The Hindu Business Line : Ahead of Infosys numbers... Still a foggy outlook

As the software bellwether and a credible source of financial guidance vis-à-vis its frontline software peers, investors will be waiting for the pronouncements of the Infosys management to discern the industry's future direction.

Since its admission to pricing and margin pressures in early April, while providing the financial projections for 2003-04, the valuation and institutional/retail investor's fancy for the software sector has taken a knock.

The question foremost in the investor's mind is: Have the fundamentals of the sector changed to warrant an immediate re-rating? In order to gather a better perspective of developments in the sector in the past quarter, the key variables are:

The potential triggers

Iraq war and SARS: The dreaded combination of the Iraq war and the SARS (Severe Acute Respiratory Syndrome) outbreak in February/March was expected to slow down client visits and affect corporate travel in a big way. In turn, it was predicted that it will delay decision making by US corporates, change technology spending patterns and reduce offshore outsourcing to countries such as India. Mercifully, both risks have been short-lived ones. Though client visits and corporate travel resumed and confidence in the US economy has been restored to some extent, the tight rein on tech spending by corporates has not yet eased.

Strategic outsourcing: The momentum for offshore outsourcing has not shown any signs of slackening in the past quarter. For that matter, both the deal sizes and quality of RFP's (request for proposals) have only improved for frontline software companies. With growing fears of an outsourcing backlash from the US, frontline companies have turned quite cagey about announcing client wins and revealing their names over the past few months.

Though the "volume based" revenue growth story is likely to remain intact, competition and billing rate pressures are expected to take a toll on margins across the board.

The lingering concerns

IT spending: Several research outfits, such as Gartner and AMR Research, and CIO Surveys by analysts such as Merill Lynch have predicted a flat year for IT budgets. There are indications that even if the US economy recovers, IT spending may lag. If the IT spending remains flat, it is likely to strengthen the hands of the fence-sitting CIO's who overrate geopolitical concerns and fear loss of control. The flat IT spending may also keep the sales or decision cycles (from the start of an RFP to the clinching of an order) between six and12 months in 2003, almost the same range as in 2002. This will also have an impact on client ramp-ups which may be slower than anticipated.

Pricing pressures: There are indications that a couple of clients of frontline companies have renegotiated rates downwards. So, the billing rate pressures are unlikely to ease in a hurry. It is likely that pricing pressures will continue as three key elements of the pricing equation have not changed the past quarter.

One, both the American and European majors are exploiting their outsourcing deal size and improved understanding of the offshore business model to drive down the billing rates. Two, since cost cutting is the primary focus of US companies, a lot of application development work (which would otherwise command "premium" rates) is getting bundled with application maintenance work and the pricing is being pegged to maintenance work. Three, the outsourcing consultants, such as Technology Partners International, are slowly beginning to participate in RFP's and narrowing the pricing premium in these contracts. As new projects get signed at lower billing rates, any near term scaling-up of the project will only accentuate the impact of these pressures.

Global vendor squeeze: Global vendors, such as Accenture or IBM Global, have continued to aggressively rampup their Indian operations to compete with Indian frontline companies in the past quarter. Though the success of Accenture has been somewhat muted so far, the players have maintained the pressure on billing rates.

These global vendors have been able to match or even undercut the rate quotes by frontline Indian companies. This aggressive competition is forcing Indian vendors to get selective in choosing customers and also sacrifice volumes in favour of margins.

Onsite-offshore mix: Some reports seem to indicate that Indian companies are on the fast track towards shifting from a 50:50 onsite-offshore mix to a 30:70 mix, with a view to improve margins. Over the last few quarters, for most frontline companies, with a sharp rise in package implementation work and consulting in a small way, the onsite component has been on the rise.

Since package implementation continues to be a lucrative source of revenues, this switch in the onsite-offshore mix may take at least a few quarters. Till then, the operating and net margins are unlikely to perk up sharply.

On balance...

These variables clearly show that margin pressures for frontline software companies are here to stay. If we add the fears of an outsourcing backlash (of which L1 regulations may be a precursor) and rupee appreciation to this, a potent cocktail is complete. In this backdrop, Indian software companies may prefer to adopt a cautious wait-and-watch approach and maintain the status quo at the end of the first quarter.

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