The Hindu Business Line : On a flat note...

THE market sentiment for frontline software stocks has remained tepid, despite a healthy earnings performance for the third quarter of 2005-06. Most of the frontline stocks had run-up sharply in the homestretch to the earnings announcement. The exception to this trend was Wipro, which surprised the markets with a robust third quarter.

The prognosis for the fourth quarter has, however, not been too encouraging, whether it is the relatively weak fourth quarter guidance by Infosys or possible margin pressures for Tata Consultancy Services stemming from integration of Tata Infotech and the UK-based Pearl Insurance. As the quarter progresses, some of the key variables that could influence market sentiment are:

Peek into earnings guidance

Among software companies, the Nasdaq-listed Cognizant Technologies will be the first off the block to offer earnings guidance for calendar 2006 on February 9. Going by past stock price trends, a favourable guidance by Cognizant (with its largely India-centric operations) has triggered buying interest across Indian frontline companies in the software sector. For instance, in early February 2005, Cognizant's upbeat guidance had fuelled the Infosys, Wipro and Satyam's ADRs (American Depository Receipts) by 5-12 per cent in two trading days, with Infosys leading the pack.

However, it will be interesting to watch if this trend still holds good, primarily because the gap between forecast and actual guidance for Cognizant has narrowed in calendar 2005. Based on the present guidance for calendar 2005, it is expected to end the year with a revenue growth of 50 per cent at $881 million and per share earnings growth of 40 per cent at $1.03. Though this growth is higher than the 44 per cent and 37 per cent projected at the start of the year, it is not a significant jump. Especially in the light of calendar year 2004, when the company started with a projected revenue growth of 40 per cent and ended with a growth of 60 per cent.

A similar trend is also discernible in the guidance of Infosys Technologies. It is expected to end with revenue growth of 33 per cent and per share earnings growth of 31 per cent in 2005-06 compared to the forecast at the start of the year at 25 per cent and 24 per cent, respectively. In 2004-05, Infosys had started with revenue forecast of 24 per cent, but ended the year with a growth of 46 per cent.

Intuitively, it appears that a strong guidance from Cognizant will move the stocks up across-the-board, but nowhere near the rise seen in 2005. But a weak guidance may trigger panic in the markets, as Cognizant's revenue base at under $1 billion is less than half of TCS, Infosys or Wipro.

Large contract wins

The buzz surrounding new large-sized contracts got a pep-up with HCL Technologies recently announcing a five-year $330-million contract with DSG International. It has also indicated that one more large deal is in the offing, which may come through in this quarter.

If the growth momentum has to be sustained by the frontline companies at over 30 per cent, these large-sized deals (in $50-300 million bracket) will play a crucial role. Not only in terms of providing stability to revenues, but also to help nurture client revenues above $50 million. Though companies such as TCS and Infosys have about 5-7 clients with a run rate above $50 million, taking it to a significantly higher level from here is said to be difficult.

More so, as existing service lines such as application development and maintenance and low-end R&D services are already heavily penetrated and may not grow in line with the overall industry growth. Clearly, the newer service offerings such as infrastructure management, testing, non-voice BPO or consulting hold the key to future growth.

Recognising this element, in the latest quarter, Infosys announced that it had launched a new programme called large account development, which will be mainly focussed on customers above $50 million and the strategy to further grow them to the next level.

According to the global sourcing advisory, TPI, 83 per cent of the offshore contracts were competitive and the Big Six (IBM, Accenture, EDS, CSC, HP and ACS) share in this market is falling steadily. The latest TPI Index shows that in the TPI-advised deals between $50-200 million, the win rate of the Big Six has dropped to 58 per cent in 2005 from 83 per cent between 2002-04. Even if some of the large deals turn out to be margin-dilutive for Indian frontline companies, a steady flow of such deals is bound to create the next leg of opportunities in deal sizes above $200 million.

The uncertain variable

Though there are no indications of changes in taxation, the Budget can throw up some surprises for the software sector in end-February. The only uncertain variable will be the rollback of the tax deduction under Section 10A/10B, which provides for tax holiday to software technology parks (STP) till 2009. However, a couple of years ago, the Budget had reduced this deduction from 100 per cent to 90 per cent, but restored it to 100 per cent in the following year. Any drastic change of this kind or any negative surprises on fringe benefit tax introduced last year is bound to have an adverse impact on market sentiment.

Based on the current policy regime, in order to reduce the tax impact, frontline companies are moving a bulk of new business to STPs that have tax shelter till 2009. And by the year 2008, they also plan to shift a big chunk of their incremental software revenues to Special Economic Zones, which will be 100 per cent tax-exempt for the first five years and 50 per cent taxable for the next 10 years.

maverick@thehindu.co.in

Picture by Paul Noronha