The 'Offshoring story': No change in the script

Source: EM

These are undoubtedly difficult times for investors in the Indian stock markets. The kind of volatility that has characterised the indices over the past month or so has led to numerous participants fleeing the markets altogether. With the ‘bearish sentiment’ currently prevailing, a number of investors have lost significant amounts of money. There have been horror stories about how people have lost their houses in this fall having over-leveraged their positions. This fall has taught many people valuable lessons (if at all they are willing to learn), and clearly shows the foolhardiness of ‘biting off more than one can chew’.

However, for longer-term investors, this seems to be a good opportunity to enter the markets and buy stocks at more reasonable valuations. This is particularly true of the software sector, which appears to be on a strong growth path over the medium-to-long term. The correction in stocks, particularly the top-tier stocks from this sector has, in general, not been as much as that in the benchmark index, the BSE Sensex. This can be seen in the chart below, with all the stocks in question – Satyam, Wipro, Infosys and TCS – having lost less than the Sensex.

We believe that the software sector is in for exciting times ahead. Let us re-examine the fundamentals of the sector to see whether the recent correction is warranted.

  • The demand environment for offshoring remains robust. This can be seen by trends that are fast beginning to characterise the global software industry. ‘Strategic global sourcing’ is one such trend, where the project is broken up by the client into various functions and each function is handed to the best-of-breed vendor in that function, who can combine strong domain knowledge, execution skills, global delivery capabilities and optimize costs. An example is the ABN Amro deal, where the infrastructure management part of the deal went to IBM, while the application maintenance part went to Accenture, Infosys, Patni and TCS.

  • A look at the top-tier software companies’ client metrics clearly reveals the ever-increasing order book size and revenue visibility, as a greater number of clients have expanded their relationships with Indian software vendors. To give an example, the number of clients giving Wipro revenues in excess of US$ 1 m annually has risen significantly, from 157 at the end of FY05 to 212 at the end of FY06.

  • A look at the sheer size of the opportunity ahead for the sector gives a clear indication that one must look at the long-term and view the broader picture, rather than the short term. Just to quote a few figures, the estimated size of the offshoring market in 2005, as per the NASSCOM-McKinsey Report 2005, was US$ 30 bn. This was against an estimated market potential of US$ 330 bn. India, with its low-cost base, good engineering and management talent, natural time zone advantages and global delivery capabilities, is best positioned to take full advantage of this opportunity. To be more specific, in our view, the top-tier firms will benefit more from the offshoring story, given their significantly larger size, scale, global delivery networks and top quality, visionary managements.

  • The very fact that IBM is investing as much as US$ 6 bn in building up its India centres is a clear vindication of the global delivery model invented by Indian software majors. Other MNC IT majors also have big plans for India, such as Accenture, which expects to have its total Indian employee headcount at around 50,000 over the medium-term. EDS’ latest move to acquire MphasiS BFL in order to get a strong ‘India footprint’ is yet another proof of this fact.

Therefore, we believe that, given the above fundamental factors, nothing has really changed that significantly in the software sector. We are positive on the sector as a whole. Of course, one must always take into account the risks, which chiefly include currency movements, wage inflation, ever-increasing attrition rates, margin pressures and competitive pressures.

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