The Hindu Business Line : Frontline software companies — Strategising when bottomlines byte

THE world has changed considerably for the software industry in the past one month. The widely-held perception that operating and net margins of frontline software companies may be unsustainable in the medium term has slowly started turning into reality. And the trigger for this changed perception came from the management guidance of Infosys Technologies for the financial year 2003-04.

When Infosys announced a projected 11-12 per cent growth in post-tax earnings on a revenue growth of 22-24 per cent on April 10, it rattled not only software stocks but also the market as a whole. The Infosys stock itself witnessed a massive 41 per cent fall over two trading days and has staged only a modest recovery since.

The market, which was hoping for better financial signals from Wipro, Satyam and HCL Technologies, had only disappointment in store. With Wipro providing revenue projections only for the forthcoming quarter, Satyam's projections being viewed with scepticism and HCL Technologies walking out of the guidance game altogether, there was not much to read into the future from their financials.

Writing on the wall

With the benefit of hindsight, it may not be an exaggeration to say that the possibility of a `margin decline' was well-known for the software industry for the past year or so. Companies such as Wipro and Satyam has seen a steady erosion in margins for over a year now.

But the investment community was led astray by the large RFPs (request for proposals) and strong order flows which came India's way in the past nine months. And this was reinforced to some extent by indications by the frontline company managements that from the end of the third quarter of 2002-03 billing rates were beginning to stabilise. When the Infosys numbers hit the market in early April, it delivered a body blow to margins and its sustainability.

Consistent revenue growth

Despite the weak and tough economic environment in the US and Europe, Infosys has projected a revenue growth of 22-24 per cent, which essentially translates into a volume growth of 27-29 per cent (before the anticipated pricing decline). When Infosys projected a 30 per cent revenue rise for 2001-02 in April 2001 after logging over 100 per cent growth in 2000-01, in one stroke, it had moderated the entire industry growth to the 25-30 per cent range.

Since then, on the revenue front, two trends have been clearly visible. One, the larger RFPs have been bagged by the bigger players, such as Tata Consultancy Services, Infosys and Wipro and to a smaller extent, Satyam. Essentially, with offshore becoming more strategic, there is a consolidation of the limited information technology (IT) spending by Fortune 500/Global 1000 among the few frontline players.

The trend of marginalisation of select second-rung and small players has continued unabated over the past two years. Second, in an uncertain environment, the frontline companies are building greater predictability into their business models, by settling for large multi-million dollar, multi-year deals which will assure consistent volume growth.

On a margin decline

The first pillar of revenue growth has been fairly predictable so far. But the unpredictable characteristics have switched to margins, which have been on a decline on the gross, operating and net profit levels. The EPS (earnings per share) decline projected by Infosys is effectively a reflection of falling margins.

In less than nine months, the yardstick for evaluating the sector has shifted from bagging mega offshore outsourcing RFPs and rising engagement sizes to the `billing rate' and `margins' at which the deals have been struck. Stemming the margin decline presents a complex mosaic of challenges and risks which have to be managed by frontline companiesThese include:

Sluggish IT spending: The possibility of a speedy recovery of IT spending in the US in 2003 remains bleak. Several research outfits, such as Gartner, SoundView Technology Group and AMR Research, are predicting a flat year of IT spending. This essentially means discretionary spend will continue to be tight, decision cycles will remain long and client ramp-ups slower than expected. Managing these with geopolitical and other risks, such as SARS, will remain a challenge.

Billing rates and consultants: The pricing power has shifted from software vendors to the buyers over the past year and as clients ramp-up, billing is the key to margins (see accompanying story on billing rates). So far, outsourcing consultants such as Technology Partners International Inc., Gartner Consulting and probably the Everest Group or the Meta Group have been playing a fairly active role in outsourcing engagements for first-time and relatively less-mature customers to India.

So far, in large RFPs, Indian vendors, such as TCS, Infosys and Wipro, have negotiated directly with the customers. However, if these consultants start participating in these RFPs, the pricing premium and margins of frontline companies may shrink further.

Onsite-offshore mix: So far, the frontline companies appear to have managed the onsite-offshore ratio reasonably well. However, for almost all the players, with a sharp rise in package implementation work and, in a smaller way, consulting, the onsite component has been on the rise.

Any further rise in this component will put greater pressure on margins and managing this may turn out be a major challenge.

Manpower utilisation: For Infosys and Wipro, which have added 4,618 and 3,848 employees and, thereby, taking their total staff strength to 15,356 and 13,474 respectively, the utilisation rate (including trainees) holds the key to their margins. Over the first two quarters of 2003-04, the utilisation rates may slow down from the optimum levels of over 75-80 per cent in 2002-03. The third and fourth quarters will be crucial for ramping-up the utilisation for the year.

Acquisition risks: Wipro has clearly articulated that it wants to become a global players competing with the Big Three and global outsourcing majors such as IBM Global, Accenture, EDS and Deloitte Consulting. It has also indicated that operating in the current environment will only help create an Indian software factory in which margins will be eroded over a period of time.

Satyam, too, has indicated that it will also examine mergers and acquisitions as a strategy for growth.

While this strategy will help frontline companies move up the value chain, it is riddled with risks and will require closer monitoring of the companies..

Logout for now

GIVEN the uncertainty surrounding a whole range of issues — the key, of course, being margins — it may be prudent for investors to stick to their current holdings in frontline companies and contemplate using any uptrend to pare exposures.

But fresh exposures in the sector is a strict no-no for at least the next six months.

Until these companies start articulating and launching new strategies to stem margin erosion, or there are signs of an upturn in the US economy, investment in the sector may be avoided by small investors.

To compound matters, if the IPO (initial public offering) of Tata Consultancy Services happens this year, it may only intensify the churn within the sector.

For now, the IPO plans remain shrouded in secrecy.

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