Markets are truly in the stratospheric territory. Abundant liquidity, not just by the 'usual suspects', the Foreign Institutional Investors (FIIs), but also by domestic mutual funds (MFs) has pushed the indices up into totally uncharted waters. At levels of over 8,700, the indices now trade at a price to earnings multiple of around 18 times trailing 12-months earnings, certainly not 'cheap' by any standards. The extent of the rally can be gauged by the fact that the Sensex had crossed the 7,000-mark on June 20. Since then, in about three-and-a-half months, it has gained nearly 25%!
India Inc.'s 2QFY06 results are slated to begin next week. This is expected to determine the short-term trend of the indices in general. As always, it is the software companies that will be first off the block to announce their results. This time around, as many as three companies will announce their results on the same day - October 11 - Infosys, MphasiS and TCS.
Software stocks have gained significant ground since 1QFY06. Infosys, TCS and Satyam have gained over 20% each since their lows in July, while Wipro has gained about 16%. However, it must be mentioned that liquidity has been the major driver of this surge in share prices. Fundamentals have not changed that much to warrant such a steep rise in valuations. At current levels, a number of these stocks are more-than-fully valued and the scope for any further upside is very limited in our view, while the downside risk is much higher. Clearly, there is ample room for disappointment and one must practice utmost caution at these levels.
It has been quite a start to the earnings season this time around, with Geometric Software giving a profit warning for the second successive quarter. Not surprisingly, the stock has crashed since then. But the top tier companies have remained strong. The announcement of big deals, such as the ABN Amro outsourcing contract, by Infosys and TCS has further enthused participants and improved revenue visibility for these companies over the medium to long term.
Major drivers in 2QFY06
We attempt to analyse a few major operating metrics that are likely to influence the 2QFY06 results of the software companies.
Volumes: Once again, as has been the case in the recent past, it is volume growth that is expected to be the major driver of revenue growth. Initial concerns about a slowdown in the key US market and political pressures against offshoring have proved to be short-lived and offshoring is well and truly becoming more mainstream for global corporations. The ABN Amro deal is ample proof of this fact, which saw both Infosys and TCS recording their largest-ever order wins.
Billing rates: As has been the case recently, the billing rate environment appears to be largely stable. Managements in conference calls with us have mentioned that the major growth drivers for revenues, as mentioned above, will be volumes, rather than billing rate increases. The increases are coming at the newer clients' end. However, since new clients' business does not contribute even 10% of the top tier companies' revenues, this increase will not have any significant impact on the topline.
It should be mentioned that although companies are not facing any significant downward pressures on their billing rates, getting increases is not proving to be easy either, rather a challenge. Going forward, if cost pressures become acute, then companies may have to push harder for increases. Again, the major driver for an increase in average billing rates will remain an improving business mix in favour of higher-end business like consulting and systems integration.
Exchange rates and margins: Once again, the rupee-dollar exchange rate will also play a role in determining margins of software companies. This time around, there has been a pleasant surprise on this front. The rupee has actually depreciated against the dollar, euro and pound sterling. Therefore, there does exist a margin upside to that extent. The rupee has lost as much as 1% against the dollar this quarter, while losing in equal measure against the euro. The movement against the pound sterling was largely flat, with a slight depreciation witnessed.
This assumes significance in light of the fact that in 1QFY06, margins were adversely impacted by the appreciation of the rupee against the euro and pound. This time around, however, the rupee has lost the maximum against the dollar, the major billing currency of the software companies. This might have a positive impact on margins.
Major levers of margin expansion this quarter are expected to be rupee depreciation against the major currencies, salary hikes already factored in, higher utilisation rates, increasing shift to offshore from onsite and cost efficiencies.
What to expect?
While we have outlined our expectations on the major operating metrics that are expected to affect software companies during 2QFY06, we are of the belief that, as an investor, one must take a long-term view of any business, including software. Given the strong momentum expected in offshoring and the fact that Europe, traditionally conservative and a late adopter of outsourcing, has also started to increasingly adopt it, prospects appear bright. This has been adequately proved by the ABN Amro deal. The fact that a leading financial services company has so comprehensively resorted to offshoring would encourage other large companies in Europe to do the same.
On an overall basis, we continue to remain positive on the sector's prospects. The winning of US$ 100 m-plus deals is expected to intensify and scalability is of critical importance, more now than ever before. Investors can surely look forward to exciting times ahead!