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Software: Why the spurt? - Views on News from Equitymaster
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  • Sep 4, 2003

    Software: Why the spurt?

    Software stocks seem to be back in the limelight on the bourses. The general argument is that 'prospects' of software companies are looking good on the back of expectations of revival in tech spending in the global market. While it is right that as global technology spending improves, it will take the Indian software sector along, some concerning questions still remain. Is the global technology spending really improving? If not, what is it that is taking the stocks upwards? Are they simply mirroring the market movements (as the table below indicates)?

    Before going forward, let us take a look at the table below that highlights gains in the stock price of Indian software majors and the Sensex, over July 10, 2003 (the day Infosys announced its 1QFY04 results and revised its FY04 earnings projections upwards).

    The revision helped!
    (Rs) 10-Jul-03 4-Sep-03 Gains
    Infosys 3,614 4,110 13.7%
    Wipro 1,005 1,158 15.2%
    Satyam Infoway 206 245 18.9%
    BSE-Sensex 3,680 4,311 17.1%

    The present...
    Post the tech boom in 2000, three key factors are posing greater challenge for the Indian software sector as a whole.

    1. Firstly, clients are demanding finer billing rates. As a result, even though volumes are growing at a faster rate, with billing rates under pressure, there is pressure at the operating margin level.

    2. Secondly, there is a strong resistance in the US market for 'outsourcing' per se. Outsourcing is resulting in job losses in developed countries.

    3. Thirdly, global majors are increasing presence in India in an attempt to replicate the business model of Indian software companies. While outsourcing is gaining prominence and acceptance as a result of this move, employee retention issues have surfaced in Indian software companies (both at the top and at the bottom level).

    Consider whether these three factors are of great significance in the long term.

    1. It was obvious that Indian software companies cannot maintain 30% operating margins for long. In a downturn, pressure on operating margins should not come as a surprise to many (like a steel company). Secondly, Indian companies have been expanding presence in the global market as a result of which there has been cost escalation. Thus, one has to watch for the long-term benefits arising out of the same as opposed to complaining about it.

    2. As far as resistance to outsourcing is concerned, it is too early to arrive at any conclusion. However, it makes business and commercial sense for MNCs to 'outsource' to save costs. In this process, they can focus on their core business.

    3. Is it new for a foreign company to set up a base in India and utilize the facility to meet its global requirements? Look around in sectors like auto components, automobiles, pharma and engineering. This has been going on for years. However, the difference is that software companies are all about intellectual capital. The challenge for Indian companies is to grow the employee base and retain most of them in the long term. In simple terms, scalability. Only very few managements have this skill set.

    At present, while the pressure on billing rates is expected to continue, Indian software companies are trying hard to grow on the volumes front. To gain acceptance in the global market, you need size. And to build size, it takes time. What Indian software companies are trying to do is commendable and has solid growth potential in the long term. As for improvement in global technology spending is concerned, while there have been some indications in this regard, it will still take some time before any clear picture emerges. Till that happens, from a retail investor's perspective, it is a matter of playing safe and looking beyond quarter-on-quarter performances.

    A look at valuations...
    Infosys* Satyam* Wipro**
    Current market price (Rs) 4,103 246 1,166
    P/E (x) 24.4 15.4 29.2
    Market cap/sales (x) 6.1 3.2 5.2
    * based on companies' FY04 projections
    ** based on our FY04 projections



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