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Software: Biggies show the way! - Views on News from Equitymaster
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  • Nov 17, 2005

    Software: Biggies show the way!

    The markets are looking as strong as ever. Even after the correction witnessed in October, the BSE-Sensex has recouped about 80% of its losses after it hit its lifetime high of 8,800+. The software majors have certainly been a big part of this rally and these stocks have appreciated significantly on the back of the enthusing results announced by these companies.

    However, as regards the software mid-cap stocks, the performance was mixed. In this write-up, we compare these two sets of players and reason as to what could be the future for these companies in the software industry.

    Bigger is better!
    Clearly, in the context of the software industry, it is undoubtedly the large companies that rule the roost. Unlike in, say, the FMCG sector, where the mid-sized companies like Marico, Godrej Consumers or Dabur have managed to perform better than the larger companies like HLL, in the software industry, it has been the biggies all the way, as can be seen from the table below.

    Software: Big is beautiful!
    (FY05) Infosys TCS Wipro Satyam MphasiS i-flex Geometric
    Sales (Rs m) 71,297 97,272 81,606 35,208 7,657 11,386 1,682
    EBITDA margin (%) 32.8% 29.3% 25.1% 24.7% 18.5% 26.4% 27.7%
    Net profit (Rs m) 18,917 20,521 16,285 7,116 1,248 2,324 275
    Sales CAGR (FY01-FY05, %) 39.2% 33.6% 27.6% 25.6% 29.4% 38.6% 38.5%
    Profit CAGR (FY01-FY05, %) 31.7% 27.4% 24.8% 28.0% 34.7% 20.6% 35.7%
    Return on Equity (%) 43.7% 70.6% 36.0% 23.9% 19.5% 20.3% 22.9%
    Revenues per employee (Rs m) 2.3 2.6 2.3 2.1 1.0 2.9 1.7

    As usual, Infosys and TCS have outperformed the other companies. Wipro, on account of its higher dependence on R&D services, which tend to be volatile, has under-performed Infosys and TCS marginally. Satyam, after showing a fair bit of volatility till FY03, has since picked up and performed well.

    However, when one comes to the mid-sized companies, the performances of these companies differ. A greater amount of volatility has characterised the performances of these companies and this has clearly been reflected this year, with Geometric Software, the PLM specialist, having already given two profit warnings due to execution issues faced by it. These companies generally do not have the scale to compete effectively with the larger players.

    We give here, a few trends and what these mid-sized companies need to do to stay in the game.

    Unbundling of deals: The unbundling of the big, billion-dollar deals is well and truly on. Earlier, large companies used to hand out massive multi-billion dollar deals to large technology service providers like Accenture, EDS and IBM. These deals involved takeover of assets as well as people. Often, there used to be time and cost overruns and inefficient service. The price also used to be highly uncompetitive.

    Then came the Indian method of 'Global Delivery', which ensured a much more competitive cost structure, process and execution excellence. This was too good a proposition to resist and, as the global delivery model slowly established itself as the de facto standard of process execution in the global IT industry, the unbundling of deals has become a reality. The ABN Amro deal is proof of this. Deals are broken up into various parts and the parts are handed out to the best-of-breed vendors. This suits Indian companies fine, particularly the larger companies, which have the scale, size and resources to execute US$ 100 m-plus deals globally.

    Partners, not vendors:The mindset of IT services providers has to change from being just mere vendors or technology solution providers, to that of being partners in their clients' growth. A greater degree of accountability is needed and the top companies are now starting to think more strategically from a business point of view. In order to execute this vision effectively, domain expertise is required. Thus, when firms develop such expertise, the consulting business will start to flow in as well. This is a crucial differentiator for firms, as they increasingly seek to grow their higher-end businesses like consulting and package implementation.

    What should mid-sized companies do?

    Strengths in niche areas: Undoubtedly, in order to stay in contention, these companies will need to develop skills in niche areas where the large players are not present in a big way. For example, Geometric Software operates in the product lifecycle management (PLM) space, which is a highly specialised area and, although the big players do have a presence, it is not a major part of their business. i-flex, on the other hand, specialises in the banking, financial services and insurance (BFSI) vertical, developing best-of-breed banking products like Flexcube and providing services through deep domain expertise. Thus, this is the sort of strategy that these companies need to follow if they are to remain long-term players.

    It is undoubtedly going to be a tall order for mid-sized companies to compete against the larger companies. It is no use becoming a 'me-too' player and clearly, a differentiated strategy is the need of the hour. While we are not saying that these companies are not a good investment, in case one would like to invest in mid-sized software companies, he or she will have to be very choosy about which companies to put their money in.

    We have always maintained that it is the large companies that are expected to be the major beneficiaries of the offshoring boom, while the mid-sized companies struggle. The volatility of their performance is proof of the fact that they have not been able to build predictability into their business models, akin to an Infosys. However, it should also be noted that these companies differ in their businesses, the verticals they tap and services that they offer (products/services).

    Therefore, we would say that it is not advisable to view these companies as one homogeneous lot and, in fact, one should make the efforts to study their businesses, which often are fundamentally different. All in all, we would say that, while we prefer the large-sized companies as a whole in terms of business growth, selective mid-sized companies would also be a good bet for investors willing to take just that extra bit of risk and add a little bit of spice to his or her portfolio.



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