Back Frontline software companies — Keep faith in their growth program
Krishnan Thiagarajan
A couple of other positive signals also reinforced this view in the run-up to the earnings season. For instance, the Nasdaq-listed Cognizant Technology Solutions projected a strong revenue growth of 44 per cent and a per share earnings of 37 per cent for 2005. And the President of the North American operations of Tata Consultancy Services (TCS), also indicated that the frontline players' could grow 40-50 per cent over the next couple of years.
As a result, when Infosys Technologies announced its earnings guidance on April 14, market expectations were running high. The consensus market estimates were higher than 30 per cent for both revenues and per share earnings. However, a combination of lower-than-expected earnings guidance of about 25 per cent, a weak fourth quarter and a flat first quarter for FY 2005-06 spooked the market.
IBM missing its earnings estimates at the global level compounded this problem. Given the market's low tolerance for earnings disappointments or surprises, software stocks were hammered in the domestic market on April 15.
The market was somewhat jittery when the TCS earnings announcement was to roll out on April 19. And when the numbers turned out to be disappointing for the fourth quarter, all hell broke loose at the bourses, the stock shedding over 15 per cent in two trading sessions.
Relatively good numbers from Satyam for the fourth quarter and guidance in line with market expectations followed by encouraging results from Wipro helped the market make a near-term recovery. HCL Technologies is announcing its earnings numbers for the third quarter tomorrow (on April 25).
Altered perceptions
What has been the red rag for the software bull? Reading the Infosys and TCS earnings closely, the elements that appear to be causing concern in the market are:
Slowdown of the US economy: Both Infosys and TCS recorded flattish to negative growth in the contribution of the US geography in the fourth quarter of 2005-06. Since 55-65 per cent of these majors' revenues come from this geography, worries have surfaced over the pace of revenue growth over the year, if this were to become a trend.
At the global level, the tech bellwether, IBM, fell sharply in short-term bookings in late March, which led to lower revenue growth in the first quarter ended March. Though the management has indicated that it can recover from this slippage in the second quarter, doubts are emerging on this score. Both Accenture and Unisys Corp. have also reflected flat new bookings from outsourcing in the latest quarter.
Scale-up issues: The revenue growth of Infosys and TCS reflects a delay in the ramp-up of some clients, either on account of internal re-organisation or longer sales cycle in closing deals with existing clients or winning new ones. In the fourth quarter, the top client of Infosys grew over 36 per cent.
Leaving aside the top client, the overall growth has been muted at 4.4 per cent, after being either in the high single-digit or double-digits over the past few quarters. Some crucial issues that have come to the fore are:
Impact of dollar depreciation: The depreciation of the dollar vis-à-vis the rupee is another dread at the top of everybody's mind. Except for forward cover, companies have little control over dollar movement, but its impact can be quite harsh. Since one per cent depreciation in the dollar can shave 0.40-0.50 percentage points from the bottomline, the impact of this factor can hardly be ignored.
What continues to cheer
Even as these short-term concerns have emerged, the potential for offshoring to India remains intact. The factors that will continue to bolster the Indian growth story are:
Volumes unaffected: Going by the CIO polls and recent surveys, the momentum for offshoring is still fairly strong, across different economies. Similar strong trends are evident in the IT budgets of top global corporations.
The Accenture top management confirmed in a recent conference call that while the size of the deals has shrunk, the volume and momentum are stronger. This, according to them, will help build a "more balanced and consistent growth trajectory in outsourcing". For frontline companies, volume growth can come from two sources. One, apart from an increase in the offshore component, relatively new service lines — from package implementation, infrastructure management, testing, BPO to consulting — can drive revenue growth over the next year. For the top five companies, new service lines now account for 20-30 per cent of revenues.
Two, since new client addition over the past four quarters has not shown any loss of momentum among the frontline companies (though client churn is high), the scope for volume growth remains encouraging. For the moment, the slowdown in volume growth in the fourth quarter for the top two players may be attributed largely to company-specific reasons.
The hiring patterns of the top three players also suggests that a 25 per cent rise in employee strength is already built into the revenue growth guidance from these companies. A big chunk of that recruitment will happen over the first two quarters of FY 2005-06, early pointers of which will be available by the first quarter.
Client milestone growth: The top three companies have built up a solid pipeline of clients in different revenue brackets — $5 million, $10 million and $20 million. Even assuming that $40-million clients are switching to a multi-vendor environment to reduce dependence on the top vendors, these companies have an adequate number of clients at the $5-million, $10-million and $20-million levels to grow in line with the industry.
To top it all, there are at least three large deals on the negotiating table at the moment. Since most of the Indian vendors are actively involved, these deal flows to some or all of them can provide the upside necessary to comfortably outpace industry growth rates. These, obviously, would not have figured in the earnings guidance of any of these companies.
Upside from pricing: If these fears of a US slowdown recede, there is a good chance that billing rates may be renegotiated upwards among the top ten client accounts by Infosys, Wipro and TCS through business mix and greater offshoring. But most of this pricing upside may happen only in the third and fourth quarters.
But the trend of new clients coming in at a higher billing rate will continue as the pricing has remained stable over the past four quarters.
What could go wrong?
From a short-term standpoint, we will continue to monitor some key variables that can provide pointers to a slowdown in growth:
Corporate earnings from the US economy: Any slowdown on this front can put a check on application development work, which traditionally provides a good margin upside to vendors. The fears of a depreciation of the dollar may also accentuate if corporate earnings outline a depressing picture.
Mid-sized multinational vendors bagging large clients: If mid-sized niche players start bagging any new client accounts from the top ten clients of the frontline players, it may be a cause for concern as this will clearly show that the existing clients are experimenting with a much larger set of vendors, than in the past.
Similarly, if multinational vendors such as Accenture or IBM bag some of the large deals on offer, it may be a setback for the Indian vendors.
Billing rate/selling and employee costs: If the revenue realisation remains stable and at the same time, employee and selling costs keep going up in the next two quarters, it may begin to show up on the margins in the next couple of quarters for some of the players. It will help draw some inferences about the rest of the market.
Hedging your investment
Weighing the pros and cons of this offshoring debate, it appears that the returns from investment in select frontline companies may outweigh the risks involved. If investors have realistic expectations of 15 per cent return from these stocks over a one-year horizon, these stocks offer a good entry point.
In our view, from a valuation standpoint, Satyam, Infosys, TCS and Wipro, in that order, are good investment options. Since each of these players can spring a positive surprise in its earnings numbers for the full year, any weakness in the broad market may be used to step up exposure in these stocks.
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