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Indian IT: Meet the leaders!

December 08, 2004 15:18 IST

The financial year 2004-05 till date has clearly belonged to the large cap software stocks. Be it their financial performance or (consequently) their stock's performance in the markets, the Indian IT behemoths (read Infosys and Wipro) have surely stolen the show from their mid-cap peers (See chart below).

He we look at some of the reasons that have contributed to this 'widening of gap' between these companies.

In light of backlash in the US and certain regions of Europe against offshoring of IT services to low cost countries like India, there were certain apprehensions built up in the initial part of the fiscal.

Over that, political uncertainty also played its part in dampening investor sentiment towards equities, software stocks including.

However, these tensions eased on account of managements of these companies coming out and mitigating fears about the outsourcing backlash. It was indicated that the Indian offshoring story was here to stay and, sooner or later, sound economics was to take precedence over political rhetoric.

The leaders. . .

This was indicated in the strong volume growth reported by Infosys and Wipro in both, the first and the second quarter of the fiscal. As a matter of fact, onsite and offshore volumes for Infosys grew QoQ by 7% and 17%, respectively, in 2QFY05.

Also, the fact that these companies are getting higher than average billing rates from new clients, has led to improvement in their financial performance. Another important factor to be considered for these two majors is the faster growth in revenues from key services that generate enthusiasm about the recovery of global technology spending.

For instance, Wipro has witnessed decent growth in R&D services segment that had seen the biggest hit during the past years of slowdown. Growth in this segment indicates that clients that had reduced spending towards new R&D initiatives, have been moving on a fast track in the recent quarters.

These companies have performed well on the margins front as well. Scale benefits from investments made in the past have been a key factor in helping these companies maintain (and grow in case of Wipro) margins in 2QFY05.

. . . and the laggards

Now, while performance of the leading players enthuses, those from the mid-size segment like MphasiS, i-flex and Hughes concerns.

MphasiS, for example, continues to perform poorly on the organic software services front. In the latest quarter, while revenues from software services grew QoQ by 10%, much of this growth (around 8%) was accounted for by Kshema Technologies, which MphasiS had acquired in FY04.

In case of Hughes, the product business continues to ail. In a recent meeting with us, the management indicated that it is expecting strong demand from the Voice over Internet Protocol (VoIP) technology space and this is the area where the company is likely to have most of its product and service offerings.

While the effect is already being seen in the non-HNS (Hughes Network Systems) services space, the product business is still to attain momentum.

This is a cause for concern as continued spending towards product R&D without consequent returns might put pressure on the company's profitability going forward.

Finally, in case of the banking product major, i-flex, growth in revenues from the product segment slowed down in 2QFY05. Now, while the services segment posted strong YoY growth of 72%, it must be noted that this business has low margins (17%) as compared to the product business (45%).

A rising contribution from the services segment will, thus, put pressure on the margins of the consolidated entity.

Overall, while we are positive about the company's long-term growth prospects, continued pressure on profitability due to high investments might lead to volatile performance, thus impairing valuations.

Conclusion

While we are optimistic about the Indian offshoring story gathering pace, as more and more global corporations vie to improve profitability through outsourcing to low cost-high quality destinations like India, we believe that the biggest beneficiaries will be companies that have proven execution capabilities and scalable businesses.

We are also of the belief that, as offshoring becomes mainstream, demand for technology solutions is likely to be more guided by the 'return on investment' factor, i.e., how much of cost saving or return on investment can be obtained by clients from their IT spending.

And in that case, a few large players are likely to be the biggest beneficiaries.

Now, while this is not to deny the importance of niche and focused players who have a very important role to play in the growth of the Indian software industry, risks are relatively higher.

Equitymaster.com is one of India's premier finance portals. The web site offers a user-friendly portfolio tracker, a weekly buy/sell recommendation service and research reports on India's top companies.