Infosys losing margin edge as rivals catch up

As clients get cost-wary, it's getting hard for Infy to sustain profitability gap over rivals

AFTER years of commanding up to 15% better rates for outsourcing projects than domestic peers, Infosys Technologies now sees its premium pricing erode, raising concerns about whether India's most profitable software company can sustain its high operating margins.
    With customers such as BT giving more work to fewer vendors at lower rates, it's becoming difficult for Infosys to sustain the profitability gap it used to have over bigger and aggressive rivals such as Tata Consultancy Services (TCS).
    During the second quarter ended September last year, TCS reported operating margins of 28%, quite close to Infosys' 30% margins during the same period.
    "In my mind the premium pricing for us was 10-15%, it would have come down a bit, but we still command premium. Today it's definitely not 15%," Infosys COO SD Shibulal said in an interview last month. "The fact is that it's a treadmill, and you have to keep at it, and that's where the aspiration comes in," he added.
    "Factors that got Infosys ahead of peers on pricing in the past will not take it ahead today. This is a departure from the past when Infosys drew on a combination of both volume growth and meaningful price rises to drive performance," JP Morgan Analysts Viju K George and Nishit Jasani said in their report.
    In many ways, Infosys' relationship with large customers such as BT and Goldman Sachs helped it build its premium positioning in the past.
    However, during the past 2-3 years, when customers, including BT, started looking beyond just a few vendors to further squeeze costs, that positioning was threatened.
    BT, for instance, is now working with both TCS and Wipro apart from Infosys. Clearly, the challenge Infosys faces is more of inventing newer models and service lines to keep widening the gap.
    "The only problem is that whatever distance you create, it keeps coming down, so you have to keep building that distance," Shibulal had said.
    Infosys — the first among peers to announce earnings every quarter — will report results for the third quarter ended December on Thursday.
    Brokerage firms such as Citi and Kotak expect the top three Indian software exporters to register 5-7% sequential revenue growth. Investors forecast TCS and Infosys to post 27-28% and 31-33% operating margins, respectively, for the quarter ending December. Infy margins may shrink to 32%
INFOSYS' margins have shrunk from almost 35.5% during the December quarter of 2009. Kotak analysts expect the margins to drop to around 32% during the year ending March 2011.
    The problem for Infosys has been accentuated by the fact that last year's recession has brought cost back on the agenda for many customers - they still want the best, but are questioning every extra buck they have to pay for 'premium services'. "Historical premiums, enjoyed in the past on certain accounts such as BT by Infosys may still exist, but stand considerably diminished today relative to where they stood. In other words, we do not see a case for pricing premium in favour of any one player in this industry, going forward, unless companies differentiate on clear parameters," the JP Morgan analysts said.
    Rivals say as lines of differentiation between the top three Indian software exporters blur, the gaps would fade away.
    "We have been catching up, and it's no secret. Some customers have now realised that they were paying for brand, when in fact they should be paying for services being offered," said a senior executive at one of the top five Indian software exporters. "We now work with at least two of large Infosys customers," he added.
    Some customers are also questioning high margins enjoyed by vendors such as Infosys, as they struggle to cope with pressures of their business amid a jobless recovery in the US.
    "I know of at least 3-4 customer discussions during the past few months where the high margin of vendors was used as a tool to negotiate better, lower rates," said an outsourcing consultant based in the US who helps mid-sized customers plan their outsourcing strategy.
    Analysts tracking TCS and Infosys say India's biggest software exporter has been reducing wage costs, among other initiatives, to narrow its profitability gap with Infosys.
    "TCS' strong margin performance through the last 3-4 quarters can be traced to a series of steps that began in early 2009. The key focus of margin defence has revolved around controlling the manpower costs, which form 75-80% of total costs for Indian techs," CLSA Analysts Bhavtosh Vajpayee and Nimish Joshi said in a report.
    Other cost-cutting initiatives to increase margins include closing redundant offices. "It (TCS) had four times as many offices as Infosys at one time - raising overhead costs," the CLSA analysts said.
    On its part, Infosys still sees scope for premium pricing though this is being driven more by aspiration than anything else. The company is pushing harder to increase its revenues from newer areas that are not commoditised. Infosys plans to have a third of its total revenues coming from new services, including cloud computing and platform-based offerings, over the next few years, even as such engagements mean lower profitability to begin with. The company has already started serving four customers using these models of delivering services, and derives nearly 5% of its revenues from such services currently.
    In a cloud computing or platformbased model, Infosys can serve multiple customers using same set of services developed for an existing customer such as Royal Philips Electronics.
    But rivals TCS and Wipro are already offering similar services to customers who are seeking to lower their capital expenditure by adopting pay-as-you-go model. "Profitability is more about aspirations than anything else; you have to have high aspirations. Profitability is your cost of production and what a customer is willing to pay for it, the more unique you are, the more intellectual properties you have, customer would be willing to pay for it," said Shibulal.

Gopalakrishnan & Murthy