Cost cutting gone too far for the IT sector?

Cost cutting gone too far for the IT sector?

Mumbai: India’s software firms have done better than survive the worst global economic crisis since the Great Depression, maintaining or even boosting profit margins, but some experts fear they have cut the good flab along with the bad.

Profit margins are at 12-quarter highs for the country’s top three software exporters—Tata Consultancy Services Ltd, Infosys Technologies Ltd and Wipro Ltd—and at historical highs for mid-sized firms such as Patni Computer Systems Ltd, Tech Mahindra Ltd, MphasiS Ltd, Polaris Software Lab Ltd and MindTree Ltd, according to market analysts.

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“A cut-back in investments has indeed helped the mid-size companies report historically high margins and free cash generation during the downturn, but may just have robbed them of the opportunity to gain market share from the larger players in the next phase of growth," analysts Kawaljeet Saluja and Rohit Chordia of Kotak Institutional Equities Research said in a note to clients dated 16 September.

Besides Saluja and Chordia, several other analysts, too, believe the cost cuts undertaken during the global economic downturn have been indiscriminate.

“We believe that while Indian companies are doing well to cut back on dispensable SG&A (selling, general and administrative expenses), they are not uniformly well enough to step up the ‘good’ SG&A," analysts Viju George, Kunal Sangoi, and Pratik Gandhi of Edelweiss Securities Ltd said in a 10 September research note. “Unfortunately, they have cut back on this (good) aspect till now."

Among bad SG&A are expenses on redundant personnel in onsite support services and uncoordinated and excess sales offices, while good SG&A includes costs for hiring domain specialists and creating focused teams for canvassing new clients.

Surjeet Singh, chief financial officer of Patni Computer, argues cutting waste was imperative to increase accountability.

“Cost rationalization is not something that is driven only by the recession. All companies look to cut costs, rationalize investments and optimize existing resources in order to run lean and profitable businesses," he said in an email.

Infosys did not respond to Mint’s questions, TCS spokespersons were travelling and Wipro declined to offer comments as the firm was in a “silent period" ahead of its quarterly results announcement. MphasiS and Tech Mahindra, too, did not respond to Mint’s queries.

According to some analysts, the firms should instead have used the downturn to sustain their sales and marketing efforts and to train their staff so they could expand their services portfolio.

Kumar R. Parakala, global head of sourcing at audit and consultancy firm KPMG, said there was a need during the slowdown “for service providers to diversify into newer markets and newer verticals, reducing client concentration and getting more clients on board. This demands, at times, higher marketing expenses rather than cutting back on marketing spends".

Not all analysts agree with this contrarian view. Analysts Ashwin Mehta and Vihang Naik of Motilal Oswal Securities Ltd believe the benefits from the cost controls would increase when growth returns.

In a research note dated 8 September, Mehta and Naik said first-quarter Ebitda (earnings before interest, taxes, depreciation and amortization) margins for Indian IT firms are near 12-quarter highs and that they expect this to expand for TCS, Infosys and Wipro through fiscal 2009 to fiscal 2011 “as demand increases and further efficiencies in utilization, SGA leverage and cost controls kick in".

Some caution that it may be too early yet to declare that the cost cuts would hurt in the long run. “It may be worth waiting for a quarter or two to find out whether the mid-tier companies have really lost an opportunity," KPMG’s Parakala said.

Graphics by Ahmed Raza Khan / Mint