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Software: Strong growth momentum!

Oct 26, 2005

16,535 - that was precisely the number of employees that the top 4 software companies hired during 2QFY06! It has, indeed, been a fabulous performance from all the top software companies in this quarter, with strong performance parameters on virtually all fronts. Revenue growth has been strong on a sequential as well as a year-on-year basis. Profit has also grown at a fast clip and, in fact, has outpaced the growth in the topline. The demand environment for offshoring appears to be stronger than ever and clients globally are clearly warming up to this. And, of course, as mentioned in the first sentence of this paragraph, the employee hiring has been very strong, with most of the companies having record hirings in any quarter, giving a clear indication of the strong order pipeline and growth expectations, going forward.Markets have certainly been enthused by the results and the stocks have done well since then. We analyse the consolidated performance of the 'Top 4' software companies and see what trends have emerged, are likely to emerge and what investors can expect in future.

Indian IT: 2QFY06 performance...
(Rs m)1QFY062QFY06Change
Net sales81,115 88,944 9.7%
Expenditure58,647 64,463 9.9%
Operating profit (EBDITA)22,468 24,481 9.0%
Operating profit margin (%)27.7%27.5% 
Other income 740 1,341 81.2%
Depreciation2,381 2,648 11.2%
Interest 12 10 -16.7%
Profit before tax20,815 23,164 11.3%
Tax3,069 3,171 3.3%
Profit after tax/(loss)17,746 19,993 12.7%
Extraordinary items(1)(10) 
Minority interest 86 102  
Profit/(loss) in earnings of affiliates 27 66  
Net profit 17,686 19,947 12.8%
Net profit margin (%)21.8%22.4% 

About the sector
For Indian software companies, the past few years have marked a shift in demand from low-end services to high-end ones, like IT consulting, package implementation and systems integration. Now, while Indian software companies are increasingly facing competition from global MNCs who are replicating the Indian offshoring model, the need of the hour is to rapidly move up the software value chain. Increasingly, the demand for technology is likely to be more guided by the 'Return on Investment' factor, i.e., how much of cost saving or return on investment can be obtained by clients from their IT spending when quality execution capabilities is a given attribute. As such, large Indian IT companies that provide a broad range of services and have proven capabilities in executing large and complex projects are likely to emerge winners. However, to maintain strong growth in the long-term, a highly credible and visionary management team, long-term relationship building with major clients, scalability and quality offerings would be the key.

What has driven growth in 2QFY06?
In one word, volumes: It is very clear that volume growth has been the main force behind the strong topline growth for the top-tier software companies this quarter. Infosys and Wipro both recorded double-digit volume growth for both onsite and offshore volumes. Satyam and TCS also saw healthy volume growth. As regards billing rates, most of the companies actually saw an up tick in both offshore as well as onsite rates. Wipro was the only company to witness a decline in billing rates. Going forward, all the companies have indicated that they are seeing a largely stable billing rate environment. New clients are coming in at 3% to 4% higher rates. The contracts that are coming up for renegotiation could also see some upward trend in pricing.Clearly, the demand environment is very strong for offshoring. The ABN Amro deal recently is clear proof of this fact. The employee hiring has been the strongest ever for these companies and this indicates a strong order pipeline. Infosys hired as many as 6,390 people during the quarter. Of course, this is traditionally the quarter in which the campus recruits join the company and to that extent, the figures could be skewed. Nonetheless, this has still been a record quarter for hiring and undoubtedly, it implies more growth ahead.

As regards service lines, companies are witnessing strength in the package implementation business in particular. In fact, each of these companies has seen a double-digit sequential growth in this business this quarter and this clearly shows the increasing preference of clients to go in for packaged software. By extension, the share of new services in overall revenues is also consistently going up for the Indian companies, such as systems integration, testing, infrastructure management and consulting. This indicates a clear move up the value chain and is certainly a positive in the long run. Companies like Infosys continue to invest in their consulting practices for future growth.

Margins flat again: As was the case in the previous quarter as well, margins remained flat, declining by just 20 basis points. However, we need to take a company-specific view on this. Infosys, by and large, managed to maintain its margins at 32%, despite having lower utilisation rates during the quarter, due to leveraging on its past investments in sales and marketing. TCS' margins reduced due to the hike in onsite salaries. Wipro managed to improve margins in its global IT services business by 40 basis points. However, Satyam was the best performer as far as margins are concerned, as they improved by 120 basis points. This was driven mainly by efficient cost management and reduction of employee costs as a percentage of sales.

Taking the last two quarters, margins have declined by 30 basis points for the top four companies. It must be said that as these companies move higher up the value chain, margins will be under pressure. Major levers for margin expansion will be increasing percentage of freshers in recruitment, control on SG&A costs and improving the business mix.

Bottomline soars: The combined bottomline for the top four companies has risen at a strong sequential rate of 12.8% this quarter. All these companies performed strongly and except for TCS, all recorded double-digit profit growth individually. Satyam, in fact, saw a 24.8% sequential jump in net profit. Other income soared for these companies this quarter. This was partly due to the depreciation of the rupee against the dollar, a positive surprise. As a result, the forex gains registered a strong jump. The tax rates also saw a fall in 2QFY06, thus helping the bottomline growth to outpace the topline growth.

We had mentioned in the previous quarter about factors such as a pick-up in business, leverage on various cost fronts and the impact of salary hikes being factored in as drivers of an improvement in the performance of these companies. Most of this has happened this quarter and looks likely to continue, going forward.

What to expect?
At current valuations, these companies appear to be fairly valued from a medium-term perspective. However, as a long-term investor, future business prospects appear strong. We believe that it is the large companies that will benefit the most from the offshoring story. It is being observed as an industry trend that while the large companies are becoming bigger, the mid-sized software companies are struggling to maintain consistency in their growth. Therefore, we believe that at some point, consolidation could result in a shake-up in the industry, with the mid-sized players either acquiring a company or getting acquired themselves. There is a clear need to differentiate their services from the large companies rather than become a 'me-too' player. Only then will they survive in the long run.

While this quarter has been good, one should also take into account the fact that markets will start expecting these companies to continue their performances over the next few quarters as well. Thus, when expectations begin to go sky-high, there is always the risk of a hard crash-landing. However, we believe that one must maintain a long-term investment horizon for equities and given robust topline and bottomline growth expected for these large software companies, longer-term valuations are not entirely out of line. Of course, risks always abound, such as currency risks, wage inflation, managing growth on a higher base and attrition of key employees. Investors must always consider these factors before making an investment decision.

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