The Hindu Business Line : IT resembles a commodity market

INFORMATION technology (IT) stocks, as an investment theme, can safely be counted out for the next six months, at least. The outlook is very much uncertain compared to the situation that prevailed post-9 /11, or even a year ago. The earnings announcements of IT companies at the Indian and global level in the past two weeks reveal these broad trends:

Insipid IT spend: The story of growth in IT spend continues to be largely on paper. Quite a few consultancy firms and global companies had expressed the view that spending will look up and steadily improve from the last quarter of 2002. That did not happen. Much the same view — with expected growth rates at about 2-3 per cent — has been indicated for 2003. But the signals so far do not support such a possibility.

Offshoring on: One evident trend is the enhanced levels of offshoring of businesses. The ramp up of revenues in the fourth quarter by 50 per cent by Infosys and 31 per cent by Wipro is a pointer. The valuation of IT stocks was pushed up largely on expectations that this volume ramp up will translate into earnings growth. But that has not happened.

Pricing pressures: This has been identified as the prime reason for the poor earnings numbers. Here, the companies have been caught by surprise. When Wipro announced its April-June 2002 earnings numbers, it struck a bullish note. The impression conveyed was of a company that was not going to get stuck in such issues as pricing pressures. Infosys, too, had talked of pricing pressure stabilising a few months ago. But the reality has been different. Any improvement in pricing may be a year away, even in an extremely optimistic scenario.

Scaling down value chain: Until about 18 months ago, moving up the value chain was at the core of the growth strategy. No longer. Companies are now in the business of chasing volumes, even if it means moving down the value chain. It does make business sense in a difficult business environment. In this process, companies are also trying to take an ever-increasing pie of their client's IT spending budget.

Clients drive trends: With growth a problem in key economies, every company is obviously trying to save every penny possible. Clients now have a hold on IT service providers. The strategy of IT service providers taking a larger part of a client's spend also has the potential to place the latter in a position of strength to drive pricing. As the IT service provider increasingly handles a greater part of the services, the client may also move higher-end consulting to other outfits. This could have an impact on stepping up margins.

Excess capacity: Excess capacity is commonly identified as the key cause for problems in the commodity and automobile sectors. Companies here have learnt to adjust to business cycles by cutting capacities, consolidating and emphasising efficiencies. Commoditisation with low margins and high volumes as driving factors for earnings is well accepted. This is now likely to apply in equal measure to the IT sector as well. But the adjustment process is at an early stage.

Margins, the untold story: If there is one aspect that even frontline IT companies have hesitated to highlight, it is the unsustainable nature of their operating profit margin (OPM). As volumes become the dominant factor, margins are likely to only dip further. This may not happen in a year or two. But over a four-to-five-year period, the OPM may decline steadily. The key factor to watch would be the ability of companies to ramp up volumes to counter this imminent threat to the bottomlime.

Employee ramp-up risk: Frontline IT companies have added to their manpower in a big way in the last six months. The trend is to tailor recruitment and compensation to the pricing patterns offered by clients. This appears suitable at a time when volumes have become the key. But if companies happen to lose one or two key clients, they could be saddled with excess manpower — that too of a kind, that may be difficult to upgrade to other jobs. In such a situation, `hire and fire' may also become a key aspect of Indian IT majors' operations.

More global competition: Increasingly, global IT service providers such as IBM and EDS are strengthening their operations in countries such as India. Going forward, this can only add to the competitive pressures on even companies such as Infosys, Wipro and Satyam Computer.

More downside signals: A slew of global IT company earning cards for the January-March quarter does not provide any comfort or of the possibility of an improved outlook. The most commonly cited reasons are tight capital spending and longer decision cycles by user companies.

The lingering impact of SARS and the Iraq war and uninspiring signals from the US economy are not encouraging pointers either.

An investment perspective has to focus on cutting exposures using any uptrend, and waiting for greater clarity to emerge. A short list of companies likely to weather the storm are Infosys, I-Flex, Wipro, Digital GlobalSoft and MphasiS BFL.

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