Should software stocks be so soft?

Computer software is India’s fastest-growing and most competitive industry. The global recession of 2001 sent most technology companies the world over into a tailspin. Yet the Indian software industry kept growing by 25 % annually. This was slower than the 40% growth rate earlier, but nevertheless very impressive in difficult global conditions.

You might think that software companies of such proven resilience should be stock market stars. Instead, their market prices have crashed. Wipro trades at one-tenth of its peak 2001 price. Now, a crash from the stratospheric levels of 2000-01 was understandable as the global recession set in, coinciding with the Ketan Parekh episode. A second crash occurred after 9/11, but was followed by a bounce back. What few investors anticipated was yet another crash, this time from relatively low levels, last month. The war with Iraq had gone better than anybody could have expected, Iraq’s oil wells were not blown up. Even so, software stocks crashed after Infosys revealed the depth of problems facing the industry.

How do we explain the paradox of rising global reputations and revenue but falling market prices for software companies? I think we are witnessing the last stages of the bursting of the technology bubble of 2001. Software started as a high-tech area, but is being transformed by competition into a commodity. Staggering profit margins originally obtained by displacing US software are giving way to ever-falling margins, as newcomers develop the ability to keep undercutting the big companies. Besides, all global majors have now set up subsidiaries in India, realise how low-cost operations in this country can be, and so insist on ever-lower prices. This downward pressure on margins probably has some way to go still. The net profit margin for major software companies has come down from 35% to around 25%, and could ultimately fall to 15%, which is still a respectable margin. Specialist product companies like I-flex (banking software products) or Kale Consultants (airline software products) will be able to command much higher margins, because their products cannot be replicated by every Tom Dick and Harry. But computer services, the bread and butter of the industry, are going to fetch the sort of margins that bread and butter do.

In sum, the software industry will experience rapid sales growth but modest profit growth. That will be excellent for the economy, but not quite so good for investors.

The bad news does not stop here. Investors now need to factor in a new development. US accounting rules are going to change to make the issue of stock options an expense in company accounts. So far, companies have treated stock options as a footnote item, outside the regular accounts. A debate still rages in the west on how to value stock options. The Black-Scholes model favoured by economists has come under attack. Possibly stock options will be expensed but then marked to market in balance sheets, rather like securities held by financial institutions. Europe too has decided that stock options must be treated as an expense. Within the next year, expect global agreement on a new way to expense stock options.

Indian companies will have to fall in line: their industry is too globalised for them to resist. Sebi will probably insist on such a change. This will hit Indian balance sheets hard. According to one report, Wipro’s profits will fall by around 25% if the Black-Scholes method of expensing is used. Other companies may suffer as badly. This shows that the profitability of software companies has long been artificially inflated by dubious accounting, and investors must now wake up to this reality.

Critics point out that stock options become worthless if the share price does not rise. So what Black-Scholes shows initially as a major expense may ultimately cost the company nothing, and should be written back into the accounts as profits. True, but that will happen only if share prices stagnate, and so will be cold comfort for investors. If share prices rise, the cost of options will rise disproportionately higher, constituting a progressive tax.

Yet another gloomy factor for software companies is the rising rupee. In earlier years, rupee depreciation boosted software profits artificially, and now the process is in reverse gear. Consider a company with exports of Rs 100 and domestic expenses of Rs 80, leaving a profit of Rs 20. Suppose now that the dollar falls 5%, reducing export value to Rs 95. Net profit will drop from Rs 20 to Rs 15, which is a drop of 25%. See the problem? A 5% change in the exchange rate can translate into a 25% change in net profit. The impact will be reduced to the extent a company’s expenses are also in dollars, as is the case with onsite work. But increasingly work is being done in India, involving expenses in rupees rather than dollars.

Rupee appreciation has hit software company results in recent quarters, and will continue doing so. Software and BPO exports should keep rising by 25-30% a year, and could cross $60 billion by 2010. Such a huge export boom will tend to keep strengthening the rupee. The faster software exports grow, the more the rupee is likely to appreciate, so the more profits are likely to be hit. That’s the irony.

Finally, the tax-free status of software is unwarranted, and must surely end soon. Here is an industry that is world class, with zooming exports and high profitability relative to old economy companies. No longer can software be regarded as an infant industry: it has grown up into a prize athlete. Taxation is inevitable, and will further trim the bottom line.

In sum, the market has sound reasons to downgrade software stocks. The best software companies will outperform the market, but the sector as a whole may not. Remember the basic maxim of market economics that competition benefits consumers over producers. Software too is subject to this basic rule.

What do you think?