Software: What Now?

Presenting, a guide for the bewildered investor

The software industry has never had it so bad. Phenomenal growth has been replaced by a turbulent slowdown as US companies -- India's largest software market -- cut back on information technology spending. The Q1 results say it all.

What does this mean for you? Should you sell, hold or consider this a never-before opportunity to buy cheap? The Smart Investor outlines the future of the industry based on current trends to serve as a road-map. Our prediction: stick with the big 'uns.

We say this because the current uncertainty plus the need to manage quarterly expectations are forcing software companies to look at their business in a new way.

For most domestic companies, the much-hyped theory of the expected increase in out-sourcing from India and the shift towards the offshore development model has remained little more than a dream.

Though the Indian out-sourcing story built around the two competitive advantages of large resource pool and low cost has not changed, "offshore IT services" as a concept is based on the assumption of long-term business relationships with the clients.

Besides, barring large entities such as Tata Consultancy Services (TCS), Wipro, Infosys and others, most companies lack this critical criterion. "It takes lot of effort and time to get offshore development orders. Moreover, normally offshore orders have a fairly large cycle time," says Nikunj Doshi, head-research, Refco-Sify Securities.

Volumes vs price: In a bid to boost volumes, domestic software companies seem to be succumbing to the "rate" pressure. Though companies with a strong technological skill base still command decent rates in the range of about $25 per hour for offshore development work, most of the second-rung companies get low-value work and are even working on rates below $16 per hour. It is believed that even a company such as TCS acquired the recent order $75 million order from Verizone at rates well below $20 per hour.

The excessive recruitment in the last couple of years has caused a demand-supply mismatch in the industry which has resulted in a significant rise in the bench rate for most of the companies.

At the same time, customers have become cost conscious and demand more value for money. Consequently, the domestic software companies are adopting the strategy of focusing on volumes to shore up revenues.

This coupled with the slowdown in recruitment will also result in an improvement in the employee utilisation rates. This trend is visible in many Indian companies, including Infosys, which has shown an improvement of 2.6 percentage points in employee utilisation rate in the first quarter of this fiscal.

"Gone are the days when there was a huge demand and companies could pocket high margins,' says Shatanu Rudra, chief financial officer, Mahindra British Telecom.

Indeed, the blended billing rates (weighted average of onsite and offshore billing rates) for the premier software companies such as Infosys and Satyam Computers has declined by over 2 per cent in the first quarter of this fiscal.

However, Wipro, an exception to the general trend, has been quite rigid in terms of billing rates. The situation gets worse for the second-rung companies. "With new business being increasingly hard to come by, companies are aggressively competing on the pricing front," says Ravindra Datar, principal analyst and director, Gartner India.

But this might not be sustainable in the long run. That's because at the such low rates the second-rung companies will not be able retain the quality manpower that is essential to move up the value chain and survive.

On the brighter side, analysts expect the slowdown in the recruitment to substantially narrow the demand-supply mismatch. For instance, the net employee addition in Infosys and Satyam has been 116 and 210 employees respectively in the last quarter, much lower than the average addition of over 500 employees in each quarter last year. The head count at Wipro has actually declined by 139 professionals in the last quarter.

"Once the demand-supply situation improves, the rates will stabilise. This should happen in next couple of quarters," opines Hrishi Modi, senior investment analyst, Ask Raymond James Securities.

Geographical expansion: To shore up revenues, software companies have been turning their eyes to new destinations -- Europe, Asia-Pacific, Far East and Australia. Even smaller companies such as Melstar and Mastek have set-up offices in Singapore, Australia and some European countries.

Analysts believe that the geographic expansion might not be enough to compensate for the lower growth in business from US. That's because average billing rates in non-US regions are 10-20 per cent lower than US.

Thus, incremental business from non-US regions will be at lower billing rates which will adversely impact margins. Moreover, entry into new markets requires additional marketing and sales expenses -- which will have an adverse impact on the bottom-line.

This apart, US accounts for over 70 per cent of IT spending in the world (Europe and Japan constitute about 20 per cent of the global software market). Thus, unless there is improvement in the US markets, the global demand for software is expected to be subdued.

Tightening the belt: With billing rates under pressure, cost management has taken the front seat. It is clear that historical cost structures of software companies have largely been fixed in nature, though some may look like variables.

That's because once a company recruits, salaries, which account for about 50 per cent of the total expenditure, is more or less fixed in nature. This apart, sales, general & administrative expenses drive marketing, making it difficult to pare costs here either.

The challenge for companies now is to create a more variable cost structure. Companies are now talking about just-in-time recruitment, performance linked remuneration packages and so on.

The Infosys FY2001 annual report shows that business development managers have received widely varying total compensation depending on incentives -- a trend that will become more widespread.

Moreover, the annual increments in many companies has been more conservative at about 10 to 15 per cent that are again linked to the performance of the company. The 15 per cent increment for the senior management at Infosys has a fixed component of 5 per cent and the rest is linked to the performance of the company. There also is focus on curtailing travel expenses which account for about seven to ten per cent of total expenditure.

Outlook: It is quite evident that the tough times will separate the chaff from the wheat. Cracks are already visible in second-rung software development companies.

The declining enrollment for software courses have made a significant dent on the fortunes of the software training and education companies such as NIIT, Aptech and SSI. However, the leading and large domestic software companies are better placed to weather the adversities of the downturn.

Everyone linked to the sector is eagerly waiting signs of revival in the US economy. But unfortunately, there seems to be none. The CIO user survey, covering over 50 chief information officers of US-based major Fortune 1,000 organisations, conducted by Merrill Lynch in June this year expects the IT budgets of the US companies to decline by 2.4 per cent in the current year.

This in contrast to the expected tepid growth of 2 per cent by even the most pessimistic analysts. Moreover, with projects being delayed or cancelled, sales cycles are expected to remain lengthy.

Though some analysts believe that the huge interest rate cut of 2.75 per cent in the US will eventually lead to an upturn, the impact will only be visible by the end of this fiscal.

In the meantime, smaller player are expected to become increasingly marginalised while the market gets polarised towards the top ten domestic software companies in the country.

The big three

Infosys and Satyam Computer have shown roughly similar trends in the recently announced results for Q1 2002. On a quarterly sequential basis, the net revenues grew for Infosys and Satyam grew by 9 per cent and 6.6 per cent respectively.

The net revenue growth for both companies was aided by the volume growth (Infosys -- 10.9 per cent, Satyam -- 8.9 per cent) while the blended man-hour rates declined by over 2 per cent during the period. This clearly indicates that both the companies have adopted the strategy of focusing on volumes to shore up revenues.

The decline in blended rates was largely contributed by the sharp drop in offshore billing rates. In fact, for Infosys on-site rates actually improved by 1.2 per cent due to the high-value consulting and enterprise resource planning (ERP) implementation work done by the company. Going forward, both the companies have indicated that the pressure on billing rates is expected to continue during the current quarter.

This increase in volumes coupled with slowdown in recruitment has enabled these companies to improve the employee utilisation in the last quarter.

While the utilisation rate of Infosys improved by 460 basis points to 69.5 per cent, Satyam reported an improvement of 260 basis points to 71.2 per cent in its utilisation rate. For the quarter, the net employee addition for Infosys and Satyam was a nominal 116 and 210 employees respectively.

On the other hand, Wipro has so far avoided succumbing to the rate pressure. Consequently, the highlight of the company's results for the last quarter was stronger-than-expected pricing and margins but weaker-than-expected sequential volume growth.

While the blended billing rates improved by 3 per cent, Wipro Technologies' (global IT services division) sequential growth was just 0.75 per cent and volumes dropped by 4 per cent over the previous quarter.

However, the company's cost-cutting initiatives have helped improve operating margins slightly to 25.1 per cent from 24.7 in Q4 of FY01 which has mitigated the impact of the overall sequential slowdown.

Given the decline in key revenue metrics, analysts have expressed concern about the company's ability to meet the revenue growth guidance of 40 per cent in the current fiscal.

The decline in the head-count by 139 professionals during the last quarter and the utilisation rate of about 66 per cent (lower than both Infosys and Satyam) is also a cause of concern.

Further, analysts point to the company's high (30 per cent) exposure to the telecom industry. This is a point of worry because revenues from this division fell by 1 per cent last quarter, against the management's earlier assurance to analysts that telecom and Internet-working as a basket would actually grow.

Some disappointments

NIIT: With the sharp decline in the enrollment for new courses, NIIT, the leading IT training major, reported a dismal performance for the third quarter ended June 2001.

Net sales at Rs 150.59 crore declined 25 per cent while earnings plummeted by 93 per cent to Rs 5.29 crore during the period. Nor was the performance of its software services division any better.

Margins in the software services division fell from 27 per cent in Q2 to just 14 per cent last quarter. US revenues fell 33 per cent, and utilisation rates dropped from 70 per cent to 65 per cent.

The IT training and education companies has been one of the hardest hit segments of the domestic IT sector. With the marked slowdown in recruitments, students seems to have adopted a wait-and-watch approach.

Moreo-ver, the sudden changes in the demand for certain technological skills such as Java and other Internet-related technologies have confused the student community.

Some hype is being generated about .NET and C# (pronounced C-SHARP), new packages by Microsoft and others, but they are just too distant at this point of time to convince students in large numbers. Job-guaranteed courses have failed, because they actually do not lead to jobs.

Though there are signs of increased demand for basic courses like databases, core languages such as C ++ and others, the decline in profitability at the franchisee end is a worrying trend for the industry.

Meanwhile, despite the drop of 43 per cent (year-on-year) in revenues from the training business, NIIT has hinted that it will continue to expand its network and has commissioned 114 new centres in the last quarter.

As costs relating to the training business are primarily fixed in nature, the operating margins are expected to be under pressure in the near future.

Polaris: Polaris' results for the first quarter have been much below the expectations of analyst. On a sequential basis, Polaris has reported a negative net sales growth of 9.7 per cent while net profits at Rs 15.56 crore have declined by 14.48 per cent over the previous quarter.

Further, operating margins have also declined by 170 basis points to 23.1 per cent. The sharp decline in top-line growth was largely contributed by the pronounced decline in the on-site volumes (particularly from US and UK) coupled with less-than-expected revenues from the sales of its product -- Bankware. Moreover, offshore volumes have remained stagnant in the last quarter.

Compared with revenues of Rs 4.6 crore in Q4 of FY01, Bankware has contributed only Rs 1.6 crore in this quarter. However, not withstanding the performance in this quarter, the management expects to achieve the target revenues of Rs 20 crore from Bankware in the current fiscal.

Moreover, Polaris has added 8 new clients this quarter, as against 6 added in Q4 fiscal 2001. Polaris has indicated that two of these clients have the potential to scale up to the $ 5 million bracket in couple of years.

Advantage parentage

Digital Equipment/Hughes Software Given the prevailing tough conditions, the strong parentage link of Digital Equipment and Hughes Software Systems (HSS) is turning out to be a major advantage. This is in sharp contrast to the concerns raised by analysts earlier regarding the over-dependence of these companies on a single company.

In an environment where the second-rung companies are finding it difficult to get new business, both the companies have strong and steady flow of business from their parent companies -- Compaq and Hughes Network Systems (HNS).

Moreover, these companies do not have incur any marketing and sales-related expenses for the business from their parents. This also frees resources that can be utilised to build relationships with other clients.

For the quarter Q1 of FY01, Compaq contributed to about 85 per cent of Digital's revenues, down from 88 per cent in the previous quarter. However, in absolute terms, the business from Compaq rose to Rs 59.63 crore, up 135 per cent on annual basis and a jump of 7.7 per cent on the quarterly sequential basis.

Non-Compaq business grew at an exponential rate of 46.6 per cent (sequentially) to Rs 10.7 crore. Digital reported a top-line sequential growth of 12. 4 per cent to Rs 70.33 crore.

Though, on the yearly basis, net profits grew by 232 per cent to Rs 19.2 crore, the drop in the operating margins by 60 basis points to 29.1 per cent limited the sequential growth in earnings to 3.5 per cent.

On the other hand, HSS's dependence on its parent increased by 200 basis to 36 per cent in the last quarter. HSS reported revenue of Rs 63.4 crore for the first quarter of FY02, an increase of 77 per cent (year-on-year) and a sequential increase of 2.3 per cent.

Net income at Rs 18.7 crore rose 102 per cent (year-on-year) but declined by 15 per cent sequentially. Traditionally, the company has a weak first quarter.

Despite the global meltdown in the telecom sector, the company claims that it has not faced any pressure on billing rates. This could be due to the high-value work undertaken by the company. HSS has maintained its earlier growth of over 60 per cent for the current year.