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Software: A reality check

Oct 11, 2005

Well, today is the BIG DAY! Infosys Technologies, India's second-largest software services company, is scheduled to announce its 2QFY06 results, as usual, the first major company to do so. While all the usual excitement, anticipation and expectation abounds, we do a little bit of soul-searching, taking a step back and viewing the larger picture. A little bit of history...
India's software sector has been amongst the fastest-growing sectors over the past few years now. This sector has been a showpiece of the country's technical and managerial talent. It has also created a lot of jobs and currently employs over a million people (IT+BPO). In fact, the indirect employment alone attributed to this industry is estimated at around 2.5 m people.

The fundamentals...
Let us go 'back to basics' for a brief while in order to understand as to what are the main factors that markets take into consideration while valuing a software stock.

Management quality: Undoubtedly, this is the major factor to take into consideration while valuing a software company. The management's vision and ability to respond to a dynamic environment in a highly competitive industry where competition is global in nature is a big differentiating factor.

Track record: The company's past track record is also of importance, as a company that has shown inconsistency in the past would get a discount to its more consistent peers. Satyam, for example, has shown inconsistency in past years and due to this, it gets a significant discount to TCS, Infosys and Wipro.

Margins: Margins reflect the operating efficiency of the company, its ability to control costs, make productivity improvements and leverage with clients on the billing rates front. Thus, the higher the margins, the more efficient a company is. Infosys, for example, enjoys the highest operating margins in the industry of nearly 33%.

Growth prospects: Undoubtedly, this is the major factor that markets take into account while valuing not just software, but most other stocks as well. Therefore, if future growth prospects are strong, as is the case with software companies, markets would accordingly give such companies higher valuations than the average.

Why have software stocks run up so much?
Well, we ourselves are at a loss to answer this question! That is, of course, on the basis of fundamentals and a long-term perspective. One needs to understand that we are in the midst of a secular bull run and a large part of this is on the back of sustained liquidity from mainly Foreign Institutional Investors (FIIs). It is very rightly said that 'this time it's different' are the most dangerous words in such a market.

While growth prospects are, no doubt, strong for the industry and offshoring is taking off in a big way, whether this actually implies according the current high valuations for these stocks is a highly debatable point. First of all, while it is true that clients are consolidating their vendors and increasingly opting for 'strategic global sourcing', such a move might not justify a re-rating of these companies. Rather, it has been the incessant FII inflows that have been the major driver for these stocks.

There is huge liquidity globally, created by accommodative monetary policies of central banks globally and multi-decade low interest rates in many countries, including the US and EU. Thus, this money has found its way into most emerging markets, especially India, which is viewed as a 'high-growth' destination with the potential to deliver high returns. Therefore, even though fundamentals may not have changed that much, stocks have moved to fairly high levels.

Secondly, growth rates are, in fact, beginning to show a slight deceleration. One cannot expect these companies to grow at 35% to 40% consistently over the next few years. Given tough competition, pressure on margins due to flat billing rates and high employee costs as also part movement offshore, it is unlikely that revenue growth as well as profit growth would keep pace with that of past years.

Thirdly, and perhaps, most importantly, the industry appears to be moving towards a consolidation phase. The top players are only getting bigger and the gap between these players and the rest of the pack is increasing all the time. It is the niche players that are expected to hold their own, while the mid-caps struggle. In such a scenario, a maturing industry should ideally get lower multiples than an industry that is just beginning to grow. So, this once again questions the logic for such high valuations.

Conclusion
While we are enthused by the growth prospects of the software industry and the offshoring story over the longer term, we believe that the valuations of numerous stocks (and this is true not just for software, but many other stocks as well) have run up well ahead of fundamentals. Short-term drivers like the earnings season and other news flow will affect these stocks. But, as we have always maintained, invest with a longer-term time horizon and buy into stocks that are not too expensive.

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