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Sunday, April 22, 2007

Software majors in Q4: Performance beats perceptions


Uncertainty and jitters. That probably best sums up the homestretch to the earnings announcements of software service majors this year. The prospect of a US slowdown, sharp rupee appreciation and possible turbulence in the financial services sector heightened fears of earnings growth skidding in 2007-08.

But, going by the management guidance and earnings conference calls of the top five software companies, most of the fears appear to have been assuaged, at least for the time being.

By toning down market expectations that were set much higher — at 25-30 per cent plus on revenues/earnings in the run-up to the results — Infosys Technologies managed to minimise the negative fallout to a large extent. And with Satyam Computers coming out with fairly strong guidance (apart from a good fourth quarter), most of the apprehensions have been set to rest.

While Tata Consultancy Services, Wipro (except for offering revenue guidance for the latest quarter) and HCL Technologies do not provide financial guidance, the senior management's comments on key trends in the marketplace are encouraging. Scanning the earnings radar throws up five key variables that are still working in favour of the software majors:

US SLOWDOWN

Almost every single frontline company has downplayed the impact of the probable US slowdown on software revenues. Except for the sub-prime mortgage woes that have hit a small segment of the financial services space, the overall business momentum appears quite robust.

In late March, Accenture, the multinational consulting-cum-services major, dwelt on its robust outsourcing pipeline, led by its management consulting practice. The company, which has 13,000 management consultants, is expected to nearly double its size over the next three years. Some part of this growth is likely come from low-cost, highly skilled locations such as India.

Similarly, SAP, the business management software company, has turned in weaker-than-expected earnings, though its software and software-related revenues have been fairly strong.

Similar views were echoed by the frontline domestic players. Take, for instance, the response of the top management of HCL Technologies in the latest conference call. Asked specifically about the slowdown, its President, Mr Vineet Nayar, said: "Am I concerned about the slowdown in America? The answer is no. Because we have polled our customers, especially the high-tech customers, and four of the deals we announced are in the high-tech area. So, as we speak, I do not see a slowdown trend."

Most other majors also responded in similar vein. A couple, however, witnessed sluggish revenue growth in the latest quarter from the financial services segment, one of the largest spend areas for the IT industry. Given the large-scale consolidation expected in the space, concerns had surfaced on whether the segment may witness an unexpected slowdown.

Dismissing such concerns, TCS' N. Chandrasekaran, Executive Vice-President and Head, Global Sales, said: "...the BFSI segment is not experiencing any slowdown at all.

On an annual basis if we really look at it, we have gone from 1.2 billion to 1.8 billion and all our clients are growing and it will continue to grow."

LARGE DEAL MOMENTUM

Pursuing large deals ($50-250 million) is fast becoming an integral part of the demand equation and overall corporate strategy of the top five domestic software companies. And by their very nature, these deals span multiple service offerings that range from application development/maintenance to infrastructure management, and engineering services to BPOs. At least four of the five frontline firms have talked extensively about the impact of large deals on their earnings call. For instance, TCS stated that it ended 2006-07 closing twelve $50-million plus deals across major markets and it is pursuing at least 10 deals which are more than $50 million plus.

Wipro also indicated that it has won 10 $50-million accounts and its pipeline remains strong in this area. Satyam stated that it bagged three large deals during the year, with its latest five-year $200-million Applied Materials contract being one of the largest deals it signed.

HCL Technologies, which announced six large deals over the past year or so, indicated that the EBIT (earnings before interest and tax) margins are higher than the company average for these big deals. The five majors have clocked revenues of $12-13 billion and if they have to maintain revenue growth of 25 per cent plus over the next year, they will have to clock incremental revenues of over $3 billion. Clearly, these large deals will play a crucial role in keeping the growth engine humming.

OTHER GROWTH LEVERS

For frontline players, the client pipeline across different revenue buckets — ranging from $1 million through $5 million and $10 million to $50 million — is still robust. Since mining the existing clients and repeat businesses have been key indicators of predictable growth, this metric has been tracked closely by analysts and observers alike. Take, for instance, Infosys. It has increased its million-dollar clients from 256 to 275. And at the upper end, the number of $50-million clients has increased to 12 from 11; $100-million clients from 2 to 3; and it has one client with revenues of $200 million.

The contribution of new service offerings, that was an insignificant proportion of revenues two years ago, today accounts for a fairly sizeable chunk. New service offerings such as engineering services, infrastructure management, testing and BPO account for over 20 per cent to a third of revenues for frontline companies. And this basket is only set to expand in the coming quarters.

Finally, the focus on the European geography has begun to pay handsome dividends for the top companies over the past year. This has helped broadbase the overall risks.

KEY POINTS TO WATCH

While IT companies have managed to tame expectations for 2007-08, a few key variables will influence their performance. These are:

Wage inflation and attrition: While frontline companies are budgeting yet another year of 12-15 per cent offshore salary increase, they hope to offset it through better utilisation and productivity increases. As supply challenges increase at the bottom of the employment pyramid in terms of recruitment of freshers, employee utilisation will be a metric that will be watched carefully in the coming quarters.

Billing rates: Though companies continue to maintain an upward bias to billing rates, it will be interesting to watch if this trend pans out as expected. This can offer some positive upside in some cases.

Client pipeline: While the top-ten clients have been firing on all cylinders for the frontline majors over the past year, the growth of non-top ten clients also needs to be monitored closely. In an unanticipated slowdown, they will hold greater scope for increased volumes and protect margin growth.