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Software: Conservatism sets in!

Jun 16, 2003

Infosysí FY03 results announced on April 11, 2003 were an eye-opener for Indian investors who have been perennially bullish about the Indian software sector. While topline grew at an impressive rate, margins came under significant pressure on account of decline in billing rates. We take a look at the reasons for the pressure on margins and the likely trend going forward. Software companies have been trying to compensate for falling billing rates by trying to grow strongly on the volumes front. Since Indian tech sector is miniscule when compared at the global level, the bargaining power of companies like Infosys is on the lower side. Hence, clients are able to squeeze Indian tech companies for lower billing rates.

The decline in operating margins has to be viewed in context of the downtrend in the global economy. Fortune 500 companies are faced with a difficult situation of stagnant/declining revenues and there is a concerted effort to reduce costs. Clients of Indian software vendors are thus being forced to offer finer billing rates for existing business as well as incremental business. Thus software companies have to sacrifice margins to gain volumes.

Declining billing rates (US$/hour)
Infosys FY01 FY02 Change FY03 Change*
Onsite 62 65 5% 63 -3%
Offshore 30 28 -7% 26 -7%
Onsite 61 61 0% 57 -7%
Offshore 24 24 0% 23 -4%
*FY03 over FY02

Another reason for pressure on margins is that MNCís that have set-up bases in India are poaching the mid-management and high-tech staff of top Indian companies. This comes as a double whammy for the Indian software companies. Already staff costs for these companies are as high as around 45% of revenues. Thus, any incremental rise in personnel expenses without commensurate growth in revenues will put these companies under greater pressure. And, if these Indian companies do not retain talent through providing monetary satisfaction to its employees, attrition rates will increase.

Increasing personnel expenses (% of revenues)
FY01 FY02 FY03
Infosys 38% 43% 46%
Satyam 39% 45% 48%

While the decline in billing rates and thus margins may have come as a surprise to investors, in reality, the sustainability of such high margins have always been in question. Higher spending toward marketing expenses (mostly related to setting up development centers, sales & distribution network abroad) tends to have long-term benefits. Keeping these factors in mind, growth is likely to be volume-based. Thus, companies like Infosys that are investing heavily in infrastructure and systems have an upper hand going forward.

This downturn has been an eye-opener for not only Indian software companies but also for investors in general. In that case, investors have shown their wrath by shunning companies that are low on operational efficiencies but high on projecting unachievable growth numbers. To conclude, it is important to stick with quality companies. By quality, we mean the managementís ability to foresee trends and position themselves accordingly.

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