The software sector embodies that contradictory figure of speech - the oxymoron. It's a manufacturing business. But its products can be classified as mainly services. The business has further peculiarities. It has high fixed overheads as percentage of total expenses since there are no raw materials costs, inventories etc. It has very high depreciation and replacement costs. Unlike, say, a cement plant, a software company will actually use depreciation to replace machines every 2-3 years. Its potential installed capacity is almost literally infinite. Demand, may however, vary exponentially quarter to quarter. It's a totally human-oriented business where intellectual capital is the key. The revenues/employee ratio varies by factors of ten between companies.
It is projected to continue growing at a breakneck speed of over 50 per cent for sometime. The icing is that it is export-oriented, and has a serious competitive advantage in cheap labour. Not surprisingly, the discounts have been 80 plus.
But, it is quite possible that analysts may have gone overboard in hyping IT. It is such an unpredictable business that insiders are usually wrong about strategic direction.
There are several straws in the wind pointing to a likely slowdown in growth rates in the medium term. Indian companies are all into low end unbranded services. None of them have moved up into the high end applications and products market - where marketing and adspend would have to rise exponentially.
In 1996-97, Nasscom estimated that Y2K solutions contributed approximately 10-12 per cent of export turnover. Most Indian Software outfits are hoping to replace that Y2K revenue stream with orders generated from the Euro-currency merger. While several Indian firms have already won Euro contracts, the quanta of work is estimated not to be so large. The worldwide cost of Y2K solutions is estimated to be anywhere between $600 bn by the Gartner Group (UK) to $1500 bn by the US-based Capers Jones Research group. The wildest Euro-conversion estimates are around $60-100 bn. Nasscom estimates that the Euro may contribute $1-2bn to Indian software exports at best. Anyhow, the Euro schedule is also committed to a switchover by 2002 so it cannot be a reliable long term growth engine.
The competition is also fiercer since the Euro-conversion is more sophisticated and high end than Y2K. Cobol-trained Y2K engineers will need extensive retraining. Indian software firms also lack access to cheap forex specialists to guide programmers about trader's needs. Because the rupee has never been fully convertible, traders and forex analysts aren't thick on the ground.
Another critical input for the growth of software industry is the availability of venture capital and a tax and company law structure that allows start-ups to offer easy compensation in the form of stock options rather than cash upfront. Venture capital has not yet emerged from the womb here and the freedom to issue lucrative stock options is also very circumscribed.
The non-Y2K component of Indian software turnover is mainly derived from the American miracle of the 1990s. If secular growth in America slows, order books will be affected since 70 per cent of India's software exports are to the US. The US economy may have topped out after seven straight years of boom. In the second quarter, US growth has flattened. The labour market is tight with unemployment at a historic low and everyone is expecting an interest rate hike from the Federal Reserve to control possible inflation. That would also cut back GDP growth expectations and hurt the Indian IT industry in the short term at least.
Mirrroring those concerns, the American stock markets are also topping out. Many American analysts now concur that it is a full scale bear market. Since Indian software stocks show a clear correlation with the Nasdaq Index, Indian software stocks might start falling.
Indian analysts are going to have to factor in the chances of a contraction in growth rates even if the industry quickly adjusts to life after Y2K. While the industry will remain a major growth area, current projections may be drastically trimmed. And high discount industries slide quickly once the growth rate drops. The IT investor will have to get more selective.
The market may already have started downgrading though most analysts are still bullish. Indian IT stocks have already started reacting to the pessimism abroad about a continuing American boom. When the
Dow fell 3.5 per cent on Monday, Indian IT stocks hit downside circuits. While pricelines seem technically sound, there are some nasty negative technical divergences in background signals.
A divergence normally relates to the momentum of a price trend. A momentum indicator which indicates whether the velocity of a trend is slowing/speeding up ought to normally confirm a trend. At critical turning points, they tend to move in the opposite direction. Momentum indicators have now started hitting lower highs and lows. This is a sign of weakness - a negative divergence which usually comes up at market tops.
In addition, trading volumes have also eased which is a sign of lower demand. This could be simply due to a general recession and depressed market conditions but nevertheless it is a bearish signal. It is unlikely that software stocks will continue to hit higher peaks for very much longer and a sharp technical correction looks very likely. Investors could contemplate booking profits and getting back selectively after the correction.
We have taken a short look at six major software stocks. Since paid-up capital has changed several times for all of them, we have used net worth as the basis for benchmarking rather than earnings per share.
Infosys Technologies
The company does not have too high a Y2K dependance. Estimates of Y2K exposure for Infosys range upto 25 per cent which is below the estimated industry average of 35 per cent and well below companies like IIS Infotech (40 per cent). The company had an 1997-98 turnover of Rs 257.66 crore with a net profit of Rs 16 crore. It has an EPS of Rs 37.68 with a return on net worth (RNW) of 43.30 per cent versus a 5-year average of 37.76 per cent. The new ADR could significantly affect the return ratios since equity will expand.
The scrip moved up sharply from a base around Rs 1100 in early February 1998. It hit a high of Rs 2624 in June and then moved to a double top around Rs 2790 in mid-August. A double top is in itself a bearish signal and the scrip has since gone into a down trend that has pushed it to Rs 2462. There is apparent support at Rs 2420-2440 where the stock has rested several times.
The negative divergences show on both short and long time frames. Every
momentum indicator such as the RSI, the ROC and the Per cent R have all registered
lower tops across the Rs 2624-2798 range while the stock registered higher tops. In
the intermediate time frame Infosys may move sideways between Rs 2400-2600.
If the sideways trend is breached on the downside, the scrip could go down to Rs 2150 and possibly Rs 1900 quite quickly. By definition, the price trend must be still reckoned bullish. But the negative divergence suggests that investors should book profits and look to reenter if the scrip drops below Rs 2400.
NIIT
Another company which is low Y2K dependant. NIIT intends to avoid taking more than 10 per cent of Y2K orders in its portfolio. The company does not see this as a core area. In 1997-98, NIIT had a turnover of Rs 324 crore and a net profit of Rs 67.89 crore. It had an EPS of Rs 26.34 and a RNW of 40.71 per cent which is very close to its 5-year average of 40.08 per cent.The scrip moved up off a base at Rs 655 in early February 1998. It hit a double-top at Rs 1750-1765 in late May-early June. There was sharp correction to Rs 1080 level and subsequently the scrip has moved up again to a recent high of Rs 1690 before dropping to trade at current levels of Rs 1535. There was much disappointment his week since rumours surfaced that promoter Shiv Nadar could not sell a 6 per cent holding at market price.
The scrip showed negative divergence since late April-early May on most momentum indicators. This happened in both long and short term time frames. A drop to Rs 1300 could easily occur on the basis of price chart formations.
Pentafour Software
This company has a far higher Y2K reliance and it can expect to have to fight to retain its current position. It is also diversified into multi-media. In 1997-98, the company had a net profit of Rs 68.37 crore, turnover of Rs 284 crore. It had an EPS of Rs 40 and an RNW of 30.84 per cent versus a 5-year average RNW of 44 per cent.
The all time top came in May at around Rs 1110. Since then, the scrip has a bearish price pattern with lower tops along a -36 degree trendline. The correction has already pulled the price-line down to Rs 595. If the stock drops below support at Rs 555, it will slide to around Rs 400 at the least.
Satyam Computer Services
A fairly high Y2K dependence for the stock which has around 35 per cent of its turnover accruing from solutions. In 1997-98, the company had net profits of Rs 39 crore on a turnover of Rs 179 crore. It had an EPS of Rs 15.02 and RNW of 26.65 per cent versus a 5-year average of 28.45 per cent.
Satyam has the distinction of becoming the highest traded scrip in the market. The scrip shot up from Rs 166 in February to a high of Rs 613 in June. It then corrected sharply to a bottom of Rs 261 in July. In August it hit a lower high of Rs 556 before moving sideways with a perceptible downside bias. Its current price is Rs 463. A breach of support at Rs 450 could push the stock down to Rs 370. There is however a short term possibility of the scrip also going back to test resistance at Rs 500. Again there has been a clear negative divergence starting early May on long term charts.
Tata Infotech
Tata Infotech does not have the same overdependence of TCS on Y2K. The company had net profits of Rs 34.33 crore on Rs 324 turnover and an EPS of Rs 28.02. The RNW was at 28.92 per cent versus a 5-year average of 24.12 per cent.
The scrip moved off a base at Rs 612 in February 1998 to hit an all time high of Rs 1767 in June 1998. It corrected to a low of Rs 1150 and then created a double-top at Rs 1600. This is itself bearish. Since it is combined with a longer term lower tops and negative divergences starting in April, the scrip appears to be on the verge of a full scale correction. It could drop all the way to Rs 1150 if support at Rs 1390 is broken.
Wipro
Wipro had sales of Rs 1373 crore in 1997-98 and a net profit of Rs 108 crore. It had a RNW of 38.75 per cent and an EPS of Rs 23.5. Over 5 years the RNW has averaged at 37.76 per cent.From a late February level of Rs 525, the scrip rose to a double-top of Rs 2025 in May-June. It hit a slightly higher top of Rs 2050 in July. It has corrected back to support at Rs 1720 before reaching its current price of Rs 1793. The scrip is moving sideways in a range between Rs 1700-1850. Again there has been a spectacular negative divergence since April. However Wipro has very strong support at Rs 1585-1600 in the event of the trading range being broken.
