How long can Indian profit margins defy gravity?

Steve Hamm

Infosys reported another huge quarter this morning. Revenues of $746 million were up 42.4% and net income was up 43.4%. The company's growth rates are remarkable, but even more striking is the fact that it keeps improving operating margins. They improved by 2% to 28.3% last quarter. CEO Nandan Nilekani attributes this to a combination of lower visa expenses, the effect of currency shifts, and increased efficiencies. And get this: The company became more efficient even while it hired 10,795 employees in the quarter. Western observers keep predicting that the Indians won't be able to sustain those amazingly high margins, but they keep doing it. And the fact that they keep doing it proves that labor arbitrage is no longer the primary source of their success: It's about executing on a superior business model day after day.

The predictions of margin compression aren't old news. I met last week with Salil Parekh, the new CEO of Capgemini North America, and he predicted that the best days of the Indian outsourcers are behind them. "They have done well in the first phase," he said. "But now we're in the second phase. To do well companies will have to be truly multicultural, and that's a real challenge for the Indian companies." Also, he predicts that as they add more of the high-end services, the Indian firms will add substantially to their costs and start to have operating margins closer to 15%. He believes it will be hard for them to keep up their stock price gains--a key lever in their compensation plans--if and when their margins thin out.

Nilekani rejects this analysis. "We have the potential to keep our margins in the current range long term," he told me. Even as Infosys adds people with business consulting and domain expertise, it plans on keeping up its ratio of 70% offshore labor to 30% onsite. "We're adding high-end people, but, at our scale, even if we add a few thousand people onsite, it doesn't make a big change in the cost mix"

Investors continue to favor the Indians. While the Indian players' stock prices got hammered in the general correction of Asian markets last spring, they're coming on strong again now. A bit of analysis released today by Datamonitor shows that the shares of Indian IT companies have way outperformed their Western rivals so far this year. While Datamonitor's overall Global Computing Services Index is up just 2.8 percent in the first nine months of the year, the India Top Five Index is up 17 percent.

Capgemini has been the top stock performer among the Western IT services giants, but with operating margins of just 6.7% in its US business, it has a long way to go to match the Indians on efficiency.

Before it's here, it's on the Bloomberg Terminal.