Software: The pre-2QFY04 picture…

The result season is about to begin soon with software companies slated to announce their second quarter results from the second week of October. As a prelude to this, let us pause for a moment and take a look at the performance of some of the Indian software services companies in the last five quarters, beginning 1QFY03 (June 2002).

The above graph is representative of the sequential topline growth of these Indian software companies in the last five quarters. At first glance, the picture may seem confusing. But take a closer look, and some clarity might emerge. After facing severe pressure during the period 2QFY03 and 4QFY03, there seems to be some stability in the topline performance of these companies. However, Wipro seems an exception as its growth has been relatively more volatile that its peers. This may have been due to the fact that FY03 was a year of inorganic growth initiatives for Wipro as it acquired a number of companies (like Spectramind, NerveWire, etc.). Going forward, Wipro is likely to benefit from these acquisitions that are targeted to help the company cross-sell more from its bouquet of software services to clients that such consolidation would bring with them. However, how long that would take is still to be seen.

Among others, Infosys is fast scaling up its operations in anticipation of greater demand in the future. The company gave the markets a shock by projecting downwards its FY04 EPS projections in 4QFY03. But it more than made up for that after it revised upwards the same projection in 1QFY04. All in all, Infosys seems to be well poised to take advantage of increased outsourcing contracts to India. Satyam and MphasiS are also following the same route of increasing their employee base and revamping their selling and marketing infrastructure worldwide. Due to continuance of cost cutting measures initiated by clients in the developed countries, Indian software majors are expecting larger contracts to flow to India in the future. Ramping up capacity and marketing infrastructure is intended to capture this anticipated demand.

On the flip side, markets seem concerned about the operating margin position of these companies. The graph above indicates that the margin situation for Infosys and Satyam seems to be stabilising while the pressure on MphasiS and Wipro continues. But there is a reason for declining margins of the latter two companies. While MphasiS is investing heavily on its BPO venture MsourcE, Wipro’s margins have been affected due to extraordinary expenses like acquisition retention charges on account of its recent inorganic initiatives (as mentioned above). Also, as all of these companies continue their investments in human resource and selling and marketing infrastructure, the pressure on the margins front is likely to continue for some more time.

Another cause of declining margins of Indian software companies has been the value of the rupee, which has appreciated by around 7% since its June 2002 lows. This is because the major portion of these companies’ revenues comes from exports that are billed in US dollar while their costs are calculated in rupee terms.

The concerns, as mentioned above, seem to be short-term in nature. As these companies continue to spend in anticipation of higher demand for their offerings in the future, they would definitely gain when the demand actually comes. It is just a matter of time as to when that happens. Investors, thus, need to look beyond the short-term prospects of quality companies and rather concentrate on the long-term.