And that may well be the next inflexion point for Indian IT...

That isn’t great news. In fact, if two-and-a-half years into a downturn, the IT services industry still doesn’t see an uptick around the corner, it’s probably very bad news.

There’s a reason why statements coming out of the recent spate of annual results have sounded generally more pessimistic than a first look at the numbers would indicate. A year ago, while topline revenue growth had declined considerably, the services export sector had one great thing going for it—the bottomline had remained largely unaffected. The industry had tightened belts, cut software development and general administration expenses and kept profitability intact. Not this year.

	“Today, customers want to have their cake and eat it too. They want higher value at a lower price. This trend began in 2001, and we believe it will only accelerate.”
Wipro chairman Azim Premji at the post-results press conference

This year, the bottomline has been hit—even among cost conservative companies like Wipro and Infosys, which have typically had high operating margins and high profit to revenue ratios. The one thing the industry feared most has, in fact, happened—it cut flab down to bare minimum, but pressure from customers still hasn’t eased. On the contrary, after what looked like a brief optimistic third quarter, old customers are back to renegotiating old deals.

In Q3, both Infosys and Wipro had indicated for instance that billing rate pressure seemed to be easing up and may have reached its bottom. As it turned out, they’d jumped the gun a bit. Under heavy pressure from existing customers, Wipro saw price realizations decline 6.7% on offshore jobs and 5.7% on onsite jobs. Similarly, at Infosys, Q4 was marked by a volume growth of 12.8% and a price decline of 5.1%. As a result, CEO Nandan Nilekani said, "Margins have come down. Our Q1 margins were 30%, and down to 27.5% in Q4".

That old customers who already have a certain commitment, are the ones putting the most pressure might seem a bit paradoxical. However, Wipro vice-chairman Vivek Paul told the media and investors repeatedly—customers are using the carrot-and-stick approach. "90% of those who want to renegotiate deals offer us a carrot—that of more business. But we have to keep in mind the stick that goes with it." And that stick’s the threat of moving on to smaller mid-tier companies.

Little deals
But that’s only part of the story. The other part of the story is the kind of deals that are up for grabs in the current environment. There are three distinct trends taking place here. One—there are more application-maintenance jobs available than application-build deals. Of the two, maintenance is typically perceived as a lower end job and therefore commands a substantially lower billing rate. Two—among the higher end projects, a lot of it is package implementation and consultancy, which are heavier onsite plays. That means—billing rates are high, but margins are a lot lower. Three—the large deals system integration deals are no longer happening. Even in FY02 the services sector boasted of some record-breaking deals. These included Tata Consul–tancy’s $100-million project with GE and Wipro’s $70-million SI contract with Lattice Group.

Not so in FY03. Services companies have been largely stuck with chasing smaller million dollar clients and haven’t got the kind of flexibility and margins that larger deals provide. For instance, million dollar clients at Infosys went up to 115 from 83 the year before with a similar jump in one to five million-dollar clients at Wipro.

Large expenses
The irony is that little deals cost more. More in manpower expenses which are spread across multiple projects and more in sales and marketing expenses which have only gone up in the last two years. After a brake on employment—indeed, a spate of sackings in fiscal 02—the industry has been on a major hiring spree last year. Infosys added more than 4,000 new employees—the largest ever in a single fiscal in the company’s history. Wipro added a little less than 4,000. As Paul said, "We had a record year in terms of billed man-months."

Billed man-months, however, are adding less and less to the bottomline. For the first time in many years, software development expenses in some companies have grown faster than revenues. Plus, it takes more sales and marketing effort per dollar of revenue earned today than it did before. Infosys for instance has doubled its S&M expenses from Rs 130 crore in FY 02 to Rs 267 crore in FY03. Similarly, though Wipro doesn’t give out rupee or dollar figures, it almost doubled its S&M sales force during the year. But S&M expenses include not just more S&M manpower, but simple things like CEO Nandan Nilekani having to fly down to different parts of the globe to close deals that he would have earlier left to region heads.

Software factories or…
Over the last three years, the gap between revenue and profit growth has widened. Prior to 2001 for instance, profits grew at a higher rates than revenues among many of the larger players. In FY02, that came down to almost equal growth rates. Profits seem to be growing at much slower rates than the topline.

It is possible that billing rates will look up once the downturn ends. Possible—but difficult. In the history of products and services pricing, it has been a rare case indeed that a company or an industry ever cut prices and then managed to raise them.

The contrary always happens—things get cheaper with time. But prices once cut, are very difficult to hike.

Sarita Rani