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Software: Happy days are here again

Oct 19, 2002

Ahead of Infosys’ numbers, Mphasis had impressed the bourses with a strong performance for the quarter ended September 2002 and so had Mastek. Hughes and Wipro also posted a strong performance for the quarter. Infact, all the companies have posted sequential growth in revenues of more than 5%. Further, post 2QFY03 numbers, Infosys revised its revenue guidance. The company now expects the revenues to grow by 33% for FY02, as compared to an earlier guidance of 23%. Thus, expectations on topline growth have increased by almost 10%. Do these numbers mean that the worst for the software sector is over? Well, the answer is that while things are definitely improving, the economic situation continues to be uncertain in the largest markets for IT services companies. Increasingly, the view that speculates the possibility of a double dip recession is gaining strength, which could affect the industry going forward.

Software cos: Shifting gears
Revenue growth (QoQ) 4QFY03 1QFY03 2QFY03
Infosys 2.9% 12.4% 15.0%
Wipro* -3.4% 7.4% 7.4%
Mphasis** 1.0% -0.5% 7.5%
Hughes Software -3.2% -18.3% 9.9%
Mastek 10.4% 14.5% 11.4%
* Wipro Technologies' revenues
**Revenues from IT services

But first let us look at what has happed.

The steep growth in revenues has been due to two reasons. Firstly, as an initial reaction to the slowdown, companies in the west had just frozen IT spending. Corporates are now taking a more realistic view of the economic situation and have understood that it could be quite sometime before the situation improves. Thus, they are looking at cutting costs. At the same time, Indian IT services companies with the offshore model have established their credentials as a low cost option and are now well received in western markets. Consequently, US corporates are taking greater interest in offshore development and beginning to spend.

Further, the spending that is taking place is directed towards getting more from existing IT systems rather than buying new technology. This means increased demand for services like package implementation, enterprise application integration and maintenance. These areas are traditional strong holds of the Indian IT services companies. Also, a significant part of the IT spend is also directed towards keep existing systems running.

Let us take the example of package implementation. During the IT spending frenzy a large number of corporations had spent significant amounts in buying ERP and CRM packages like SAP and Siebel with a significant number of licenses. However, inspite of buying a large number of licenses, these organisations today are using only a few. But to get more from their existing investments they would like implement these package form as many users as possible. Thus, the spending is directed towards getting more from existing systems rather than buying new software and licenses. And the Indian software companies score over the foreign counterparts in cost arbitrage. Thus, the demand for services like package implementation has been growing swiftly.

Package implementation (PI): Hot …
Revenue growth FY02 1QFY03* 2QFY03*
Infosys 86.5% -17.2% 37.8%
Satyam 207.3% 10.0% -
*QoQ revenue growth

Further, areas like application outsourcing, which Indian software companies are just beginning to test, are likely show strong growth going forward. Thus, the growth potential is immense.

While Infosys increased the revenue guidance for the year, it did not increase the bottomline guidance. One of the reasons for this is the fact that the company’s relatively newer revenue streams are onsite intensive. The operating margins for onsite projects are lower than that for offshore projects. Thus, the company is witnessing a pressure on margins.

However, on a macro level increased competition in putting pressure on the causing margins to decline for the players across the sector. Thus, going forward it seems that that margins for the Indian software industry are likely to head south. The competition today is no longer local. Initially, as the Indian software industry faced the heat of downturn in the US economy, a few players began to undercut. This triggered a price war within the industry. This made life even more difficult for foreign competition. Consequently, western software industries decided to counter the cost leadership of the Indian software industry.

Many global top rung IT services providers have now started to explore the possibility of getting the work done in India and have started offshore development centres. Thus, they are now able to offer pricing that is competitive to Indian companies. The list of global IT services majors’ offering offshore development include IBM and Cognizant. It’s a question of time before the trickle of global IT majors becomes a flow. And that means competition is likely to intensify.

While some have landed in India, others have chosen the third party route to counter competition. In 2001, Satyam and CSC entered into an agreement. According to the agreement, CSC would outsource work to Satyam and therefore, be able to provide competitive rates.

Not only will Indian IT industry’s cost leadership be threatened, but it will also have to face intense competition for talent. Already staff costs of Indian software companies are as high as 40% of revenues. Increased competition from global IT services majors will be a problem for top Indian IT companies that were till date the best names to work with. This will no longer be the case.

Employee costs as
% of revenues
FY01 FY02
Wipro 13.8% 14.7%
Satyam 39.9% 45.6%
Infosys 37.8% 42.9%

Thus, going forward, the industry that has only recently understood terms like competition and tough business environment will learn to live terms like these terms cut throat competition. Also, topline growth in the future will be based on volumes and not improvement in realisations (billing rates). Thus, the growth prospects of the sector look very attractive, only the very smart and prepared will survive. Not many will be able to cash in on the outsourcing story that is unfolding, be very sure before you make your investment.

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