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Software: Scalability's the name! - Views on News from Equitymaster
 
 
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  • Dec 27, 2005

    Software: Scalability's the name!

    Introduction
    2005 has indeed been an eventful year for the Indian software industry. In many ways, the year can be considered as a landmark one, where numerous events unfolded. Large deals were signed, acquisitions were made, growth was witnessed in some companies, de-growth in others and so on. But the conclusion is undoubtedly that the growth story continues to play out in offshoring.

    As regards index performance, the BSE Infotech index's performance has been neck-to-neck with the benchmark, the BSE-Sensex. In fact, since the beginning of the year until very recently, the Sensex had actually outperformed the IT index. The recent strong rally in technology stocks has enabled the index to come on par with the Sensex in terms of year-on-year returns.

    What was different in 2005 as compared to 2004?
    The year 2005 was characterised by a strong performance from the Indian software industry. Earlier in the year, at the end of FY05 (March), NASSCOM's reports showed that the software industry grew at its fastest pace since the dot-com bust. This is ample proof of the resilience of the country's software industry. The long-term players have proved their ability to stick it out in difficult times and this will only make these companies stronger in future.

    The offshoring story continued to play out, amidst occasional bouts of paranoia from the US, UK and EU (continental Europe) about job losses. But clearly, the noises that were made against offshoring of jobs in 2004, particularly at the time of the US presidential elections, have died down. Corporations globally are, no doubt, conscious of the need to remain competitive and thus, focus their energies on their core competencies, leading to ever-increasing offshoring.

    The highlight of the year was, undoubtedly, the signing of the landmark ABN Amro deal. The deal, worth US$ 2.2 bn, was partly given to Infosys, Patni and TCS, apart from Accenture and IBM among the global technology majors. This has proven to the world, the ability of Indian software companies to execute deals of a global nature across diverse geographies, such as the US, Europe and Latin America by leveraging their global delivery networks. Taking an industry perspective, we expect more such deals to be signed in future and global reach and size will play an increasingly important role in deciding who gets the largest share of the spoils.

    The major 'theme' of the year, we would say, was that of scalability - scalability in terms of manpower, infrastructure, size and global reach. This is the major factor that we believe will be crucial for any Indian software company if it has global ambitions and hopes to compete against the Accentures and IBMs of the world. This was again reflected in the ABN Amro deal. To put it in numbers, TCS, the biggest of them all, crossed the US$ 2 bn mark during FY05, while Infosys is expected to do so in FY06. Satyam is expected to cross US$ 1 bn in revenues in FY06, making it the fourth Indian software company to achieve the 'hallowed turf'.

    The sector outperformer: Satyam
    From the table below, it can be clearly seen that Satyam has been the major gainer in 2005. This has been due to the market re-rating the stock upwards. In the past, Satyam's performance has been fairly inconsistent when compared with the top-tier companies. As a result, it had been trading at a big discount to Infosys. But during the past 2 years, Satyam has started to perform impressively, driven by its package implementation business that has grown at a CAGR of over 60% in that period. This has resulted in the stock's valuations improving, reducing the gulf that separated it from Infosys. Of course, Infosys still gets a considerable premium to Satyam, but it has been steadily reducing. Going forward, we expect the package implementation business to continue to be the major growth driver for Satyam.

    Software: Key gainers in 2005
    24-Dec-04 23-Dec-05 % Change
    Satyam Computers 409 711 73.8%
    i-flex solutions 625 1,037 66.0%
    NIIT Limited 176 287 62.8%
    Geometric Software 73 111 50.8%
    HCL Technologies 359 525 46.3%

    The laggard: MphasiS BFL
    In 2005, there were no losers in absolute terms from the software companies under our coverage. However, there were certain companies whose stock performance was far from satisfactory. After all, at the end of the day, one must compare relative performance as a measure of evaluation and not absolute performance. MphasiS BFL has faced some trouble in the recent past in maintaining consistent, industry-beating growth rates. The company's major divisions - IT services and BPO have, at different times, faced problems growing on a consistent basis. But the biggest problem faced by MphasiS BFL has been the inability of Barings, its largest shareholder, to sell its stake. The sell-off fell through during 2005, when Barings could not find a buyer that would give a satisfactory price. As a result, since then, sentiment on the stock has been poor and has contributed in a big way to its relative under-performance.

    Software: Laggards in 2005
    24-Dec-04 23-Dec-05 % Change
    Kale Consultants 75 88 16.9%
    PSI Data Systems 101 115 14.4%
    MphasiS BFL 138 152 9.9%
    NIIT Technologies 152 162 6.8%
    Hexaware Technologies 121 126 4.4%

    What to expect in 2006?
    Indian software companies are increasingly beginning to show their clout in the global technology industry. The ABN Amro deal is just the beginning and we expect a lot more from the sector, going forward. Indian companies' inherent advantages, like low cost and highly skilled labour, time zone differential, enabling regulatory environment, mastery of the art of global delivery, execution excellence and strong relationships with Fortune 1000 majors, are expected to enable them to continue to grab the lion's share of the global offshoring pie. As we had mentioned in our 'Reflections 2004' write-up, the demand for technology solutions globally will be concentrated among a few players. This has certainly been the case in 2005 and is expected to continue.

    Indian software companies continue to climb higher up the value chain, as witnessed by the increasing share of higher-end services like package implementation, infrastructure management services, systems integration and consulting in the overall revenue mix. This is expected to continue, as these companies invest more in these businesses. Going forward, it will undoubtedly be a different ballgame competing against the likes of Accenture, IBM and Cap Gemini in their own space, where they have been the incumbents for many decades now. Thus, the building up of domain expertise is a critical factor that cannot be ignored.

    Security will be another key issue to watch out for in 2006, particularly in the BPO industry. This industry has seen scorching growth rates, as global corporations make a beeline for India as the 'back-office of the world'. But recent incidents involving breach of security and leakage of confidential data have put the spotlight on security issues. We would like to mention here that these security issues are not unique to India - they occur all over the world and undoubtedly, while there is always room for improvement, targeting India alone will not do any good. The BPO business is not expected to get impacted, except, of course, for the 'negative publicity' that these issues generate. Given that, often, the credibility of the 'supposed sting operators' themselves is questionable, over the longer term, there will not be any major impact.

    To sum it all up, as we had mentioned last year as well, it is clear that the cost arbitrage factor is becoming less relevant than it was before. Of course, it is still a big factor, but its importance is now beginning to reduce, as quality of work and domain expertise takes over. With Indian software companies getting increasingly into higher-end work, this will become more of a trend. The 'Return on Investment' factor will be closely watched and clients are now increasingly starting to work with the Indian companies on a more strategic level as partners in their growth. In other words, it is becoming more of a 'strategic relationship' now, as opposed to a mere 'tactical relationship' earlier. Watch out for scalability, movement up the value chain and domain expertise this year, as the industry moves into the next phase of growth!

    To read our thoughts on year 2005 and our view for 2006, click here - Reflections 2005.

     

     

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