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Software: Preview 2QFY07...

Oct 5, 2006

It is that time of the quarter again, when companies line up to perform their 'quarterly ritual' - announcing their quarterly results! This is expected to drive the near-term movement of the indices. However, we are of the view that the indices have already moved up significantly since the first quarter, and the current levels of the indices already factor in strong second quarter numbers expected from the index heavyweights. If there are any negative surprises seen this quarter, then we could witness a downward realignment of expectations. Amongst the earliest ones in the queue, software companies, the 'BIG ONE' is slated for next Wednesday Infosys. Undoubtedly, the markets will be keenly watching not just the results, but also what the management says about the demand environment, competitive pressures, wage pressures, employee attrition and the margin profile.

Major drivers in 2QFY07
In this write-up, we analyse major factors that are likely to influence the 2QFY07 results of the software majors.

Volumes
There has been no perceptible change in the demand environment for offshoring. Clearly, this new business model is here to stay, and the plans of the MNC IT majors such as Accenture and IBM clearly vindicate this stand. Accenture, for one, expects to increase its India-based headcount from around 19,000 presently to 50,000 in three years' time. This is clear proof of the fact that offshoring is becoming more and more mainstream.

This quarter, the top-tier Indian software companies are expected to continue to report strong volume growth. The strong employee additions in recent quarters are clear pointers to a robust order book, and ever-improving client metrics indicate continued traction in volumes in the near-term. Generally, the second quarter of the fiscal tends to be a strong one, as companies come out from the seasonally weak first quarter, and campus employees join the companies. However, as we saw, the first quarter this fiscal was an exceptional one, aided by good volume growth as well as a weaker rupee. We expect volume growth to be the major driver of the topline growth in 2QFY07, as the impact of the rupee this time around may not be as significant as it was in the first quarter.

In their 2QFY07 guidance, most companies expect decent sequential topline growth, ranging from 5.5% to 8.7%. Wipro expects revenues from its global IT services division to grow at 7% QoQ, while the figure for Satyam is around 5.5% to 6% QoQ. Infosys, on the other hand, expects revenues to grow at 8% to 8.7% sequentially. We continue to believe that volume growth will be the major driver for these companies' topline growth going forward. So far, we have not seen any indications that would lead us to change our view. Large deal wins will be instrumental in enabling these companies to sustain volume growth. The billing rate environment continues to remain stable, and new clients are coming in at 3% to 4% higher rates.

Margins
During 2QFY07, some expansion in margins could be witnessed for these companies, given the fact that most of the salary hikes are out of the way, and visa costs have also been incurred. Generally, given the above-mentioned factors, margins tend to see an up-tick in the September quarter on a sequential basis. However, it should be noted that this is also a company-specific factor, with Infosys done with its annual salary raises, while Satyam has implemented its wage hikes from July and Wipro's offshore raises are due from September and onsite raises from January 2007.

Exchange rates
As has always been the case, the exchange rate of the rupee against major currencies, particularly the dollar, will play a role in determining the performance of software companies. This time around, on an average, the Rupee has depreciated by around 1.9% against the Dollar, by 4.1% against the Pound and by 3.1% against the Euro.

This movement is more likely to help these companies at the topline and operating margin level. However, this quarter, we believe that the overall impact of this factor will not be as significant, given the significant positive impact that was seen last quarter, where the rupee depreciated much more. Therefore, the other income component could be significantly lower this quarter, reducing the impact on the bottomline.

What to expect?
As always, we have given our expectations on the major operating metrics that are expected to affect software companies during the forthcoming quarter. Nonetheless, we believe that, as an investor, one must take a long-term view of any business, including software. We remain positive on the sector's prospects on a long-term basis. Positive factors include favourable industry trends, such as the increasing use of 'strategic global sourcing', improving breadth and depth of service lines, strong execution capabilities, increasing scalability and top quality managements.

Major risks, on the other hand, would be in the form of wage inflation, higher employee attrition rates, particularly at the middle management levels, increasing competitive intensity and exchange rate movements.


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