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Software: Don't lose focus

Nov 4, 2004

The American elections are over and the incumbent George Bush has retained his presidency. The American as well as Indian bourses both saw strong gains yesterday and it more likely than not is the result of the results of the presidential elections in the US. The optimism (atleast domestically) stems from the fact that there will be limited restrictions on business (mainly outsourcing) coming India's way if the incumbent is in power. Among all the sectors that were positive yesterday, the software sector saw strong gains mainly on the assumption that, Indian companies would benefit from a relatively more liberal (with regards to outsourcing) president at the US white house. A significant majority of the business of Indian software companies comes from the US and North America. It was thought that if senator Kerry would come in to power there may be a clampdown on outsourcing from the US. Now these fears seem to have abated.

While the US elections may actually be good for the Indian software and BPO sectors, retail investors need to be cautious at this stage. If one were to notice the table below, most of the major Indian software companies are trading at their highs as far as P/E valuations are concerned. This means that a lot of the future growth is already been valued in to the prices of these stocks and investors need to be sure whether these valuations are justified.

Valuations: Justified?
  2QFY05 EPS* P/E (x)
TCS** 36.4 32.3
Infosys 66.8 29.4
Wipro 23.6 28.6
Satyam 22.3 17.5
HCL Tech** 21.8 16.9
* annualised
** US GAAP
HCL Tech's EPS is annualised for 1QFY05, while TCS EPS is annualised for 1HFY05

Outsourcing has become a reality for companies across the globe, especially when they the need of the hour is to remain competitive. Indian software and BPO companies have successfully tapped this need to remain competitive and emerged as the largest BPO destination in the world. However investors need to realise that not all software and BPO companies would benefit from this rush to outsource. Large companies and probably companies operating in a niche segment may be the ones who are able to rise the wave.

Also investors need to realise that increasingly global multinationals (who outsource) are increasingly looking to hedge their exposure and as a result they are open to the idea of outsourcing to countries like China, Philippines, Ireland and Canada. This means that Indian companies have to be on their toes to wade off competition. There is also pressure on the margin front as Indian software companies set up elaborate marketing and sales networks in Europe and US (where most of the business comes from). Rising employee expenses are another reason for the pressure on operating margins.

So what is the bottomline? For one, Indian software and BPO companies would enter in to a scenario of falling operating margins from here on unless they are able to provide high value added services. The fall in margins would have to be compensated by higher volumes in order to maintain profitability. In this scenario, as we mentioned before, large companies and probably companies operating in a niche segment may be the ones who will be left standing.

The Indian software and BPO segments are still growing at a very fast pace and it is easy to lose sight of valuation in such a scenario. While consolidation may be 5-10 years away, the focus on the business model of the company should not be lost. It is time to be cautious and take stock of one's investments in the sector.

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