Indian software services:It is the bottomline which matters

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 basis.

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.

Companies 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.

The 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.

Other 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.

On 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.

Our 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 in FY04.