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Software: Stick with the best

Nov 26, 2002

In the recent past, the software companies’ (especially the large ones) bagging large projects have enthused the markets. The Sensex and the Nifty have gained significantly on the back of buying in technology majors. So is this a ‘dead-cat-bounce’ case or is it a broader trend? It is most likely the latter. The offshore model has established its credentials as a low cost option and is now well received in western markets. Consequently, US corporates are taking greater interest in offshore development. The result is the large flow of orders. Indian software companies are uniquely propositioned as ‘value-for-money’ services providers and as a result, stand to gain the most from the drive. What could help the industry’s growth is the offshore outsourcing model gaining an even wider acceptance.

Apart from aggressive spending on marketing and establishing a strong presence in markets across the globe, help is coming from unexpected quarters - competition. In an effort to outdo the competition from India, a large number of global IT services majors like IBM are setting up their own offshore development facilities in India. Thus, if the larger IT services firms from the west are adapting the offshore model, the corporates in the west are likely to be even more comfortable with the concept. However, this is a double-edged sword. While at one end the move will certainly help offshore development gain acceptance, this will also mean a lot more competition for the Indian software majors both in terms of business as well as employees. This could result in erosion of margins going forward.

Though we were expecting the large order flows (Software sector report: Prospects), there have been two triggers for the deal flows off late. 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 going ahead with critical projects and are looking at cutting costs. The offshore model fits their requirements.

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 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 to implement these packages 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.

What happens when this market gets saturated? There is a even bigger opportunity in waiting. The major software firms are now eyeing the application outsourcing business. Term is very generic and the gamut of services extends from providing software development and maintenance services (what the industry is doing currently) to completely taking over a client’s IT department i.e. shutting down the existing IT departments and handing over the employees to the IT services vendor.

Unlike IT projects which results in improved efficiency of operation and reduced cost of operations over a period of time, the impact of outsourcing is almost immediate. To put things into perspective, many of the mega corporates in the US have IT departments that are larger than most Indian software majors. Thus, the saving potential just in terms of manpower costs is immense. While at one-end human resources costs are saved, at the other, there is substantial saving in terms of infrastructure cost as well.

The Indian software majors are now graduating from providing the software development and maintenance services to gradually taking over employees and IT infrastructure of clients. Infosys has already done that for two of its clients. Wipro too has received a letter of interest from Lehman Brothers that wants to outsource application, maintenance, remote infrastructure management, and BPO services from India. These kinds of deals are typically large in size; sometimes even bigger than US$ 50 m a year over a period of five years.

While the benefits of outsourcing are crystal clear, the biggest impediment is the fact that not everybody is comfortable with the idea of outsourcing mission critical operations. Organisations need to be very comfortable with security of information in the hands of the IT vendor. Added to this is the issue that since the scale of operations is very comprehensive, not many are going to change vendors’ everyday. The business continuity of the vendors is a must. Therefore, corporates are likely to outsource from organisations that are better known, financially stable and large in size.

In the near future, IT stocks are likely to be the centre of attraction due to increased order flows. As usual, there will be a frenzy of buying in information technology stocks. At this point, we would advise the retail investors not to get carried away. As clients look to rationalize vendors demanding all services under one roof, smaller IT firms that do not have specialized skill sets face tough times ahead. Even while selecting the larger IT companies, be very careful about the management’s track record.

This brings us to the question of valuations. Infosys at the current market price of Rs 4,535, is trading at a P/E multiple of 32x FY03E earnings. This suggests that the markets are expecting about 30% growth in earnings going forward. While valuations on the face of it seem on the higher side, they actually might not be. Infosys topline is about US$ 180 m in a quarter (2QFY03) and about US$ 675 m per annum (FY03E). A US$ 50 m contract for a year translates to 7% of the company’s revenues. Assuming that the company gets just two such contracts, 14% is added to the topline. The point we are trying the make is the immense growth opportunity staring into the fact of the IT services sector. Thus, the valuations, though marginally on the higher side, might be justified. However, at such valuations it is wiser to invest with a long-term (three to five year) perspective.

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