Time for fresh moves

Krishnan Thiagarajan

SOUNDS unfamiliar? Well, in over three years of boundless opportunities for the software services sector, terms such as this were scarcely uttered in the corridors of software companies. But for the first time, after the reality of slowdown in the US reared its ugly head in October 2000, these relatively unfamiliar terms have embellished the earnings announcement of software companies in the first quarter ended June 30, 2001.

Sample the statements of the senior management of frontline and medium-sized software companies made during the earnings announcement for the first quarter, and the reality of the slowdown and its implications becomes obvious:

We have experienced pricing pressures from both our existing and new customers, especially in new, large-scale offshore initiatives. -- S. Gopalakrishnan, Deputy Managing Director, Infosys Technologies

We have phased-out the joining schedules of campus recruits to align them with our business requirements. However, our plans for adding 1,500-2,000 employees on a gross basis in fiscal 2002 remain unchanged. -- K. Dinesh, Director, Human Resources, Infosys Technologies

In the current environment, we had the option of using price plays for getting volumes versus tougher and long term beneficial approach of focussing on value, leveraging our technology skill sets and Six Sigma quality approach to delivery. We chose to pursue big deals competing with the Big 5 and large system and telecom integration companies. -- Azim Premji, Chairman, Wipro

New customer acquisition is going to be more difficult and hence customer retention and expansion of the customer is the key strategy ... - Som Mittal, Managing Director, Digital Equipment (India) (rechristened as Digital GlobalSoft).

As the earnings season for the first quarter draws to a close, most of the software players have heaved a big sigh of relief. But from the earnings downgrades and the steady stream of adverse news from the US and Europe, it is becoming obvious that the next two quarters may hold the key to the future direction of the software industry in India.

Over the past quarter, the valuations of both frontline and medium-sized companies have suffered a sharp re-rating downwards, with most of the high-end medium-sized companies trading more or less in line with commodity stock valuations. Although offshore outsourcing possibilities remain fairly strong and compelling, from an investment perspective, investors may have to closely watch the following variables. (Although these variables are relevant to the entire software industry, they apply with greater force to medium-sized companies as frontline companies have a more structured and de-risked business model as compared to their peers in the rest of the industry.

Onsite-offshore mix

Among the Global 1000/2000 companies (particularly the US-based ones), the trauma associated with layoffs is more or less complete and the restructuring/cost-cutting initiatives has already begun in right earnest.

Since the lengthening sales cycle from US companies has been observed for well over six months, it is critical to observe the willingness on their part to undertake offshore outsourcing over the next two to three quarters. Since the future growth rate of the industry hinges on a smooth transition from onsite to offshore outsourcing by Global 1000/2000 companies, steady and sustainable increases in offshore revenues is crucial for the enduring success of the software industry.

This change in revenue mix assumes even greater significance as `scalability of development work' at competitive billing rates and higher margins are possible only through greater offshore outsourcing efforts. Any further escalation in onsite dependence may prove to be a losing proposition for the entire Indian software industry.

A recent study by the US-based Giga Information Group has rated India as the best `offshore outsourcing option' based on India's outsourcing capabilities, telecommunications infrastructure, experience and quality. This study was based on a comparison of India's outsourcing capabilities with that of China, Ireland, Ukraine, Russia, Canada and Philippines. Obviously, if India has to capitalise on this lead (which may remain in the short run only), it has to offer a value/delivery proposition which will help aggressively translate most of the existing onsite work offshore.

Fixed price contracts

If the Indian software industry has to protect its operating margins and enhance its mindshare among Global 1000/2000 companies, it may have to undertake more fixed price contracts (that is, assume greater management responsibility for timely completion of projects). Not only will it hone the project execution expertise of these companies but will also provide scope for enhanced margins in the future.

At present, even the frontline companies have a fairly meagre percentage contribution from fixed price contracts. For instance, for Infosys Technologies, the contribution of fixed price contracts was only 28.2 per cent of its total revenues for 2000-01. For Wipro, the fixed price contracts amounted to only 16 per cent of revenues for 2000-01. Although the risk associated with fixed price contracts will be higher than the time and materials contract, it will probably be critical to future growth prospects of Indian software companies.

Enhanced SGA expenditure

For the next two to three quarters, it will be essential to monitor the Sales, General and Administrative expenditure (SGA), of frontline and medium-sized companies and relate them to the growth of overall revenues.

Most companies are making sizeable investments in enhancing marketing infrastructure across the globe and unless they start translating into higher revenues over the next couple of quarters, the staying power of some of these companies may be affected.

It will be particularly interesting to see whether investments in Europe and Japan -- considered to be difficult markets to operate in -- start yielding dividends in the short run or not. It will be the true test of the ability of Indian software companies to attain geographic diversity (specially away from the US) and cushion the sharp drop in growth rates for the year as a whole.

Client concentration

For medium-sized companies which do not have a de-risked business model, a close monitoring of client concentration levels is absolutely imperative. Although client retention is the dominant objective of most software companies in this slowdown, undue concentration on a single client raises extraordinary risks in an environment which is characterised by significant reduction in volume of business, cancellation or deferral of significant projects or even acquisitions (of clients) involving loss or restructuring of business relationships under a new management.

Credit risk

It is critical to keep a close watch over receivables and ensuring that medium-sized companies consistently reduce or keep the receivable days for the year at an average of the past couple of years. The risk associated with this variable has been significantly higher for medium-sized companies as compared to frontline companies. For instance, for Polaris Software, Mascot Systems and Sonata Software, the average receivable days at 83, 86 and 94 days was significantly higher than 58 days for Infosys in 2000-01.

Investment in infrastructure manpower

As this downturn in the US has clearly shown, unless companies are able to fully align their investments in infrastructure or capital expenditure/manpower to the requirements of free cash flows, the risks of a sharp earnings surprise are fairly high. For medium-sized companies, with relatively low free cash flows, effective cash flow management (or the balance between growth and financial prudence) will hold the key to their survival. To a large extent, the future capital expenditure plans of software companies will be dependent on the faster recovery of the US economy.