Software: Preview 1QFY07…

Source: EM

The Indian stock markets are seemingly at the crossroads. After the violent correction that was witnessed from May, wherein the BSE Sensex lost nearly 30% of its value from its all-time highs of 12,600+, the markets have witnessed a significant amount of volatility, and, more recently, this has been accompanied by low volumes as well. This is a clear reflection that the indices at present are struggling to find a clear sense of direction.

However, it is that time of the year again, or rather, that time of the quarter – when the software companies line up to announce their first quarter results! This, and the overall first quarter results of other companies, is expected to drive the near-term movement of the indices. With the software companies first off the blocks to announce their quarterly results (as usual), this is expected to drive the initial sentiment and determine the near-term course of the indices.

With the ‘BIG ONE’ slated for next Wednesday – Infosys – the markets will be keenly watching not just the results, but also what the management says about the demand environment, competitive pressures, wage pressures, employee attrition and the margin profile.

Major drivers in 1QFY07
In this write-up, we analyse major factors that are likely to influence the 1QFY07 results of the software majors.

Volumes
The industry environment for offshoring appears stronger than ever. With the increasing maturity of the global delivery model, more companies are willing to experiment with offshoring. The very fact that the ‘Big Six’ IT majors (Accenture, ACS, CSC, EDS, HP and IBM Global Services) are themselves setting up offshore centres/acquiring mid-sized software companies in low-cost destinations like India is the biggest vindication of this model.

It should be noted that generally, the first quarter of the financial year tends to be the seasonally weak for software companies. While this may not necessarily be an industry-wide trend, company-specific factors could also be a reason behind this. The client-spending pattern, for example, would impact revenues, and if the larger clients spend more of their IT budgets towards the latter half of the calendar year, this would surely result in relatively slower revenue growth during the current quarter.

In their 1QFY07 guidance, most companies expect relatively muted topline growth sequentially. Wipro expects revenues from its global IT services division to grow at 4%, while the figure for Satyam is also similar. Infosys, however, expects revenues to grow at 6%-7% sequentially. We believe that volume growth will be the major driver for these companies’ topline growth going forward. Large deal wins, such as GM and DSG, will be instrumental in enabling these companies to sustain volume growth. The billing rate environment continues to remain stable, and new clients are coming in at 3% to 4% higher rates. This quarter, the depreciation of the rupee against the US dollar and pound is also likely to give a push to the topline growth.

Margins
The margins during the quarter could be subdued, given the fact that most software companies give their annual salary hikes in April (with the notable exception of Wipro, which does this exercise in October). Visa application costs are also likely to subdue the operating performance this quarter. We believe that major levers to reduce margin pressure would be improving the mix of service offerings, improving utilisation levels, leveraging on SG&A expenses, optimizing the mix of freshers and laterals in the total employee headcount and breaking-even of subsidiaries, such as Nipuna for Satyam and Infosys Consulting for Infosys. This quarter, the favourable movement of the rupee against the dollar and pound could also help margins.

Exchange rates
As always, the exchange rate of the rupee against major currencies, particularly the dollar, will play a role in determining the performance of software companies. This time around, the rupee, as we mentioned above, has moved favourably for software companies. It has depreciated by around 3% against the key US dollar, and by 9% against the British pound. This movement is more likely to help these companies at the topline and operating margin level. However, the impact on the bottomline might not be that significant, considering the fact that these companies generally adopt hedges to reduce the impact of currency movements, which tend to be volatile.

What to expect?
As always, we have given our expectations on the major operating metrics that are expected to affect software companies during each quarter, this time around, 1QFY07. Nonetheless, we believe that, as an investor, one must take a long-term view of any business, including software. We remain positive on the sector’s prospects. Favourable industry trends, such as the increasing use of ‘strategic global sourcing’, improving breadth and depth of service lines, strong execution capabilities, increasing scalability and top quality managements are the major factors that are working in favour of the top-tier Indian software incumbents.

We continue to believe that the big players will be able to compete in high-end areas such as consulting and thus, avoid getting commoditised. The increasing trend of winning of large deals is also providing these companies with better visibility and the ability to sustain growth rates between 25% and 30% over the next few years. Nonetheless, we believe that the major risks would be in the form of wage inflation, higher employee attrition rates, particularly at the middle management levels, increasing competitive intensity and exchange rate movements.

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