The already battered CNX IT index has lost another 14% this month, double the rate at which the rest of the market has fallen.
News flow from the US suggests that things are getting worse on the micro front, with companies cutting earnings targets and announcing large layoffs. Worse still, other economies such as Japan announced they were in recession.
Although the impact of all this wasn’t visible in the September quarter results of Indian IT firms, it won’t be long before their financials start getting impacted. Already, many firms have cut hiring targets in anticipation of a slowdown in demand.
But despite this act of prudence, margins of Indian IT companies are at considerable risk in this downturn. And this is not just because of the risk of a drop in billing rates.
Analysts at Edelweiss Securities Ltd point out in a note to clients that Indian IT firms have a high cost structure, which will have a “not-so-pleasant consequence in times of a downturn”. People costs account for as much as 80-85% of operating costs, and even if one were to adjust for the fact that about one-fifth of these costs are variable in nature, it still implies that about three-fourths of the total operating cost is fixed or semi-fixed in nature.
For a company operating at a 20% margin and where three-fourths of the costs is fixed in nature, a 2% drop in revenues would lead to an 8% drop in profit just because of the above cost structure. In case any of a company’s clients go bust, IT firms would either need to quickly deploy its people in other projects or take the harsh measure of laying off people. The former option wouldn’t be easy to come by in the current economic environment, and laying off people would be a difficult call to take.
Under the circumstances, the downturn can be expected to result in a drop in profitability in the near term, and the situation would only get accentuated because of a possible drop in billing rates.
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