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Software: Innovate! Innovate! Innovate!

Jun 24, 2004

In our previous article, we had discussed about the various pressures accruing on to the Indian software companies due to rising employee costs and incongruent rise in revenue per employee. The reason we had mentioned was the low contribution to these companies' revenue from the product segment. In this article, we will talk about the biggest deficiency - less initiative on the R&D front - that is affecting these companies' growth in the product segment.

The above graph is indicative of the miniscule levels of R&D expenses (as percent of sales) that Indian software companies incur in comparison with their global counterparts. For example, while R&D expenses as percent of revenues for Microsoft stands at 21%, Indian software major spends just below 1% of its revenues towards R&D. Even if we take a long-term average, say 10 years, while the figure stands at 17% for Microsoft, it remains at less than 1% for Infosys. However, one might argue that Microsoft is a pure product player with an operating system (Windows) that runs almost every second PC in the world. Therefore, the company has to invest such large amounts towards R&D to consistently upgrade its offerings. On the other hand, companies like Infosys that derives almost 98% of its revenues from software services do not need to invest such large amount towards R&D.

To counter this argument, we believe that in a globalised sector like technology, whether you are a product player or a services provider, you need to innovate, and innovate consistently. Even a services company like Infosys needs to understand technology to build its services expertise over a period of time. Take for example the high-end consulting business. If a software services company intends to penetrate this segment, high domain expertise and not cost arbitrage advantage will help it to get through.

While it is understandable that Infosys has an 'IP' (intellectual property) or an 'innovator's edge' in the project execution front, the company needs to spend more aggressive in building up its domain expertise. Now, if such an aggressive spending on R&D leads to margin erosion, we believe investors need not worry. Microsoft, even after spending large amounts towards R&D earns an OPM of 30% (10-year average of 39%). And this has become possible, as the company had sacrificed higher profitability for higher innovation in the past. And long-term investors in the company have reaped the rewards of the same.

After all, be it any business, whether a company is dispensable or indispensable is extremely critical for a long-term investor.

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