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Software: Watch out! - Views on News from Equitymaster
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  • Dec 30, 2004

    Software: Watch out!

    Between the two under-performers of the calender year 2003 in relation to the benchmark index i.e. the Sensex, the software sector was a surprising one besides FMCG. Forward to the calender year 2004, the CNX IT index has outperformed the Nifty Fifty. We take a closer look at the events that shaped up for the software sector in calender year that passed by, including the reasons for the outperformance, and what lies ahead?

    What was different in 2004 as compared to 2003?
    The year 2004 marked the continuity in prospects for the Indian software sector with billing rates stabilising (at least for Tier-1 companies) and volume expanding at ‘faster than earlier’ pace. However, the year also led the management of Indian software companies chew on risks on the outsourcing front in wake of the US presidential elections held in November. While the return of Mr. Bush Junior brought some respite for these companies as the year drew to a close, it was not before a lot of apprehensions were raised whether the backlash would affect Indian software companies.

    These apprehensions were, however, laid to rest by managements of most of leading software players as they reported their first quarter results for the fiscal 2004-05. While we did not deny that the backlash against outsourcing had seeds of much larger resistance throughout the globe, we believed that, in the long-term, economic senses would prevail as global corporations, in their aim of becoming globally more competitive, would outsource their non-core operations to low-cost countries that provide high-quality services (India, for example). This belief was vindicated as most of the leading players from the Indian software sector came out with improved forecasts for the future. The rest is, as they say, history!

    2004 also saw the listing of TCS, Asia’s largest software services exporter onto the Indian bourses. The issue received a wide response and the stock was listed at the upper end of the issue price. Another event to have marked 2004 was the crossing of US$ 1 bn revenue mark by two Indian tech majors – Infosys and Wipro. While size of these three Indian software players are still miniscule as compared to global technology majors, the crossover of the US$ 1 bn revenue mark definitely marks their emergence into the global technology domain where balance sheet size plays a vital role in garnering large-scale contracts and growing businesses rapidly.

    The sector outperformer: Infosys
    A look at the tables of key gainers below indicates that this year has belonged to the leading players in the industry, be it from the end-to-end segment (Infosys and Wipro) or from the focused and niche categories (Hexaware and Kale Consultants). Gains, specifically, in stocks of large players like Infosys and Wipro were due to belief that these would be the biggest beneficiaries of the increased outsourcing momentum. These players are consistently building up their employee bases, investing consistently in building up infrastructure (development centres, marketing and distribution network), and this is all in the anticipation that they would get enough work to justify their investments. However, we believe that if that fails to fructify, or that if these companies fail to garner adequate business in line with their expectations, times might come out to be tough.

    Software: Key gainers in 2004
      26-Dec-03 27-Dec-04 % Change
    INFOSYS 1,348 2,055 52.5%
    HEXAWARE TECH 407 598 47.0%
    WIPRO 571 753 31.9%
    KALE CONSULTANTS 59 75 27.1%
    RAMCO SYSTEMS 366 462 26.3%

    The laggard: SSI
    Companies that have had a poor track record and that were named in the stock markets scam of 2000, lost out considerably in 2004. This is a good sign considering the historical performance when such stocks rallied along with the better players from the sector. As a matter of fact, the major loser in the calender year 2003 was Silverline (down 71%) followed by Pentasoft (down 60%).

    Software: Key losers in 2004
      26-Dec-03 27-Dec-04 % Change
    SSI LTD 192 44 -77.1%
    PENTASOFT TECH 8 3 -61.2%
    VISUALSOFT 258 128 -50.4%
    DSQ SOFTWARE 17 9 -48.3%
    NIIT 266 178 -33.2%

    What to expect in 2005?
    While software has been considered a relatively insulated sector from geo-political ‘upheavals’ in the domestic and global arena, the degree of insulation varies across companies. We believe that continuing from what has been witnessed off late in 2004, demand for technology solution from global clients is likely to be concentrated among a few players. These could be any of those who operate across the value chain or who are focused on specific domain(s). This is because 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.

    Moreover, taking cue from the changes that increasing global competition is bringing, many Indian software companies are moving from competing just on the cost front to improving their domain competencies (like establishing greater presence in high-technology telecom and financial services verticals) to compete with global majors in their territories. Some, like Infosys and Wipro, have succeeded to an extent in this endeavour. However, for other Indian companies to make a mark on the global scale, it would require a Herculean effort. They cannot rely on the cost arbitrage advantage for long. And if they do so, investors, better keep a watch. Overall, while 2005 might bring in greater challenges for Indian software companies, these challenges are not likely to be adrift of the consequent opportunities. Watch out!



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