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Sunday, Apr 14, 2002

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Frontline software companies -- Lessons from the returns

Krishnan Thiagarajan

THE 2001-02 fiscal turned to be the most turbulent year in the software sector's history so far. It was dejection all-round with hardly a ray of hope. For the frontline companies, the key events that dictated the course of stock prices were:

Warning from a key player: On April 10, Infosys announced that it expected its revenues to decline from over 100 per cent in 2000-01 to 30 per cent in 2001-02. That should have set the stage for a huge de-rating in the Infosys stock and the industry as a whole. But, as it turned out, a slew of profit warnings at end-December from major telecom/Internet companies in the US and Europe led to an initialmarkdown in the stock prices of frontline companies.

The second round of decline began in early February as poor performance, a spate of lay-offs and a massive dip in capital spending started to show up. Among Indian frontline companies, NIIT was the first to blow the profit-warning whistle on March 7, 2001. It indicated a lower than expected growth rate in its software services revenue from the US for the January- March quarter.

The subsequent flood: Other frontline companies remained in denial mode till the first quarter ended June 30. The first to break this deadlock was Satyam Computers. It announced a lowering of its total income to 40 per cent (followed later by two rounds of revision) . Soon, the trickle became a spate of lower management guidance. The ones to follow were HCL Technologies in August and Hughes Software on September 14.

Deteriorating global economic conditions: The deteriorating economic conditions in the US and Europe led to a virtual freeze in technology spending, elongated sales/decision cycles and slower client ramp-ups.

The combination of a slower rise in revenue volumes and the pressure on billing rates resulted in a relatively slow (even negative) sequential growth in most frontline companies. Fortunately for the industry, the war in Afghanistan showed signs of going in favour of the US by end-October and that brought hopes of visibility and stability to the revenue/earnings stream of these companies.

Move up the value chain

With no near-term crutches such as Y2K or e-commerce to prop up revenues, the software industry was forced to re-examine its business model. Its bread-and-butter activity — custom application and maintenance — accounted for less than 5 per cent of the global IT services market of $440 billion in 2001. While the potential for growth in this segment continues to be huge, several players pouncing on the shrinking pie led to a "commoditisation of these services" in the past year.

This forced players to channel their energies towards processing services, information services outsourcing and packaged software support and installation in the near term, while progressing towards IT consulting, systems integration and the high-end business process outsourcing market in the long run. But the long-run objectives will take at least 18 months to start yielding significant results and kickstart growth rates.

Analysis of returns

Business Line examined the returns logged by frontline software companies between September 21, 2001 (the day BSE Sensex and the Business Line Technology Index — part of BL -250 Index — touched their lowest levels in 2001) and April 10, 2002 to examine whether any entry/exit strategies can be evolved from the returns clocked during this and subsequent periods.

From these returns, the following conclusions were drawn:

Fear of external environment: Just as `greed' represents an extraordinary opportunity to book profits , `fear' is a good entry point for the savvy investor. Investors who took a bold call on the overall market direction, bet on the traditional strength of the software industry and invested in frontline stocks on September 21, holding them till date, were significant gainers in 2001-02.

Despite the overall uncertainty in the market, the valuation of these stocks had turned extremely attractive. The key frontline companies clearly outperformed the BSE Sensex between September 21, 2001 and April 10, 2002. While the Sensex returned 33.8 per cent during this period, companies such as Infosys, Wipro and HCL Technologies appreciated by 70.7 per cent, 99.8 per cent and 81.3 per cent respectively.

Timing is the key: Given the turbulence post-September 21, taking a bold investment call must have been beyond the grasp of most small investors. But all investors who were shrewd enough to take an exposure in the frontline stocks towards late October/early November (as the US-led war in Afghanistan began to swing in favour of the US) and hold on till April 10, would have earned handsome returns, though not as high as from September 21. Compared to an appreciation in the BSE Sensex by 16.4 per cent (since end-October to April 10), Infosys, Wipro and Satyam Computers returned 29.5 per cent, 65.1 per cent and 90 per cent respectively.

Lowered forecast, a good entry point: As growth stocks have low tolerance for earnings disappointments and even lowering of revenue/profit forecasts, these stocks are battered at such times. But following the declines, if the fundamentals are intact, they represent good entry points into such stocks. Hughes Software Systems is a good example of this phenomenon.

On September 14, 2001, Hughes announced that it was cutting its revenue growth from the 55-60 per cent indicated earlier to 25-35 per cent. In less than five trading days, the stock was pummelled by 50 per cent, representing a good entry point in the stock.

Clearly, the stock had been beaten to lower levels than the fundamentals justified. Had someone taken an exposure on September 21, the current returns on the stock would be 65 per cent. Satyam Computers represented a similar opportunity, immediately after the announcement of its revised management guidance in the third week of October 2001.

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