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Krishnan Thiagarajan

DOES the run-up in the software stocks earlier in the week suggest a sharp re-rating of the frontline players in the sector ahead? The trigger for this question stems from the Nasdaq-listed Cognizant Technologies' revenue and per-share earnings guidance of 44 per cent and 37 per cent for calendar 2005.

Cognizant, with its largely India-centric operations, has suggested that its revenues will grow to $845 million (44 per cent growth) and that its employee headcount would rise to 22500, a growth of 47 per cent, matching the projected revenue growth.

Fuelled by this earnings guidance of February 10, Cognizant's stock marched up 24 per cent at Nasdaq in two trading days following this announcement. And, it also perked up the Infosys, Wipro and Satyam ADRs (American Depository Receipts) at Nasdaq/NYSE by 5-12 per cent, with Infosys leading the pack. Trailing the surge in the ADS, the stocks in India also factored in this change to a large extent.

Cognizant's guidance clearly confirms that the demand environment for software services will be fairly strong and a robust year lies ahead for the software services sector. But, in our view, the possibility of a measured and sedate change in the PEM (price-earnings multiple) outweigh the chances of a sharp re-rating in software multiples.

First, through its earnings guidance, Infosys Technologies has managed investor expectations better and sustained it longer than any of the other software players. When it stands up to announce the earnings guidance on April 10 for 2005-06, it is unlikely to shed its conservative stance of the past. Both Infosys and Cognizant have exceeded the earnings guidance by a long chalk, but this may not necessarily be the future trend as well.

For instance, in calendar 2004, Cognizant started off projecting 40 per cent revenue growth and after revising the outlook a couple of times, ended the year with actual growth of about 60 per cent.

Similarly, Infosys also started 2004-05 with a guidance of 24 per cent growth in revenues (and 20 per cent growth in EPS), but by the first quarter it had substantially revised its guidance to 39-40 per cent and to 46 per cent in the subsequent quarters. Ditto for EPS growth.

Second, Infosys may remain conservative in the earnings guidance, probably in the 30 per cent range, because several variables are not within its control yet:

Greater competitive intensity: As IBM and Accenture have stepped up their headcount and delivery resources in India in a big way and with the listing of TCS and Patni, the competitive intensity in the software sector has gone up sharply. As growth stocks by their very nature have little tolerance for earnings disappointments, Infosys will face greater pressure to meet investor expectations than in the past.

Billing rate upside: While all frontline companies have indicated that billing rates are fairly stable, with new clients coming in at a higher billing rate, the upside from existing clients has not manifested as yet. As existing clients continue to account for a bulk of the revenues of frontline companies, this upside alone will provide greater comfort to upgrade the earnings numbers.

As American companies have launched into a frenzied merger wave, after three years of quiet, the implications for IT spends and billing rate negotiations are as yet unclear.

According to Fortune, from November through January, US companies have announced 48 deals of $1 billion or more, totalling to $357 billion. Some of the big mergers are SBC Communications acquisition of AT&T, Sprint's merger with Nextel and P&G's acquisition of Gillette.

New service lines: Starting from a small base, practically all frontline companies are moving into new service lines such as remote infrastructure management, process consulting, engineering services or BPO. While the potential for growth from these segments is immense, the predictability of revenue streams will be lower, for the purpose of earnings guidance.

Similarly, application development that has been a strong growth driver for some of the frontline companies in the past year, on account of pent-up demand, remains quite difficult to predict and factor into revenue projections. The Wipro management has also indicated that demand for specific engineering services may slow in 2005 compared to 2004.

Foray into Continental Europe: A combination of aggressive selling and marketing expenses and focused acquisitions is likely to mark the foray of frontline companies into Continental Europe this year. As this is a difficult market to penetrate, earnings projections (with the exception of UK) are likely to remain quite conservative for most companies.

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