Software – Positive: Daiwa

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Sector thesis: low-cost outsourcing – the trend continues
If we go by the past three quarters’ volume-growth rates for our coverage universe,
we note that demand from existing and new clients has been strong. In addition, the
sales cycle is becoming shorter, and the most recent trend is that billing rates,
which were under pressure until 1Q FY11, are turning around. The Indian vendors
are witnessing a favourable demand environment, as is evident from the
improvement in the deal pipeline. Regardless of the various non-tariff barriers that
the US and EU governments may consider, the deal flow between global
companies and IT vendors in India is on the increase.



Just to drive home the point, Infosys won US$865m worth of projects in 2Q FY11,
across sectors, services and geographies. The off-shoring to low-cost economies
remains an attractive value proposition in terms of cost arbitrage, in our view, as
we do not expect the significant pool of engineers entering the system to diminish.
In addition, the wage disparity between an Indian engineer (holding an H1B visa)
and a US resident engineer is diminishing with unemployment in the US high.
Besides, vendors in India are working on various pricing models for various sets of
services, and thus we believe the overall business model will migrate from
‘efforts-based’ to ‘subscription-based’ over the next few years.
Structural outlook: three-year view
As the operating costs of global corporations in advanced economies are still high,
alternative pricing models for delivering work assignments are gaining attention
among the managements of these large corporations. Indian vendors have started to
offer pricing models that reduce the Indian vendors’ dependence on capex-led
contracts in favour of those where the unit of work can be measured and an apt
pricing per unit derived.
The shift to a pay-per-use or pay-as-you-go model (from the traditional pay-for-the
effort model) in all probability would prevent the need for frequent billing-rate
negotiations. This has been the bane for both the parties. The new pricing regimes
(which at present make up less than 5% of revenue) have the potential to move more
towards becoming variable costs (ie, instead of incurring the cost of software
development upfront, clients can pay as they go) by giving clients the chance to
fine-tune their services spend in line with their changing business needs, including the
ability to add and procure capacity without having to incur capex or upfront fixed costs.
To take the alternative pricing model (or the non-linear model) to its logical end, cloud
computing would have to evolve. However, we believe the move towards cloud
computing is inevitable for global enterprises, as this is likely to reduce the cost of
owning IT assets by 35-40%, compared with the current model of owning them on a
freehold basis. Instead of incurring capital expenditure upfront (and recurring fixed
costs), cloud computing would enable the global enterprises to migrate to a user/usage
model of spending on IT. This model would bring the spending variable in line with
the seasonal demand spikes and troughs of end-product sales.
In addition, enterprises are looking to save on the costs of maintaining facilities,
licence fees and manpower, which would be borne by the vendors. As cloud
computing reduces the cost of IT ownership, it is likely to enable many SMEs to
upscale their use of IT systems, which hitherto had not been possible as these
enterprises would have had to incur costs upfront. Thus, along with existing large
enterprises’ spending shifting to cloud computing, we believe many small and
medium-sized enterprises would look at the global outsourcing market, which
would in turn benefit many Indian IT vendors.



Best-positioned: Tata Consultancy Services
We believe TCS is best-positioned to accelerate its US-Dollar revenue growth in
excess of 25% YoY for the next couple of years, as it has put in place various
revenue-growth initiatives, keeping in mind the needs of clients in various sectors.
Its entry into aeronautics and automotive engineering is likely to be the future
revenue-growth driver. Among its peers, it has the highest proportion of revenue
from fixed-price projects, thus its ability to offer alternative pricing to clients
should be much easier. It has a well-developed roadmap for rolling out its
cloud-computing strategy by targeting SMEs, and is rolling out its cloud strategy
with 50 odd clients on an experimental basis.

Worst-positioned: Patni Computer Systems
In terms of revenue growth, PCS has been a laggard, and going forward, we expect
the company’s revenue growth to be significantly lower than that of most of its
peers, as we are concerned about its ability to add clients and mine existing
customers. In our view, the main problem the company is facing centres on
published news reports that management may be planning to sell its stake to a
strategic buyer. Thus, we believe many prospective clients are not keen to work
with PCS, as they would not want any discontinuity after project initiation. In
addition, this has led to a lot of attrition in the recent past, which has had a negative
impact on its EBITDA margin as: a) high attrition leads to cost and time over-runs
of projects under fixed-price contracts, and b) the lower utilisation rates lead to a
reduction in operating leverage.