The Hindu Business Line : Dominant trends

THE valuation of frontline software companies appears linked to a combination of long-term trends and threats facing them. On the one hand, their risk-reward equations are undergoing a dramatic transformation on account of a change in business model and the valuation in future is likely to be dictated by these changes. On the other hand, long-term trends are reshaping the software landscape. The protection of the long-term competitive advantage of software companies is inextricably linked to the fund allocation by investors in software stocks, the impact of these developments on valuation may be crucial:

Listing of TCS: The software services scene could change materially if the premier software giant, Tata Consultancy Services, subsidiary of the privately held Tata Sons, were to come out with an initial public offering in 2002. The likelihood of such an event is probably fairly high as the software industry is showing signs of reaching a steady state after the turbulence in the last two years. In the run-up to such an event, it is likely that there will be a massive churning of the mutual fund/institutional portfolios as institutional participation will be the key driver. If the basket of quality stocks expands with the entry of TCS, it is likely that the portfolio rebalancing may affect other frontline stocks such as Infosys, Wipro, Satyam and HCL Technologies.

The MNC expansion brigade: Over the past few years, the captive offshore development centres set up in India by MNCs such as GE, Texas Instruments, Motorola, Cisco Systems, Hewlett Packard ISO, Intel, Microsoft and Sun Microsystems have witnessed rapid growth. According to Nasscom estimates, these MNC back-ends alone accounted for 14-15 per cent of the overall software export revenues in 2000-01. Besides these, global outsourcing majors such as IBM Global Services and EDS or consultants such as Sapient or Cap Gemini have also stepped up offshore outsourcing activity in India.

It may not be far-fetched to presume that global outsourcing majors may sooner or latter contemplate major acquisitions to secure a firm foothold in the Indian market. There is little doubt that in the short run, the presence of these majors will expand the size of the overall market for offshore outsourcing, benefiting both the MNCs and the Indian software majors. But in the long run, as the comfort level of MNCs increases with offshoring, its implications may turn out to be unfavourable. It is imperative watch closely these developments, given its strong linkages to the valuation of listed Indian frontline companies.

Swearing by alliances: As both frontline companies such as Satyam Computers (through its alliance with CSC, US) and medium-sized companies such as Mastek's joint venture with Deloitte Consulting seek the alliance route to growth, there is a growing apprehension that there may be a diffusion of the offshore market. It is likely that the market may get segmented into four parts — one will be the pure play software vendors of the likes of TCS, Infosys or Wipro; second is the MNC backends which may have an increasingly important role; third is the medium-sized players growing on the back of alliances; and finally, the niche and focussed product/service providers. As long as the software market continues to grow at over 30 per cent, this will not pose a threat. But if the markets fail to expand, a growing breed of players attacking a shrinking outsourcing pie may prove to be counterproductive to the interest of the industry as a whole.

Acquisition signals: If the frontline companies are to succeed in making a dramatic change in their business model to move up the software value chain, acquisition may be one of the vehicles to achieve this objective. To a large extent, the future valuation of these companies will hinge upon the quality of acquisitions, say in the consulting or systems integration space. With the huge cash reserves and the ADR currency available with Infosys, Wipro or Satyam, activity on this front is bound to be the trigger for future run-up in valuation.

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