IT: slower hiring=lower margins

IT: slower hiring=lower margins
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First Published: Sat, Aug 23 2008. 12 08 AM IST

Updated: Sat, Aug 23 2008. 12 08 AM IST
India’s software services sector, faced with a slowdown in the US and some other parts of the world, has reacted by slowing down its hiring plans. The top firms in the sector plan to increase headcount by about 20% this fiscal year, compared with a historical average of approximately 35%. At first look, it seems like a good way to protect margins. After all, if software firms ended with more people than they need, margins will take a hit.
But scaling down hiring may not ensure protection of margins. In an interesting report released this week by India Infoline Ltd’s institutional research division, analysts Aniruddha Dange and Sandeep Muthangi say the scaling down of hiring plans is likely to drag down margins. This is how: traditionally, large companies such as Infosys Technologies Ltd and Tata Consultancy Services Ltd (TCS) have leveraged their wide employee base by hiring an increasing proportion of freshers every year. New recruits draw much lower salaries and an increase in their proportion leads to a containment in overall employee expenses. India Infoline notes that although software firms gave average annual salary hikes of 7.5% in the three years between fiscal year 2004-05 and 2007-08, they managed to restrict the rise per employee cost to 0-4% per annum during the period.
TCS increased the proportion of employees with experience of five years, or less from 65% in fiscal 2004 to 72% last fiscal year. Infosys, too, has “widened its age pyramid” (to use industry parlance) during this period. Its average employee age of 26 is among the lowest in the industry.
But with efficiency on this count being at high levels currently, and with a drop in the target for fresh hires (thanks to the slowdown), it’s unlikely that there would be any improvement in the age pyramid. India Infoline suggests that things would deteriorate on this count. In fiscal 2002, the last time the US went into a recession and demand for IT services slowed down, Infosys had scaled down recruitment and its average employee age had increased by 0.7 years, the analysts note. Infosys’ salary costs had then risen by 56%, although the employee base had risen by just 36%.
According to India Infoline, an increase of one year in the average employee age would reduce a firm’s margins by 3 percentage points. The extent of the impact can be contested, but the fact remains that margins will be hit to some extent because of the slowdown in hiring. In a slow growth scenario, firms just won’t be able to hire the high number of freshers required to keep widening the base, or even maintain it at current levels.
More downgrades in earnings a ‘high certainty event’: Citigroup
As the focus of the markets shifts to the slowdown, earnings growth is being revised downwards. A Citigroup note on Asia- Pacific ex-Japan strategy points out that the forecast on the region’s 2008 earnings per share (EPS) growth, as estimated by the institutional brokers’ estimate system, was 10.4% in December 2007. By the end of March, that estimate had been revised to 8.4%. By end-June, it was down to 6.4% and, as on 6 August, it stood at 4.4%. Not only that the numbers are being lowered, but the cuts are at a more rapid rate.
The note says: “It (the downgrades) will accelerate further over the course of the next six months on higher input costs (commodity price index is still up 16% year-to- date even post the recent decline) and secondly, the global growth slowdown.”
As many as four markets — Hong Kong, Malaysia, Singapore and Taiwan — are expected to show a contraction in earnings. For India, earnings growth is expected to be 15.9% for 2008, slightly more than China’s 15.4%. For India, the earnings growth estimate at the start of the year was 21%. Citigroup believes that for China and India, the risk of further downgrades is a “high certainty event”.
In fact, according to Citigroup’s computations, the Indian market is trading around its mid-cycle valuation. In contrast, Korean valuations are at a 37% discount to their mid-cycle valuation, while Taiwan, Australia and Thailand, too, are at discounts to mid-cycle values. The implication is that these markets have already priced in further fall in earnings, unlike the Indian market.
The other important point is that while 2008 earnings have been revised down, 2009 earnings for the Asia ex-Japan region have not been cut. The note says: “As a result, the EPS growth rate for 2009 continues to move higher and stands at 15.9%.”
In India, the consensus estimates provided by Bloomberg show the total EPS of the 30 Sensex firms at Rs1,170 for 2009, compared with Rs978 for the current year. That’s a growth of 19.6%. Clearly, the market expects V-shaped downturn, with a swift recovery next year. Given the fact that the Reserve Bank of India’s tightening measures will have an impact only with a lag and that the present government is leaving a fiscal mess that will have to be cleaned up next year, the recovery may not come about so quickly.
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First Published: Sat, Aug 23 2008. 12 08 AM IST