIs), without any corresponding change in fundamentals, we would advise investors to practice caution and stick to the basic principles of investing, more now than ever before. As regards the software companies, we believe that judging a company on the performance of just one quarter is not a proper way of investing. The long-term offshoring story remains intact and companies that have built up strong long-term relationships with major clients, have good management quality and scalability will be the major beneficiaries of this growth.

However, as always, any investor must consider the risks. Currency appreciation, as has been seen in the past quarter, could be a risk and threaten margins of the software companies. Employee attrition, as always, given that software is a people-intensive industry, remains a challenge to be dealt with. Given enormous competition for talent in this sector, from Indian as well as MNC companies, wage inflation will remain a reality and has to be countered by moving up the value chain and effective cost management. Managing growth will also be a key issue to be addressed, as they grow bigger and the base enlarges further. This will certainly be a key challenge for these companies, apart from managing an ever-expanding pool of employees.

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