The recently concluded fourth quarter of FY05 saw Indian software majors reporting a slower (relative to previous quarter) sequential growth in the topline and a dip in bottomline, much due to lacklustre performance from Tata Consultancy Services [Get Quote] and the appreciation in the value of rupee vis-�-vis the US dollar.

The effect was also seen on the operating margins front. In this write up, we analyse the performance of the sector (through consolidation of results of the four majors) and see what investors in software stocks can expect going forward.

About the sector

For Indian software companies, the past two years have marked a shift in demand from low-end services to high-end ones, like IT consulting, package implementation and systems integration.

Now, while Indian software companies are increasingly facing competition from global MNCs who are replicating the Indian offshoring model, the need of the hour is to rapidly move up the software value chain.

Increasingly, the demand for technology 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 when quality execution capabilities is a given attribute.

As such, large Indian IT companies that have provide a broad range of services and have proven capabilities in executing large and complex projects are likely to emerge winners. However, to maintain strong growth in the long-term, scalability and quality offerings would be the key.

What has driven performance in 4QFY05?

Positive bias for billing rate continues:  The fourth quarter witnessed the positive bias for billing rates continue as these IT companies increasingly saw higher than average billing rates from their existing and new clients.

The strongest growth in rates came for Infosys, which saw its onsite and offshore rates jump sequentially by around 1% each. On the other hand, while there was a slight improvement in offshore rates for Wipro, their onsite rates declined by around 3% QoQ.

Overall, while the change in billing rates has not been significant enough to make a major effect on the topline, volumes have continued to lead the growth in the same (the topline). For instance, offshore and onsite volumes for Infosys grew QoQ by 5% and 7% respectively. However, the growth in volumes for all the companies was relatively lower than what was seen in the previous quarters.

Particularly, the managements of Infosys and TCS have indicated that certain client specific issues have led to this marginal slowdown in offshoring volumes in the fourth quarter, something that might have an impact on performance in 1QFY06 as well. 4QFY05 also saw companies report higher utilisation levels, which were possible fallout of a lower rate of hiring in the quarter.

Margins under pressure from rupee appreciation:  While Infosys reported a margin expansion in the quarter and Satyam reported flat margins, those for Wipro and TCS contracted. However, if one were to consider margins for the full year, all the four companies have reported improvement in the same.

Increased proportion of revenues coming from offshore services, higher utilisation levels and leverage on the SG&A front have been the key factors aiding margin expansion in FY05. We believe that these factors will continue to help these companies report muted declines in margins going forward.

However, uncertainty on account of rupee-dollar movement will also have an impact on the margins. As a matter of fact, every 1% appreciation in the value of rupee negatively affects operating margins by 30 basis points (this is assuming that, on an average, 30% of costs are in rupee terms).

TCS casts pressure on the bottomline:  The graph below clearly indicates the kind of pressure exerted by TCS on the net profit growth of the consolidated entities during the quarter. The company, on account of poor operating performance and some extraordinary expenses during the quarter, reported a 34% sequential decline in net profits.

If one were to remove the TCS figures and consolidates only for the other three companies, the sequential net profit growth stands at 10%, from a negative of 7.3% as shown in the table above.

What to expect?

As per our calculations, the average P/E of these four companies -- TCS, Infosys, Satyam and Wipro -- under consideration is around 17.8 times expected EPS for FY07. This seems pretty attractive from a long-term basis.

As mentioned above, while some managements have indicated of a sedate growth in 1QFY06, investors should not base their decision on the expected performance of just one quarter. Looking further ahead, we expect these software services majors to continue on the path of a strong growth as the improvement in Indian offshoring story strengthens.

However, there is a risk to our assumptions. For the sector as a whole, the movement on the currency front is likely to be a strong factor that could affect profitability in the coming quarters.

As seen in recent times, led by pressures of a huge current account deficit, the US dollar has resumed its depreciation against the Indian rupee and other major global currencies. If this were to continue in the future, and that the rupee were to strengthen further, profitability of these companies would be impacted.

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