Software sector -- Growth scores over value

Krishnan Thiagarajan

THE DEBATE that has raged over the part two years over `growth' stocks (that seem overpriced but hold out the prospect of a rise in values) versus `value' stocks (that seem underpriced at current levels) appears to be swinging in favour of the former.

The astounding rise in equity values (well over 55-60 per cent) of the software services companies over the past five years has made mockery of conventional valuation models. These models seem to have no significant role in a sector in which the yearly growth rates are higher than the cost of capital (or the discount rate).

Clearly, the `new economy stocks' are driving academicians and financial analysts towards new variants of conventional financial models. Thus, models such as the PEG (price-to-earnings growth) ratio have been developed to account for the seeming anomaly in valuation that defies the conventional parameters. The PEG ratio essentially uses `future earnings' as the key to valuation. But lay investors do not seem impressed with these models. The investor's problem is his inability to make a reasonable assessment whether the current market price of any of the `growth' stocks is justified. But taking the current market price as given, he has the option of arriving at the growth rate in future earnings that would be required if the current price is to be sustained. The latter alternative seems somehow more amenable to a judgment as an intuitive assessment of the required growth rate can be made (see Methodology).

As the dynamics and fundamentals driving companies in the software sector vary significantly, companies within the industry were split into four groups - frontline, medium-sized niche and bottom-rung. For this analysis, the required growth rates were examined for each segment.

Frontline companies

As the Table shows, Wipro and Infosys Technologies have to achieve growth rates of 73.9 per cent and 70.3 per cent over the next five years to justify the current market capitalisation. Prima facie, this appears stiff. But, clearly, the window of opportunity for frontline companies is extremely wide, going by the December 1999 Nasscom-McKinsey report on `The Indian IT Strategy Summit.

This report forecasts that IT services and e-business alone are expected to grow to $48.5 billion (excluding the contribution of software products and IT-enabled services) in 2008, from the $5.70 billion in 1999-2000.

On a relative scale, Infosys, as a pure software services company, is better placed compared to Wipro, with its diversified profile and forays into consumer-care and lighting. With a diversified profile, even growth rates of 73 per cent for the company as a whole will translate into a much higher growth rate for the information technology division.

A sensitivity analysis done for Infosys and Wipro at the highest and the lowest level touched by the BL Technology Index in 2000 brings out a clear picture of the risks associated with future earnings growth. At the highest level of the BL Technology Index, while Infosys had to grow at 73.38 per cent, Wipro had to clock 94.08 per cent to justify its market capitalisation. Similarly, at the lowest level, Wipro had to grow at 60.78 per cent, and Infosys at 63.42 per cent. It is obvious that the future earnings volatility is lower in Infosys than in Wipro.

The striking feature of frontline companies is their ability to use proven management skills and technical expertise to ``build scalability and pricing power'' into their financials. These attributes helped them balance growth in business volumes with an improvement in operating profit margins.

HCL Technologies and Satyam Computers, the two other frontline companies analysed, may find growth rates of 58.1 per cent and 57.6 per cent achievable over the next five years, subject to the risks that firms of this genre are exposed to. However, Mastek, which was de-rated sharply in the second quarter of this year, with growth rates of future earnings of 48.5 per cent, seems the most attractive from an investment perspective.

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Medium-sized companies still `simmering'

For medium-sized companies, the risks stem from evolving a growth strategy that balances the progression up the software value chain with scalability of operations. In meeting the outsourcing requirements of customers in the developed world, the real challenge for these companies lies in standardising the delivery mechanism through quality systems and internal processes, managing the investment in offshore infrastructure, setting up marketing offices, retention of employees and handling post-acquisition integration issues effectively.

Though there are at least 15 software companies in this segment waiting to move into the frontline group, only a few managed `scalability' and `growth' effectively.

In the study, Polaris Software, Silverline Technologies, PSI Data Systems and SSI hold promise. The higher growth rates projected (40-55 per cent) for these companies over the next five years is a reflection of their current cash earnings. Among these, Polaris Software and PSI Data Systems, with their strong focus on select domains and good management, are in a better position than SSI and Silverline.

For SSI, the education segment could prove a drag on the overall revenue growth. Even otherwise, the litmus test for SSI's software division is in scaling up revenues smoothly. For Silverline Technologies, making the American Depository Shares (ADS) offer and listing at the New York Stock Exchange amid scepticism was a major shot in the arm. But since then, handling the risks arising from client and geographic concentration, and managing acquisitions versus strategic investments appear to have bogged it down somewhat.

Niche companies in expansion mode

For Hughes Software and VisualSoft Technologies - two prominent niche companies that are still establishing themselves in this segment - the growth estimates of future cash earnings, at 60.2 per cent and 64.7 per cent, appear conservative vis-a-vis their frontline software peers. The valuations of these companies are higher as they used ``the high-risk-high-return'' strategy to achieve their objectives.

Both the companies propose to achieve this growth rate by using different strategies. Hughes Software, the subsidiary of Hughes Electronics Corporation, US, proposes to commit substantial financial resources to its product-led strategy. It aims to enhance the proportion of product revenues from around 20 per cent in 1999-2000 to around 50 per cent over the next two years.

In contrast, VisualSoft, which specialises in e-commerce, made sufficient progress in moving from a product-led strategy to a business model in which both services and products account for equal proportions of the total revenue.

Companies in their infancy

Among the upcoming companies, Sierra Optima and Kale Consultants hold promise. In relative terms, Sierra Optima appears a better choice, as it is sharply focussed on software services. As relatively small companies, they may have to use all the technical, financial, operational and marketing capabilities to ramp up and become medium-sized companies.