After the rapid run over the past few months, stocks from the software sector have finally witnessed some pressure. Apart from owing to profit booking, Infosys' latest filing with the SEC (US Securities and Exchange Commission) has raised fears of Indian software companies not being able to maintain margins in the wake of rising competition from global corporations.
In its latest filing with the SEC, Infosys' management has indicated that the company might see increasing pressure on its margins in the wake of pricing pressure on some of its services, volatility of the rupee against the US dollar and wage inflation in India. The company has also maintained that in its initiatives of moving up the value chain by providing high-end services, high onsite component might also impact its margins going forward.
While the above factors have hurt the company's margins in the past, a new impediment in the form of 'expensing of stock options' is likely to put additional pressure. Infosys is required to adopt revised accounting policies with regard to expensing of stock options from the month of July 2005. And the company's filing with the SEC states that this change in the accounting policy with respect to the treatment of employee stock option grants will adversely affect its earnings in the future.
While the modalities of ESOP expensing are still in the process of being finalised, we believe that it will affect profitability of the company. This risk also applies to its peers who have been following a similar strategy of employee reward and retention. The table below indicates the effect on Infosys' net profits (based on US GAAP) if the company had applied the accounting policy for stock-based compensation (SFAS Statement No. 23).
Effect of expensing ESOPs
Reported net income
Net ESOP expenses*
Adjusted net income
% of actual
* Determined under SFAS Statement no. 23
As seen from the table above, Infosys' net profits reduce to 64.0%, 70.8% and 82.6% in the last three financial years if the respective expenses on account of ESOPs are charges to the P&L account. A similar calculation for Wipro reduces its net income to 77.0%, 63.1% and 79.2% in the respective years.
While the effect of adopting the new accounting policy is likely to be clarified by the management of Infosys in the upcoming 3QFY05 result announcements, we believe that stock options (or ESOPs), apart from being a reward mechanism, will continue to be one of the most potent tools to retain people. Moreover, while companies like Infosys and Wipro are likely to have greater challenges in maintaining their profitability growth despite the new adjustments, we believe that long-term investors should look at scalability and execution capabilities as more important factors in making their investment decisions in the software sector.
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