Software: Margin concerns

The markets termed the numbers that came out of the software sector disappointing due to the fact that the earnings reported by the software majors Satyam and Infosys were marginally below street expectations. The markets are concerned about falling margins of the software companies and therefore, their future growth in profitability. We look at how much of these concerns are justified.

Let us first take a look at operating margins for Infosys and Satyam the exclusively software companies for 9mFY03. Infosys' operating margins have declined by 4.1%. While increased software development expenses have caused a 2.4% erosion in operating margins, the company has managed to offset the impact by cutting corners. Lower general and administrative costs have helped cushioned operating margins decline by 1.1%. Thus, net, net there has been a negative impact of 1.3%.

However, the real blow has come from the company stepping up its selling and marketing expenses. The figure has shot up from 4.9% of revenues in 9mFY02 to 7.6% of revenues in 9mFY03, shaving off 2.7% from operating margins. This is the moot point. Many feel that this increase is due to competitive pressure and therefore, is a reason for concern. However, our view is that since the company is graduating up the value chain and looking at more complex tasks it is investing in sales and marketing infrastructure that is required to pitch for these mission critical projects. Thus, increase in the marketing costs is not a reason to be disappointed. This could lead to the software companies bagging significantly larger projects over due course of time and the margin erosion could be offset by significant volume growth.

But that is not to say that there is no margin pressure on the software companies. The point we are trying to make is that the pressure exists, but going forward the decline in margins is likely to be gradual as compared to expectations of a steep fall (as seen in 9mFY03). The Indian software industry has grown rapidly due to its ability to offer services at a much lower price (sometimes as low as one fourth) as compared to their western counterparts thanks to the availability of cheaper manpower. Leveraging on the cost arbitrage, the companies today have operating margins in the range of 30% plus. Initially, as the Indian software industry faced the heat of downturn in the US economy, a few players began to undercut. This triggered a price war within the industry. This made life even more difficult for foreign competition. Consequently, western software industries decided to counter the cost leadership of the Indian software industry.

Not only will the Indian IT industry's cost leadership be threatened, but it will also have to face intense competition for talent. Already staff costs for Indian software companies are as high as 40% of revenues. Increased competition from global IT services majors will be a problem for top rung IT companies that were till date the best names to work with. This will no longer be the case.

However, global IT services adopting the offshore model might not be all bad news for the Indian IT services companies. With names like IBM showing interest in offshore development the whole concept gains a lot more credibility among western clients. Going forward many companies that were apprehensive of working with Indian software companies might be more open to the idea.

Considering the low penetration of global IT services markets, there continues to be significant opportunity for the Indian IT services companies. The growth in the future will be volume based and therefore, those spending on infrastructure and people to get those volumes are likely to be the winners going forward. Thus, what appears to be a cause for concern right now, may just be the reason that brings in growth for the IT services companies. However, not all have lost margins due to spending on marketing, but largely because they were simply unable to compete. Therefore, be very careful while making your investment decision.