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Software: Will 3Q and 4Q be any better? - Views on News from Equitymaster

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Software: Will 3Q and 4Q be any better?

Dec 13, 2007

Over the past few days, the software stocks have had a decent run after touching their 52-week low levels in mid November. Is this newfound optimism from the investors who were running away from these stocks in June and July this year justified? At these levels, are the sector stocks a good bargain? We try to look into the factors, which may have prompted this move. Rupee stabilization: Over the past 12 months, the appreciation of the Indian rupee against the US dollar has emerged as the biggest villain for the export driven technology sector. What was termed as an industry risk a few years back has now emerged as company specific risk for most of the IT services companies. But over the past 3 months, the rupee has hovered around the 39.4 to 39.8 mark, giving the IT companies much needed stability in the currency movement. What does this essentially mean to them?

We believe that more than the appreciation in currency, it is the speed of the appreciation, which was a cause for concern. Why? The rupee was at 49 to a dollar in June-02 and appreciated to 44 in December-06 and then the recent rally of rupee against the dollar began. Didnít the rupee appreciate from mid 2002 to 2006 end? It did, but the IT companies were unfazed with this appreciation. Why? Because the currency appreciation over the 4-1/2 years was more stable and anticipated with the gradual growth of the economy and more so, it gave them the time to adjust itself to the new currency regime. But the currency appreciation from 44 to a dollar to 40 to a dollar in six months time was un-anticipated and it caught the entire industry by surprise. The IT companies were not in a position to adjust their business models to this sudden change and this was reflecting in their performance in the last 2 quarters in the form of lower topline growth and declining operating margins.

But with rupee stabilising over the last 3 months, we believe that the impact of appreciation will be very negligible on the companyís performance from hereon and IT companies are slowly adapting themselves to the changed industry dynamics and currency scenario. A general contention is that to counter the appreciation in rupee, the IT companies should reduce their dependence on US. On this front, we have a different view. However, such a move also has its fair share of negatives. Why? The IT companies are making 25% to 30% operating margins and these high margins essentially come from the US clients. So when they are moving away from US, they are also sacrificing on margins, as the same are lower in other regions. Thus, to counter this impact, the concept of near shoring is gaining confidence very rapidly. In near shoring, the IT companies are opening development centres in Latin America and are servicing the US clients from there.

CY08 IT budgets: Perhaps everyday we get to hear some news regarding the US slowdown and that it will impact the IT companies in a big way. At the current juncture, we would like to state that none of the IT companies have acknowledged any signals of a slowdown. And rightly so. Because if they acknowledge a slowdown then in addition to rupee, this will be the second negative signal to the investors and perhaps these stocks will be battered on the bourses. Companies in US prepare their IT budgets for the next calendar year in fourth quarter of the previous calendar year. Thus, we believe that the cat will be firmly set among the pigeons in 3QFY08 results conference call in January 08.

But even if there is a cut in the IT budgets, will the companies be badly hit? To some extent yes. But the impact will depend on the kind of work the company is doing i.e. annuity based revenues or discretionary revenues. If the company has more of annuity-based revenues in their total revenues, the overall impact will be lower as even in a slowdown, annuity revenues will not be cut. But if a company has more of discretionary revenues (software development) then the impact of slowdown will be greater as in time of slowdowns, discretionary spending are cut down first.

Now the IT companies are caught in a catch-22 situation. On one hand, they have to ensure than they have enough annuity-based revenues in their overall business and they also have to move up the value chain (more high end services) to compete with the global MNCs. The problem in moving up the value chain is that the nature of services over there is more discretionary in nature. So to that extent, the revenues pattern tends to get riskier. But we believe that even if there is a slowdown, the impact will be lower for the Tier-I IT companies when compared with slowdown of 2000-01. The main reason for this is that in 2000-01 most of the deals were outsourcing deals but today most of the deals are transformational deals.

Change in service offerings: Of late, there has been a change in the services offered by the IT companies. In the last 2 quarters, we have seen a remarkable shift towards the IMS (Infrastructure Management Services) and other high-end services. Why is this practice gaining ground and why ADM is slowly fading away?

We believe that high penetration levels by Indian IT companies in this space (ADM) are one of the key reasons. As this market matures, the opportunities in this space will slow down. So IT companies are targeting newer service lines. Also, the impact of wage hikes and competition from China and other developing countries are higher in this space since ADM segment has lower margins. And IMS is a huge market with low penetration levels so the opportunities are huge over there for the IT companies. This is also evidenced by all top tier IT companies making acquisition in this space.

Conclusion
At the current valuation levels we feel that Tier I IT companies are trading at very attractive levels and with currency stabilizing, the situation will turn better for them. Overall we believe that the so-called demon of the currency will not play spoilsport in the coming quarters.

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