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Software Sector Analysis Report 

[Key Points | Financial Year '08 | Prospects | Sector Do's and dont's]

  • IT spending in the US has grown unabated during the last few years. As per IDC (a global technology research agency) and NASSCOM (India's industry body for the tech sector), revenues of the Indian IT industry have grown by 33% to US$ 64 bn in FY08. The IT-BPO industry has estimated to have grown at a CAGR of 31% since FY04, much faster than the global IT services industry. The Indian domestic market for technology is also growing as robustly as the export of IT services from India.
  • India's IT industry can be divided into five main components, viz. software products, IT services, engineering and R&D services, ITES (IT-enabled services) and hardware. Export revenues continue to drive growth. Amongst the export revenues, project-based services accounted for more than 50% of the Indian IT services exports. Multi-year annuity based outsourcing agreements are expected to increase going forward. However, the majority share of the project based revenues is going to continue on the back of custom application development and application management.
  • Cost leadership has been the competitive edge of the Indian software sector over the last few years. However, this seems to be threatened now by MNCs who are replicating the Indian outsourcing model and setting up bases in the country. Going forward, the advantage of low employee costs could peter out and the sector could get commoditised. Increased competition within the segment could lead players to ramp up selling and marketing expenses in order to acquire new customers and improve the market share, which in turn will lead to further pressure on margins.
  • Increasing competition, pressure on billing rates and increasing commoditisation of lower-end application development and maintenance (ADM) services are among the key reasons forcing the Indian software industry to make a fast move up the software value chain. IT companies have to move up the value chain to provide higher value-added services as consulting, product development, R&D and end-to-end turnkey solutions.
  • The software services segment of the industry continues to grow by leaps and bounds. However, growth in the domestic market has been relatively staid. Given that India is among the fastest-growing economies in the world and the burgeoning IT budgets of India Inc., focusing on the domestic market will definitely be an opportunity to take advantage of.

How to Research the Software Sector (Key Points)

  • Supply
  • Abundant supply across segments, mainly lower-end, such as ADM. Lower in higher-end areas like IT/business consulting, but competition is very tough.
  • Demand
  • IT is spending expected to grow at 6% CAGR over the next 3-4 years, and growth is buoyant in fast-growing economies such as India and China. Europe also shows promise. Demand largely depends upon the state of the global economy and willingness of corporations to go in for new software services and greater discretionary spending rather than consolidating existing systems.
  • Barriers to entry
  • Low in the ADM segment, which is prone to relatively easy commoditisation. In high-end services like IT/business consulting, where domain expertise creates a barrier. The size of a particular company/scalability also creates barriers to entry, as these firms have built up long-term relationships with major clients and to take business away from them is not easy.
  • Bargaining power of suppliers
  • Low, due to intense competition (oversupply), particularly in the lower-end ADM space. Low differentiating power is also another reason. High, at the higher end of the value chain.
  • Bargaining power of customers
  • High, mainly due to intense competition among suppliers/vendors. However, it is lower in higher-end services like consulting and package implementation.
  • Competition
  • Competition is global in nature and stretches across boundaries and geographies. It is expected to intensify due to the attempted replication of the Indian offshoring model by MNC IT majors.

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Financial Year '08

  • As per NASSCOM ‘Strategic Review 2008' report, the Indian IT industry is estimated to have grown by 33% in fiscal 2008 and generate revenues of US$ 64 bn. The domestic market is also growing as robustly as the export of IT services from India. Indian IT services exports (excluding revenues earned from the export of software products, engineering and R&D services, ITES and hardware) are estimated to have grown at a CAGR of 32%, from US$ 13.3 bn in FY04 to US$ 40.8 bn in FY08.
  • The ITES-BPO industry continued to grow at a scorching pace, with India retaining its market leadership position in this space. The movement up the value chain continues in this space as well, as companies move from voice-based services to non-voice services. As per IDC and NASSCOM, the global BPO industry is expected to grow from a size of US$ 462 bn in 2007 (29% share of global technology spending) to US$ 677 bn (34% share) in 2011. The BPO industry in India, which currently employs 700,000 professionals and generates revenues of US$ 11 bn, is expected to grow at a CAGR of 38% over the next 5 years.
  • The broad trend in the industry globally is that the deal sizes are getting smaller. This has suited the Indian industry perfectly, as it does not as yet have the capabilities, scale and resources to execute huge billion dollar deals. On the other side, most Tier-I companies walked away with the high profile deals and the gap between Tier-I and Tier-II companies widened in FY08. The cross-movement of work and labour has created a competitive dynamic for cost structure and knowledge leadership of concept, technology, and process innovation. Indian IT firms (especially the top notch Indian firms like TCS, Infosys and Wipro) are increasingly competing against top global players such as IBM, Accenture and EDS for large deals. The top Indian IT companies are more frequently being invited to bid on large deals that were earlier closed to them. India's top outsourcers are competing effectively with the top three global service providers on large deals.

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  • Over the next 3-4 years, the total global spending on IT is expected to grow at a CAGR of 6%. The services spend (IT services and ITES/BPO) is expected to grow faster as compared to the other segments. In particular, the offshore outsourcing story is expected to continue to play out, as firms look for quality work done at lower cost.
  • The integration of IT-BPO contracts is expected to become more common, as clients look out for end-to-end service providers. Companies like Infosys, TCS, Wipro, Satyam, HCL Technologies and MphasiS, all of which are also into BPO, will benefit from this trend.
  • IT being a resource-intensive industry, human resources will play a major role in times to come. Attrition rates will have to be managed by the companies In order to preserve margins, firms will have to maintain workforce at optimum level, improve utilization rates and control selling, general and administrative expenses.
  • Billing rates are expected to be stable, with the major clients giving no leeway on any possible increases. The increases are by and large coming from the new clients. Given that new clients contribute less than 10% to overall revenues for most IT companies, this will not have any major impact. Higher rates will be a factor of the business mix. As IT companies move higher up the value chain, they will get better billing rates for services such as consulting.
  • Rupee's volatility against the US dollar and other major currencies is expected to remain a major concern for Indian IT companies having significant offshore presence. Coupled with this, higher employee costs is expected to take a toll on the companies' profitability levels.

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Related Links for Software Sector
Quarterly Results | Sector Quote | Over The Years

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