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Software: A reality check

Nov 25, 2004

Performance Summary
In continuing with the ‘good work‘ that has aided growth in the past quarters, leading companies from the Indian IT sector have reported improved performance in the second quarter of FY05. The performance has been characterised by a higher growth in the topline, led by strong volumes and stable billing rates and improvement in operating margins, led by cost control measures and a shift offshore.

Indian IT: Good show!
(Rs m) 1QFY05 2QFY05 Change
Net sales 46,076 52,052 13.0%
Other income 982 676 -31.2%
Expenditure 34,190 37,693 10.2%
Operating profit (EBDITA) 11,886 14,359 20.8%
Operating profit margin (%) 25.8% 27.6%  
Depreciation 938 1,622 72.9%
Profit before tax 11,930 13,395 12.3%
Tax 1,707 1,969 15.3%
Profit after tax/(loss) 10,223 11,413 11.6%
Net profit margin (%) 22.2% 21.9%  
* Consolidated to include results of Infosys,Wipro, Satyam, i-flex, MphasiS, Hughes and Geometric

About the sector
Global technology spending seems to be on an up-trend after the past few years of slowdown. However, demand seems to be shifting 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 (the Indian companies) 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 have 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, scalability and quality offerings would be the key.

What has driven performance in 2QFY05?
Billing rate stabilises: Strong sequential growth in the topline for most of these technology majors was a combined result of improvement in billing rates and continuation of robust growth in volumes. For instance, offshore and onsite volumes for Infosys grew QoQ by 17% and 7% respectively, one of the highest sequential growth levels attained in the past few years. This was also one quarter when most of these companies witnessed marginal improvements in their billing rates (new clients are being added at higher than average rates). Another important facet of the topline growth in 2QFY05 was continuation of a strong sequential growth in revenues from software development services. This is an important factor because software development forms part of discretionary spending of clients and is a good indicator of improvement in the global technology outlook.

All in all, the strong growth in topline in 2QFY05 happened despite the backlash in the US and other developed markets against offshoring of software services to low cost destinations like India. This reinforces the strength of the Indian outsourcing story and the fact that as outsourcing becomes mainstream, signs of which are being seen now, Indian IT companies are likely to gain in a big way. However, as we have said earlier, scalability will be a big factor.

Operating margins: After rising by a marginal 20 basis points in 1QFY05 over 4QFY04, operating margins witnessed a strong 180 basis points rise in 2QFY05. This seemed mainly a result of the fact that these companies are adding aggressively at the ‘freshers’ level where the incremental addition to employee costs is lower than what the companies would have incurred had the recruitment done more at the experienced levels (Source: Companies). In the medium term, we believe effect on margins of hiring at the lower level will be more than compensated by the high salaries that larger software companies will pay to hire consultants and domain experts. Also, the need to penetrate deeper into global markets will have impact on the selling and marketing side, which will further affect margins.

Lower other income impacts net margins: Contrary to what was seen in 1QFY05, when other income aided growth in the bottomline, there was a reversal in this quarter. In 2QFY05, consolidated other income has declined QoQ by 31% and this has impacted the net profit growth. Most of the companies have incurred heavy forex losses on account of depreciation of the rupee (while they had hedged against the appreciation) and this has impacted their other incomes in 2QFY05.

Value of the rupee vis-à-vis the US dollar is likely to be a strong factor that could affect profitability of Indian software companies. As seen in recent times, led by pressures of a huge current account deficit, the US dollar has resumed its depreciation against the Indian rupee and other major global currencies. If this were to continue in the future, profitability of these companies would be impacted severely.

What to expect?
As the graph below shows, the average P/E (based on P/E calculations for the companies under consideration) of the Indian software sector is 24.4 times expected EPS for FY06. Also, the large players are already trading at premium valuations to the average. This is mainly a result of derisked business models and sound management and expectations that these companies will be the biggest beneficiaries of future growth in offshoring. However, valuation risk exists.

Among the mid-caps, while most of them trade at discount to the average, investors need to understand that there are reasons for the same (like their small size and relatively high risks to their businesses due to their niche capabilities). However, select companies from this segment have shown their capabilities in the past and are likely to growth strongly in the future.

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