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Software: Is IT really good?

Sep 15, 2003

In wake of the recent spurt in software stocks, we thought of taking our viewers' opinion regarding the reason for the rally and to find out whether this is for real (or simply speculative). However, the response we got differs from our general view of the sector at present. The response...

Interestingly (we would tell you why!), a majority (53%) of the respondents believed that the rally in software stocks is based on fundamentals and is a harbinger of good times to come for the sector. Out of the remaining, while 40% voted for the fact that the rally has something to do other than improvement in the prospects of the software sector, the remaining 7% decided to remain on the sidelines, probably waiting for the turn of events before spelling their verdict.

Our view...

The above response seems interesting (yet not surprising). This is because the way markets have been moving one way (that is, up) since the beginning of this year gives some indication that there is something apart from the fundamentals (improving economy and performance of corporates) that is responsible for this northwards movement.

The same seems to be the case with the Indian software sector. After its constituents (especially the fly-by-night operators) harped around with 'indigestible' growth numbers and took gullible investors for a ride (causing the IT boom an bust), some sort of realism now seems to have set in the way Indian software companies project their growth. While pressure on many accounts (MNC competition, for example) have forced these companies to bring some realism to their forecasts, these (the pressures) have also helped them to improve the way they carry out their operations.

In case of the software sector, which did not participate in the overall rally initially, it is difficult to say whether the current rally is based on fundamentals or speculation. The general argument is that 'prospects' of software companies are looking good on the back of good first quarter results and 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?

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. However, as for improvement in global technology spending is concerned, with two-thirds of this year already gone, there does not seem to be any clear evidence of a major recovery in spending. Even a 7.5% spurt in technology spending in the US (as some recent reports mentioned) in this quarter is likely to take time to percolate down to benefit Indian software companies. Before that happens, it should be a cautious wait and watch policy for investors in technology stocks.

On a final note, the table below is indicative of the fact that Indian software companies' valuations look stretched at present. While the Indian software sector growth story remains intact, we have mentioned time and again that not all companies are well placed to benefit from the same. For some companies, valuations have shot up ahead of any signs of sustained improvement in fundamentals. Just because a stock has underperformed its peers and the benchmark index in the recent stock market rally need not necessarily mean it will be an outperformer by default in the future!

Software valuations: Expensive!
10-Jul-03 5-Sep-03* Gains P/E
Infosys 3,614 4,205 16.4% 25
Mahindra Satyam 206 253 22.8% 16
Wipro 1,005 1,247 24.1% 31
Hughes 262 369 40.8% 20
NSE-Nifty 1,162 1,398 20.3% 14
*Last trading day before we conducted this poll.

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