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Wipro: Cut exposures

Krishnan Thiagarajan

The lower-than-expected fourth quarter performance and the conservative revenue guidance for 2002-03 first quarter have created a slew of near-term challenges for Wipro's Global IT Services division. Since pricing pressure is unlikely to ease over the next six months, the company's ability to grow on the volume front, while maintaining its margins, holds the key to its valuation, says Krishnan Thiagarajan.

Mr Azim Premji, Chairman, and Mr Vivek Paul, CEO and Vice-Chairman, Wipro... Despite volume growth, tough quarters lie ahead with pricing pressure likely to continue.

WITH the technology sector in the US still turbulent, Wipro's flagship — Wipro Technologies (Global IT Services Division) — managed to just stick to its revenue guidance and turned in a profit before interest and tax, lower than market expectations in the fourth quarter ended March 31, 2002. Also, a cautious revenue guidance for the first quarter ended June 30, 2002, with only a 2.3 per cent growth to $123 million in the topline, disappointed and dampened the market sentiment for the stock.

The numbers game

For the fourth quarter, Wipro Technologies recorded a 13 per cent growth in revenues to Rs 588.40 crore and a 5 per cent growth in profit before interest and tax (PBIT) at Rs 192.40 crore. Despite an improvement in the employee utilisation rate by 8 per cent this quarter and no contribution from the systems integration project of the Lattice group, the profit before interest and tax margins declined by 2.7 percentage points to 32.7 per cent in the quarter over the corresponding previous period and a sequential decline of 1.7 percentage points over the third quarter. For the first time in the year, Wipro Technologies recorded a sequential decline in offshore pricing by 2.4 per cent and onsite pricing by 4.5 per cent, although this was offset to some extent by an 8.5 per cent volume growth.

For 2001-02, Wipro Technologies recorded a 28 per cent growth in revenues and PBIT at Rs 2,290.90 crore and Rs 785.10 crore respectively. This division contributed nearly 66 per cent of total revenues of Wipro and 90 per cent of its PBIT for the year. However, in relative terms, the performance of Wipro Technologies was less robust than of Infosys Technologies, which ended the year with a 37 per cent growth in revenues and nearly 33 per cent growth in PBIT.

The big picture

Coming close on the heels of the annual guidance of Infosys Technologies, Wipro's earnings performance for 2001-02 offers another opportunity to examine the fundamentals of the industry and do a reality check of the key parameters dictating growth rates:

* Technology spending: According to Wipro's senior management, the application development or project spending has suffered a disproportionate slowdown through the year and is likely to remain sluggish in the initial part of this year. As more and more players have jumped to the maintenance and support side, that segment got commoditised with hardly any pricing discipline among players across the board. All this supports the view of the management that pricing pressure is likely to persist for at least the next six months. And it is significant that there is nothing in the US recovery which seems to suggest that a structural change in pricing is imminent for the software industry.

* Decision cycles and client ramp-up: The senior management has also indicated that the sales cycle, which has been six to nine months in the last year, is unlikely to shrink. With technology spending not showing signs of revival, there appears no immediate traction for Wipro and its peers in the software industry. Similarly, even after the finalisation of technology budgets for the year, there are hardly any signs of loosening of the purse strings by Fortune 500/Global 1000 companies. In this backdrop, the possibility of client ramp-ups are slated to remain long and uncertain.

* Volume growth: Wipro's premium valuation in the past has largely been dictated by its positioning higher up the software value chain and its unrelenting focus on verticals. But the senior management has conceded that there has been a clear shift in its strategy over the last two quarters and Wipro has also been forced to play the "volume game'' in line with the other frontline companies. To combat the severe pricing pressure in the fourth quarter, Wipro recorded a 8.5 per cent sequential volume growth. It is obvious that Wipro is likely to play the volume game only to tide over the present crisis. If the pricing pressure persists and there is an increasing push towards maintenance and support contracts, Wipro may be forced to review its `volume' strategy.

* Fixed price projects: The Wipro management has indicated that its productivity payoffs derived from its Six Sigma initiatives are now being passed on to consumers in the form of lower billing in time and material contracts. Going forward, Wipro proposes to undertake more fixed price projects which will help it capture these productivity payoffs within the company and, thereby, improve its margins. At the end of 2001-02, fixed price projects accounted for 31 per cent of its revenues, up significantly from the previous year.

* Focus on verticals: Wipro's sharp focus on verticals appears to have paid off, especially in the last two quarters of this year. Despite a huge setback in the telecom equipment space, the company has managed to neutralise it to a large extent by focussing on the banking, financial services and insurance, utilities and embedded segments. With the R&D business segment (accounting for 50 per cent of Wipro Technologies revenues in 2001-02) suffering on account of a slowdown in technology spending, it has decisively shifted focus to its enterprise solutions segment. And its future earnings performance hinges on the success of this strategy. It has also broad-based its service offerings by setting up a healthcare and life sciences unit to address this emerging segment.

* Pressure on margins: The PBIT margin of Wipro Technologies will hinge on the easing pricing pressure, sustained volume growth and improvement in employee utilisation levels. Though rationalisation of its employees in the telecom space has been completed and new hiring may begin, near-term margin pressures remain. The strong volume growth and enhanced employee utilisation levels seems to suggest that scope for significant gains on this front may be limited. Unless it bags some major systems integration project, it is likely that Wipro Technologies may experience some margin pressure going forward. It is also pertinent that the momentum of good revenue growth offered in the form of an order pipeline in the first two quarters of 2001-02 may not be as strong in 2002-03.

Investment outlook

At the current market price of Rs 1,645, the Wipro stock trades at a price earnings multiple of 43 times its 2001-02 per share earnings. Though the stock price fell by nearly Rs 180 on Friday's trading (after the earnings performance was announced), it appears that further downside is likely. In the backdrop of the near-term challenges and possibility of further margin pressure over the next two quarters, the premium price earnings multiple has to be discounted downwards. Moreover, considering the diversified revenue profile and high price volatility, shareholders may consider cutting exposure and re-entering at declines after evaluating the performance for the 2002-03 first quarter.

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