While revenues of the companies in our universe have grown 17 per cent
YoY and 6 per cent QoQ in Q103, the disappointment is in the profits
which have fallen by 1% YoY and 6% on a sequential comparison. Worse,
the EBIDTA margin for our companies have fallen by 3~4% on an annualized
We believe that pricing would be the most important variable, driving
the operating profit margins.We expect a marginal improvement in
the offshore component. Utilization levels have also reached an
optimal point and could actually drop as software companies start
hiring in anticipation of ramp ups and good volume growth.
are keeping the variable component of salaries of their employees
at reasonably high levels.This could help mitigate the adverse impact
of the decline in billing rates on margins.
sales and marketing costs of Indian companies (Infosys:$1100 per
billable employee per quarter) are lower than that for US based
companies (Accenture, ($5500 per billable employee per quarter).
We believe that as Indian companies opts for large sized deals and
hires more expensive professionals, the acquisition cost of customers
would start increasing. This would result in higher sales and marketing
costs per billable employees. However, in the long term the Sales
& marketing costs as percentage of revenue may reduce, as the ramp
up of large umbrella engagements result in generation of revenue
without incremental marketing effort.
variables which would drive the EPS growth would be depreciation,
other income and the tax rate. Clearly, if prices do not increase,
thedepreciation as a percentage of sales would increase since the
productivity (revenue)/hundred square feet would be lower. We observe
that the dollar depreciation in FY02 led to a higher other income,
which proved to be a bonus for Indian software companies and contributed
to around 10% of the PAT. With the changes in sections 10a &10b,
we expect the tax rate in FY03 to go up. If the exemption is further
diluted in subsequent years, the higher tax rate may impact the
net profit margin by about 1-2% each year.
the whole we believe that billing rates would be the key to margin
growth. Companies appear to have exhausted most cost cutting options
and hence the percentage decline in billing rates would directly
impact the PAT. In the short run, margins (next 1-2 quarters) may
stabilize or marginally improve from present levels. But in the
next 3-4 years we expect the net profit margin to decline. Our sensitivity
analysis for Infosys indicates that if the company grows revenues
by 30%, the bottom line would grow by 20~22%. Going forward, we
feel stock prices of the software companies would be driven by the
growth in the EPS rather than an expansion of the PE multiple.
top picks in the sector are Infosys, Satyam Digital & MphasiS BFL.
Infosys, Digital and MphasiS are the companies where we expect the
earning growths to outperform the sector in both FY03 & FY04. The
valuation (P/E & PEG) may look demanding on FY03 earnings but looks
attractive on FY04 earnings. We expect Satyam to show higher growth