Are IT firms’ earnings declining?

While a number of brokerages have cut their earnings estimates for the next fiscal year, most still expect earnings of top firms to grow by about 15%

Things are deteriorating faster than expected for the Indian information technology (IT) industry.

In mid-August, when this column asked the question, “Could this be the first time Infosys Technologies Ltd misses its annual guidance?”, it had seemed like the company would only narrowly miss its guidance. In fact, for most analysts, it was an unlikely outcome.

But with the global financial crisis getting worse since September, it became increasingly clear that meeting the current year’s guidance would be an uphill task for the IT giant.

Infosys lowered its guidance for the second half of the year by more than 8% last Friday, but its stock price is now higher than the pre-results level, indicating that the markets had already discounted the news.

It’s now time to ask another question: Could 2009-10 be the first year large Indian IT players see a decline in earnings?

While a number of brokerages have cut their earnings estimates for the next fiscal year, most still expect earnings of top firms to grow by about 15%.

In a report released earlier this month, Aniruddha Dange and Sandeep Muthangi of IIFL Capital have estimated that with the exception of Infosys, all other top-tier firms will report a marginal decline in earnings next year. According to its estimates, Tata Consultancy Services Ltd, Wipro Ltd and Satyam Computer Services Ltd will each see a drop of about 1% in earnings, while for HCL Technologies Ltd, the drop would be higher at 5%.

The analysts estimate that business from acquired companies such as Wachovia Corp. and American International Group Inc. (AIG) would fall by 30-60%, and the likes of Lehman Brothers Holdings Inc. and Washington Mutual Inc. which filed for bankruptcy, would cut spend by 60-90%. Other firms are expected to cut discretionary spending, or in other words, stay away from “nice-to-have” projects. All this will partly be offset by integration work for companies that have recently gone through mergers. The net result, IIFL’s analysts estimate, will be a 10% decline in revenues from the financial services sector next year.

What’s more, other industries such as retail and manufacturing are expected to be hit as well. More importantly, with the expected contraction in demand, pricing will be at risk.

In its conference call with analysts, the Infosys management said that the current downturn is different from the one in 2000-01, when there was a price bubble in the market for services offered to e-commerce providers. The point made was that there’s no price bubble now and that clients appreciate the inflationary pressures faced by service providers. IIFL’s report states that billing rates had fallen in 2000-01 not only for even e-commerce providers but also other sectors. They estimate that offshore billing rates had fallen by 12.5% for other services.

While wage inflation will be lower next year thanks to the downturn, the ability to lower cost per employee by hiring more freshers is now much more limited. For these reasons, the brokerage expects earnings to decline next year. Infosys may still manage marginal earnings growth, because it’s hurt less by price cuts thanks to its higher margins.

One may argue that IT stocks have been down to a point where all such negatives are factored in. But note that according to consensus estimates, earnings are expected to grow by about 15% next year. Instead, if earnings decline, that’ll be a big negative surprise.