Software : It is Fast Growing!

Software: It is fast growing!

Well, the quarterly ritual has come and gone, well almost! Software majors have announced their December quarter results amidst much hype and expectations. To put it in perspective, the performance has been impressive. The offshoring momentum continues unabated. But the stockmarket, as usual seems to have mixed views!

The 'Top 4' software companies continue to recruit in thousands, with TCS adding over 6,000 employees this quarter alone. The other 3 companies also saw a healthy addition, with TCS now having nearly 60,000 people on its rolls, Wipro over 50,000 and Infosys just under 50,000. Satyam also had nearly 25,000 employees on its rolls at the end of December 2005. Therefore, these numbers suggest that companies have a strong order pipeline in hand.

In terms of operating metrics, topline growth was fairly robust, both on a sequential as well as on a year-on-year basis. Margins saw an impressive expansion as well, as these players start to effectively leverage on their sales and marketing costs incurred in previous years. However, due to forex losses that adversely affected the other income component, the profit growth at the net level was not quite in sync with that seen at the operating levels, albeit healthy.

Indian IT: 3QFY06 performance…*

(Rs m)	2QFY06	3QFY06	Change
Net sales	88,944	98,270	10.5%
Expenditure	64,383	70,205	9.0%
Operating profit (EBDITA)	24,561	28,065	14.3%
Operating profit margin (%)	27.6%	28.6%
Other income	1,341	259	-80.7%
Depreciation	2,648	2,874	8.5%
Interest	10	45	354.7%
Profit before tax	23,244	25,405	9.3%
Tax	3,171	3,419	7.8%
Profit after tax/(loss)	20,073	21,986	9.5%
Extraordinary items	(10)	-
Minority interest	102	114
Profit/(loss) in earnings of affiliates	66	69
Net profit **	20,027	21,941	9.6%
Net profit margin (%)	22.5%	22.3%

* The above numbers include the results of Infosys, Satyam, TCS and Wipro.
** Excluding an extraordinary item of sale of stake in associate company by Satyam.

What has driven growth in 3QFY06?
Volumes continue to enthuse: This quarter saw a decent volume growth for all the major software companies. Wipro was by far, the best among the lot, posting double-digit volume growth for both onsite as well as offshore volumes. The fact that volume growth has been the main driver of topline growth for the past few quarters is a clear indication of the fact that the offshoring story continues to gather momentum.

This quarter however, also saw the rupee being fairly volatile against the dollar. Depreciation of the rupee early in the quarter led to topline benefits. Billing rates were flat, with companies like Wipro actually witnessing a decline. Going forward, these companies have said that they do not see too much action on this front. New clients have been coming in at 3% to 4% higher rates, and a few contracts are also coming up for re-negotiation. Better billing rates could also come from an increase in higher-end businesses like package implementation and consulting in the total business mix.

An interesting trend seen has been the slow but sure winning of larger-sized deals by Indian companies. We had the ABN Amro deal and then the DSG deal of US$ 330 m won by HCL Technologies, the largest-ever IT services deal won by any Indian software company. In such deals, which are by definition competitive, rates could be below the average rates, which would impact the margins to some extent. But winning these deals is an absolute necessity in order to sustain growth rates between 25% and 30%. Therefore, it is a sort of toss-up between growth and profitability.

Strong margin expansion: This quarter saw the 'Top 4' software companies witness a near-100 basis points margin expansion collectively. This was possible mainly due to impressive cost control as well as leverage on selling, general and administrative (SG&A) expenses by these companies. As regards a company-specific scenario, Infosys saw an impressive 200 basis points expansion, while Satyam also witnessed a near-100 basis points improvement. Wipro witnessed a strong 145 basis points expansion, despite a hike in salaries of its offshore staff. This was due to productivity improvements and cost rationalisation carried out. TCS, however, saw a marginal 11 basis points contraction in margins.

Good bottomline performance: The performance of these companies at the net level has also been enthusing, with net profits showing a decent 9.5% sequential growth. It must be said here that the bottomline did not grow at quite the same pace as the operating profits. This was mainly due to the considerably lower other income component reported.

What to expect?
At current valuations, these companies appear to be fairly valued from a medium-term perspective. But we firmly believe that, as a long-term investor, there is a lot of steam left in these companies. There is strong visibility for the top-tier companies over the next 2 to 3 years. At a recent analysts' conference organised by Wipro, the company said that NASSCOM's target for software and BPO exports is US$ 60 bn by 2010. From the FY05 levels of US$ 17.2 bn, this represents a compounded annual growth rate (CAGR) of over 28%.

While the macro-fundamentals are good, of course, one must always take into account the risks that these companies face. These include rupee appreciation, MNC competition, the emergence of other cost-competitive nations for offshoring, wage inflation and employee attrition. In the last five years, many software companies have faltered and even the likes of Infosys have had employee-related problems. So, choose your pick!