In order to gauge a company's profitability, the bottomline is the first things many investors look at in the profit and loss account. While net margin is an important indicator, it fails to provide a clear picture of the bargaining power of the company (both with the customers as well as with the suppliers).

This in turn, dictates operational efficiency. Here is where operating margins come into play. In this article, we take a look at the trend in operating margins of key Indian software companies over the past five years (FY00-FY04) and try to ascertain where they are headed going forward.

There are several conclusions that can be arrived at by looking at the chart above.

1. FY04 margins are much lower than the high levels for all companies. Also, for most companies, margins in FY04 are even lower than the average earned over the past five years. For instance, Wipro's FY04 margins are 42% and 21% less than the high and average levels respectively. Another interesting aspect is that the volatility in margins has been lower for companies like Infosys and Geometric during difficult phases.
   

2. On the other hand, FY04 margins for most of these companies were better than the low levels of the past five years. While this is indicative of the fact that these companies are witnessing reduced pressure on billing rates, we believe that the decline in margins is not likely to stop here. Rather, since these companies are aggressively investing in building up scale and penetrating deeper into the global marketplace, pressure on margins is likely to continue going forward. However, for large and strong companies like Infosys, we believe that margins are likely to stabilise around the 20%-25% levels.
   

3. Companies like Wipro, Satyam and Hughes have witnessed the largest reduction in their margins from the high levels. This is on account of the fact that these companies (especially Wipro and Hughes) were the worst affected in the past years of slowdown in global technology spending. In case of Satyam, lack of focus could be one of the reasons for the decline in margins.

As said earlier, there are several factors that have the potential to take operating margins further down for these software companies. Some of the factors are –

1. Employees: While some of the software companies like Infosys and Wipro have managed to keep some control over the rise in average employee expenses by hiring fresh engineering graduates, we believe that hiring costs are likely to rise faster going forward. This is likely to be on account of the fact that these companies, in order to improve upon their domain competencies, would have to hire high salaried experts and consultants. Also, the fact that if volumes do not come in as expected, a large chunk of the employees would be benched (thus low utilisation). This could cost the companies on the margins front.
   

2. Sales and marketing: This is another important area where a continuous investment is likely to affect margins going forward. As Indian software companies continue their stride towards penetrating deeper into the global marketplace, they have been spending aggressively in establishing sales and marketing channels across the globe. While some large companies have been successful in doing the same, we believe that it is just the tip of the iceberg.
   

3. Rupee appreciation: In FY04, software companies faced margin pressure also on account of rupee appreciation. Any adverse movement on this front could impact the margins going forward, as while revenues are mostly in dollar terms, costs are in rupee terms.
   

4. Competition: As competition (both global and local) intensifies, a host of IT services are likely to become increasingly commoditised (as is being seen currently as well). As a result, companies will have reduced bargaining power against clients. This could put pressure on billing rates and, consequently, on margins.

Despite the abovementioned factors that could affect margins in the negative, there are a couple of factors that can help pare this decline. First is the rising contribution of offshore revenues (i.e. revenues from India operations). This is because despite having lower billing rates than onsite efforts, offshore services have a lower cost structure and thus higher margins than onsite services.

Another factor that could help reduce the decline in margins is increased revenues from high-end services. While companies like Infosys and Wipro are making aggressive moves in this regard, they still have to go a long way to cover to challenge global MNCs in this part. A successful product model like that of i-flex could also help stabilise margins in the future.

Conclusion

High operating margin is also indicative of the fact that the company has relatively better bargaining power with customers because it has scaled up its contribution from higher value-add services. This will enable companies to withstand competition.

This is indicated from the fact that a large company like Infosys and a niche player like Geometric have been able to protect their margins even during difficult times (see graph above). However, these high margins are not here to stay and investors need to believe the same.

We would like reiterate that factors like increasing competition and initiatives to grow bigger are likely to eat into Indian software companies' margins.

However, a company's ability to reduce this decline by way of initiatives as mentioned above will stand it in good stead. Investors could also arrive at a proper valuation for the company by studying its margin profile.

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