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CSFB warns on software services growth

NetScribes/Ganesh Ramamoorthy

For an industry that has the hopes of a country's markets and export community pegged to it, a rating downgrade is grim news. But that is precisely what happened to the Indian IT services sector recently.

US brokerage firm Credit Suisse First Boston (CSFB) downgraded the Indian IT services sector from 'outperform' to 'neutral' on Friday, knocking a solid 8 per cent off the BSE IT index - its single biggest hit since inception. But CSFB wasn't the first in doing so - it only joined a burgeoning list dotted by financial powerhouses like Merrill Lynch, Credit Lyonnais, Jardine Fleming and Kothari Pioneer.

The CSFB report said that the Indian IT companies would continue to grow healthily, but would fall short of the market's expectation of an average 70 per cent earnings growth in the current fiscal and beyond.

"The Indian IT sector's ability to outperform is severely restricted due to the slowing US economy. They will still be worse off than their earlier position of revenue growth, being constrained on the supply side and companies enjoying great pricing power," says the report.

The downgrade, which came as a rude shock to the markets, is likely to bring the valuation of IT stocks' valuations down to the ground from the stratosphere. Even after the recent setbacks, the current valuations of Indian IT companies factor in 8-12 years of strong revenue and cash flow growths.

"Going ahead, the pricing power of Indian IT services companies will drop and will be affected by a decline in the IT budgets for 2001 across all industries," adds the report.

Though concerns on declining billing rates have worried the industry for a month now, CSFB effected the downgrade only recently because it believed that the fundamentals of Indian IT companies were not as strong as before.

Concerns on billing rates first arose in early December, but became more serious when Infosys and Wipro had to "inform" Morgan Stanley Dean Witter that their businesses were as strong as ever and that there was no slowdown in orders or billing rates.

But more than the downgrade, analysts say, the report is a warning for the Indian IT services companies. Even as they expect only the second-rung software companies to be affected first by the declining billing rates, analysts say that concerns on fundamentals cannot be left unaddressed, be it for anyone.

"Weak fundamentals are the last thing anyone wants when one's acquiring and expanding globally," said a fund manager with broker Asit C Mehta. "They will have to start working on it very soon."

While industry association Nasscom believes that the US slowdown will be a boon for Indian IT companies, as cost-cutting measures will force US companies to look at offshore development, CSFB has its reservations here too.

"Offshore project execution requires different systems, leading to potential delays in shifting of work offshore, affecting near-term growth rates. Finally, it may be politically difficult in a slowing economy to shift work to India," says CSFB. About 56 per cent of the Indian software industry's turnover during the first half of 2000-01 came from the US market.

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