The Hindu Business Line : Receding cheer

THE software party is over. That appears to be the common refrain of practically all business magazines and newspapers over the past few weeks. Obviously, the trigger was the management guidance of Infosys for 2003-04 and the relatively indifferent revenue and earnings performance of Wipro and Satyam for 2002-03. There is a grain of truth in this refrain. After all, the fabulous returns which the software sector had offered to investors between the years 1995 and 2000 may be well and truly behind it. And in several respects, there is a growing recognition among investors that this sector has gravitated from a `low-risk— high return' to a high-risk— high return' paradigm.

Key implications

Nevertheless, this changed perception of the software industry is likely to have three key implications:

Going forward, the shareholding pattern in frontline and other software companies is likely to be skewed further in favour of institutional and high net-worth investors. Risk-averse investors may exit the sector altogether. And that will definitely help reduce the stock price volatility in tune with the risks inherent in stocks in this sector.

For the next year or so, this sector will remain a volume play, with margins coming under intense pressure. But playing the volume game will be beneficial for the frontline companies as it will help them polarise business volumes (in the form of large RFPs) towards them and away from the second and third-rung software companies.

In the medium term, frontline companies can consciously make attempts to move up the value chain and enhance their range of services through organic and inorganic (through acquisitions) means. Once the current churn in the price earnings multiple of software companies stabilises, it is likely that the investors' fixation with valuation will ease and that will help the sector make some strategic and long-term choices for growth.

Focus on metrics

Over the next couple of years, the earnings performance of frontline software companies will have to be evaluated on a different set of parameters, in addition to greater rigour in some parameters which were used in the past. Some of the operational metrics which will assume increasing importance will be:

Pricing pressure: At least till the end of calendar year 2003, the focus of the industry will remain on this key metric. This metric is significant from two standpoints: One, it will help to highlight whether pricing pressure is intensifying or stabilising for the frontline companies in the industry. Since a spate of volume discounts and price re-negotiations have served to dampen the market sentiment for the sector in the fourth quarter of 2002-03, the offshore pricing has to be closely monitored in the coming quarters. Two, it appears that pricing stability will occur only when there is a revival in application development spending or new initiatives which command better price points in pricing negotiations. However, if pricing pressure continues, it will be an indication that application development work is being bundled with application maintenance and the pricing is based on maintenance work.

Quality of work: In these turbulent times, it is likely that frontline software companies will capitalise on opportunities in their core operations of application development and maintenance. In a large measure, this will be reflected in a higher percentage of fixed price projects being undertaken by these companies over the next few quarters. For the year 2002-03, all the three frontline players, Infosys, Wipro and Satyam enhanced the contribution of fixed price projects to their total revenues. At 37 per cent, Infosys recorded a 6 percentage point improvement in the contribution of fixed price projects in 2002-03 vis-a-vis 2001-02. Over the same period, Wipro's fixed price contribution at 34 per cent, was 6 percentage point higher and Satyam's at 29 per cent was around 2 percentage point higher. It will be interesting to examine the rise in fixed price projects along with an evaluation of risks on this front.

Monitoring acquisitions: The year 2003-04 may finally be the year of mergers and acquisitions (M&A) for the Indian software industry. Actually, there may be no big-bang acquisitions, but mainly acquisitions which will help position the frontline players to move up the value chain, strengthen domain expertise or expand across geographies. So far, Wipro (with four acquisitions in the last six to nine months) and HCL Technologies have been the only active players on the acquisition front. Recently, Satyam has also indicated that this year will be a year of M&A for them. Infosys probably, with the disappointing experience of making strategic investments in the past, may be slow to kick off in the acquisition arena. Monitoring acquisitions from the standpoint of employee retention, revenue per employee, client accretion, return on capital employed parameters and contribution to overall revenues will assume greater importance, going forward.

Rupee appreciation: Both Wipro and Infosys have admitted that the appreciation of the rupee against the dollar is likely to affect the bottomline in the coming year. As a thumb rule, it may be inferred that for approximately every 1 per cent increase in rupee, the revenue/bottomline will reduce by around 0.5 per cent for frontline companies. Atleast till the end of the calendar year 2003, till the US economy shows signs of an economic recovery, the software companies will have to contend with the pressure of an appreciating rupee on their financials.

Depth of management: As the Indian software companies attempt to move up the value chain or enhance their profile at the Board level in Fortune 500/Global 1000 companies, the depth of management will prove to be a decisive factor.

Increasingly, the frontline companies will have to experiment with induction of high fliers in different geographies, specially in the US and Europe, and evaluate based on the strength of the teams built up by them. In the foreseeable future, the need to monitor the entry and possibly exit of high-profile executives will acquire greater importance.

maverick@thehindu.co.in

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