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Software: Growing strength by strength… - Views on News from Equitymaster
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  • Dec 28, 2006

    Software: Growing strength by strength…

    Indian software industry continued its strong growth momentum during 2006, as the 'global delivery model' gained greater traction among the outsourcers. While volume growth for tech majors remained robust throughout the year, we were also witness to a host of companies spreading their wings wide into the global marketplace.

    However, relative to the benchmark BSE-Sensex, the BSE InfoTech's performance was a bit subdued. While the performance of top players (Infosys, TCS and Satyam) was above par, the laggards of 2005, like MphasiS and NIIT were amongst the picks of the lot.

    Our 2006 assumptions Vs reality
    Increasing global clout: At the end of the previous year, we had expected Indian software companies to increase their clout in the global technology industry. Our assumptions were backed by 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. And as we close in on the year 2006, we are being left a satisfied lot! The 5-year US$ 1 bn deal won by Tech Mahindra from British Telecom is a case in point.

    Amongst the leaders, TCS came out with sterling performances during the year. It churned out an annual income worth a whopping US$ 3 bn in FY06. Infosys, which celebrated its 25th anniversary this year, was not left far behind with strong growth seen across all its major verticals. Wipro also delivered robust performances during the year.

    Up the value chain: Software companies continue with their move up the value chain, considering that the share of higher-end services like package implementation, infrastructure management services, systems integration and consulting saw an increase in their overall revenue mix. In 2006, Indian technology companies were also able to build up on their domain expertise, either by way of organic growth or through acquiring the necessary capabilities. The latter saw a host of acquisitions made by companies across the spectrum – large and mid-size. While Wipro and TCS ramped up their subsidiary count, mid-size players like 3i Infotech were not left behind as well.

    Also, as expected, the cost arbitrage factor became less relevant than it was before. Large players aggressively build upon their scale, which is expect to take them to the next phase of growth going forward.

    Security issues: Taking 2005 as an example, we expected information security to be on the top of the priority lists of managements of Indian IT/ITES companies. It probably was, as there was no serious breach of information security during 2006.

    The outperformer: MphasiS BFL
    MphasiS, which had been an underperformer in 2005, largely due to the fact that Barings (its erstwhile largest shareholder) had difficulty in making an exit from the company. EDS picked up its stake in 2006. The acquirer's (EDS) vast global network in over 50 countries, as well as its strong client base, is expected to help MphasiS broaden its service offerings and leverage the former's global network to sell to its large clients. Given EDS' urgent need to strengthen its offshore presence, MphasiS could also witness stronger volume growth, as there is a possibility of the former offshoring a part of its work from existing and new clients. Given better traction in its IT services business and ramping up of the domestic BPO business in order to service orders like the Bharti deal, MphasiS raked in some good performances during 2006, the effect of which was seen in the stock price.

    Software: Key gainers in 2006
    21-Dec-05 22-Dec-06 % Change
    MphasiS BFL software 153 290 89.7%
    NIIT 292 493 68.7%
    I-Flex solutions 1,023 1,803 76.3%
    NIIT Technologies 164 282 71.9%
    Infosys 1,486 2,172 46.1%

    The laggard: Geometric Software (GSS)
    While there were no losers from the software sector in 2006, there were a number of stocks that underperformed the technology index. One such stock was GSS, which was incidentally on the top-performers list in 2005! 2006 has undoubtedly been a difficult year for the company, which faced delays in the execution of some projects, as well as resource fulfillment issues, leading to the company having to leave some revenues on the table. Given the fact that GSS is a niche company with a small size, these problems impacted it in an adverse manner. Considering this fact, it will be interesting to note how GSS manages its costs in line with its revenue growth going forward.

    Software: laggards in 2006
    21-Dec-05 22-Dec-06 % Change
    Geometric software 113 112 -0.6%
    Cranes software 104 104 -0.3%
    3i Infotech 160 185 15.4%
    HCL Tech 532 606 13.9%
    Wipro 458 573 25.2%

    What to expect in 2007?
    According to International Data Corporation (IDC), global IT services spending is projected to grow at a CAGR of 5.9% to reach US$ 556 bn by 2009, from US$ 441 bn in 2005. According to another estimate by Gartner, IT outsourcing spending will rise from US$ 193 bn in 2004 to US$ 260 bn in 2009. We believe that the offshore outsourcing story is expected play out strongly in 2007, as global corporations will look for quality work done at optimum cost.

    Also, the integration of IT-BPO contracts is expected to become more common, as clients look for end-to-end service providers. Companies like Infosys, TCS, Wipro, Satyam, HCL Tech and MphasiS BFL, all of which are also into BPO, are expected to benefit from this trend, though at differing magnitudes. Volume growth will be the major driver for these companies' topline growth in 2007, as billing rates are expected to remain stable, though with some positive bias.

    Outsourcing has provided companies with significant arbitrage benefits, in labor cost – through business process enhancements and improvements. Indian companies are expanding their service offerings, enabling customers to deepen their offshore engagements through shift from low-end to high-value business solutions. Inspite of the rising cost on the back of wage inflation (averaging 10% to 15% annually), Indian offshore still operations provide cost savings of 30% to 40% to 50%, which shall help keep the volume growth robust in 2007.

    To sum up, we believe that volumes are likely to be the key topline driver in 2007. However, margins are expected to be under pressure to an extent as the productivity will be a key issue. Also, the increased labor and SG&A expenditure is expected to arrest any possibility of margin expansion. Overall, the theme of enhanced value chain presence and high-end service offerings will differentiate gainers and laggards in the year(s) to come.

    To read our thoughts on year 2006 and our view for 2007, click here - Reflections 2006.



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