Mumbai, Oct. 28: While domestic software companies had mixed fortunes in the second quarter, CRIS Infac today warned that margins may fall in the next two to three years and that industry will need to overcome significant challenges, particularly those from China, to maintain the high growth rates.

However, the Credit Rating Information Services of India Ltd (Crisil) subsidiary maintained a positive long-term outlook for the software industry, adding that IT services exports are expected to grow at around 25-28 per cent.

On the negative side, the report anticipated profit margins to decline in the next two to three years. Already, most players have seen margins dip by 150-300 basis points in the first half of the current fiscal. As a result, Infosys has maintained its profit guidance for 2002-03 while increasing its revenue guidance significantly, whereas Satyam has reduced its profit guidance.

“Some of the factors which will affect margins of the industry in the medium term include the increased competition, especially from global IT services majors who have set up offshore development centres in India, the increase in employee costs and the rise in sales and marketing spends,” it said. Further, the high margins in IT consulting and systems integration will be offset by the larger component of on-site work.

According to the report, the consolidation in the Indian software industry will increase in the medium term. A ‘flight-to-scale’ towards large IT service providers is expected among global clients due to higher comfort levels with respect to delivery schedules, quality, domain knowledge and financial stability. Moreover, clients will increasingly centralise their IT spending decisions, resulting in a rationalisation of vendor base and dependence on a few strategic outsourcing partners. These factors will see top rung companies grabbing high value contracts, enabling them to post higher growth rates than their lower rung peers. Among smaller players, those focussing on specific niches, such as financial services, CAD/CAM, and product lifecycle management, may be better able to survive the consolidation phase.

However, the research outfit said industry will need to overcome significant challenges in order to maintain the high growth rates. Here it anticipated increased competition from China and expressed a need to address “geopolitical risks associated with doing business out of the country”.

“In order to expand their presence in different geographies, Indian companies will need to increase their visibility by way of increased participation in industry events, overseas stock listings and strategic acquisitions.”