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Indian IT: And the show begins

Oct 11, 2004

The second quarter result season for Indian software companies begins today with software and BPO services provider, MphasiS, slated to announce its numbers in a short while from now. Investor expectations of a strong growth in earnings in the second quarter have been the key driver for these stocks to move up in recent times.

While the long-term growth story for Indian technology companies looks promising in the wake of increased move towards offshoring, there are some short to medium term concerns that investors need to take note of. Let us discuss some of these concerns in detail.

Wage inflation and attrition: Maintaining a low employee turnover (or low attrition) is probably the biggest concern for Indian software companies. Average attrition rate in IT services currently hovers around the 15% levels and this is high considering the fact that retaining human resources is the key to any software services company sustaining its growth momentum. BPO attrition is much higher at over 25% levels. Aggressive hiring by MNC technology companies has aggravated this concern. Not only has this led to higher attrition in Indian companies, as seen by numerous mid-level managers shifting from Indian majors to MNC companies, it has also resulted in rising employee costs for Indian companies that have been trying hard to retain key people. Indian software companies, as they move up the value chain, are also likely to add a large number of high-end consultants/experts to their payrolls, and this might put additional pressure on their margins going forward.

Rupee appreciation: The rupee appreciated against the US dollar by 8.7% in FY04. This led to further pressure on margins that had already been affected by declining billing rates and companies' continuous spending towards building up physical (sales and marketing network and development centres) and human (manpower) infrastructure. However, during the period April-August 2004, the Indian rupee depreciated by 6.8%, bringing some cheer to Indian software companies. But this cheer seems to have been cut short, as the rupee has again appreciated against the dollar (1.2% appreciation since August). Considering that the US economy is reeling under a huge US$ 600 bn current account deficit, a likely pressure on the dollar cannot be ruled out in the medium term. Thus, a further appreciation of the rupee will again have a negative effect on Indian software companies' margins.

Political rhetoric: The backlash in the US against offshoring to low-cost countries like India has raised some medium-term concerns for Indian software companies. This is because of the fact that these companies have a large portion of their revenues emanating from the US. While we believe that, over the long-term, sound economics is more likely to take the front seat, near term concerns can have a serious effect on sentiment.

Software: Results this week
Company Result on
Infosys 12-Oct-04
TCS 13-Oct-04
Hughes Software 13-Oct-04
Wipro 15-Oct-04
While these concerns mark the medium term prospects of Indian software companies, investors also need to realise that huge expectations from these companies have led to their valuations reaching high levels. The average P/E for the Indian software sector is around 26.2 times our expected FY05 earnings and most of the companies are trading at or near the high levels of their respective price bands. This is, therefore, a time to practice caution. Strong fundamentals and not strong results for a quarter or two should be the basis for investment.

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