The fundamental law of motion is finally catching up with Indian IT companies and their stock prices. Having defied the law of gravity for about a decade now, the bluest of the blue-chip IT companies are realising that nothing grows forever. At least not at the pace at which the profits of big IT companies had grown in the 1990s.

This simple lesson was learnt at a huge price-Rs 25,000 crore lost in falling share prices in seven trading days between April 8 and 17-on the Indian stock markets. Now that the bloodbath is all over the market, it seems surprising that nobody, including the best and the brightest of equity analysts, saw it coming.

WEALTH LOSS

About Rs. 25,000 crore in a week. With that sank the fortunes of some of the biggest names in the IT industry. An estimate of the wealth they lost.

AZIM PREMJI Chairman Wipro Ltd. Rs. 7,176 Crore

N.R. NARAYANA MURTHY AND FAMILY Chairman Infosys Technologies Rs. 529 Crore

NANDAN NILEKANI MD Infosys Technologies Rs. 334 Crore

B.RMALINGA RAJU AND FAMILY Chairman Satyam Computers Rs. 260 Crore

SHIV NADAR Chirman HCL Technologies Rs. 599 Crore

All it took for the bubble to burst was for Infosys to announce on April 10 that its net profits would grow by only about 12 per cent during 2003-4-analysts had pegged the growth at 17 per cent. This despite the prospectus Infosys had filed for an American depository shares issue with the US Securities and Exchange Commission (SEC) on April 1. "It is possible that some of our quarterly results of operations may be below the expectations of market analysts and our investors," Infosys had warned. But that did not prepare its shareholders for the unthinkable. The share price of the infallible Infosys fell by 44.5 per cent to a low of Rs 2,300. N.R. Narayana Murthy, chairman, Infosys, tried to soothe nerves by saying that the company has seen 41 profitable quarters since it got listed in 1993. "We believe in bringing bad news proactively. We believe in the philosophy: When in doubt disclose. We believe in under-promise and over-delivery," Murthy declared.

And the bad news is that though the industry's average sales are growing at a healthy rate, the profit margins are shrinking. Infosys-one of the healthiest among the Indian IT companies-recorded a 39 per cent growth in sales in the last financial year but growth in its profits dipped from 28 per cent in 2001-2 to 18.5 per cent in 2002-3. Says Sunil Mehta, vice-president, nasscom: "While revenue growth has been encouraging, it is obvious that margins will not go up with the volumes."

The disaster at the bourses has been some time in the making. A prolonged spell of gloom in the global economy led by the US-which accounts for 70 per cent of Indian IT revenues-was bound to trim bottom lines. The Iraq war, sars and, of course, a stronger rupee-Indian IT companies earn bulk of their revenues in dollars and spend the maximum in rupees-added to the hardships. But more worrying are the long-term shifts in the fundamentals.

Indian IT companies are facing serious pricing pressures. "They seem to have lost their pricing power and IT services are becoming highly commoditised," says Nilesh Shah, senior vice-president and head, portfolio management, Kotak Securities. Infosys in its prospectus to the SEC also pointed to similar constraints. "We have experienced pricing pressures from our clients during this economic downturn, which have had a negative impact on our operating results," it said. With increased volume of sales, Infosys clients expect heavy discounts or ask for fixed-price arrangements on reduced rates. This fallout of the global slowdown is likely to stay even after the economy begins to look up. Foreign companies that have "tasted blood" by forcing Indian IT companies to lower their rates are unlikely to settle for anything more.

Plus, the Indian IT companies are fast losing out on their initial advantages. Many global IT players and consulting giants have come into India through their subsidiaries to tap the same low-cost skill base that was exclusive to the Indian firms in the 1990s.

The local companies, on the other hand, have been facing additional wage pressures. Says David M. Togut, equity researcher with Morgan Stanley: "As Indian IT services companies diversify to services, their cost structure will expand and their margins contract." Going by these pointers, the heyday of the IT boom is definitely over.

All these factors have been obvious for quite some time now. But analysts and market watchers seemed oblivious to these. Many experts till last week were asking investors to buy Infosys shares at Rs 4,000-plus levels. But on April 10, as Shah says, reality dawned. They never told us things were so bad. We thought they would grow at 17-19 per cent at least, the pundits complain.

One reason for this unreal expectation was perhaps the larger-than-life image of the Indian IT companies, especially Infosys. "The stock market has got too used to seeing high growth that it cannot settle for anything that does not fit into analysts' spreadsheet," says Ashank Desai, chairman and managing director, Mastek whose shares were battered down to 50 per cent of their previous closing on 4/10. "All we said was that we would not end the year with a 40 per cent growth but with 30 per cent. Is 30 per cent growth less by any standards?" Certainly not by the prevailing trend. The rate of growth of profit margins in the IT sector have been falling since 2000.

So is the party over? Is India's IT fairytale only based on unreal expectations? No, the IT saga is far from over. "We are seeing a redefining of the Indian IT sector. It is not a loss story. It is a difficult story", is how Shah describes the sudden upheaval at the stock markets.

Not surprisingly, it will be the smaller firms which will have to bear the brunt. Says Phiroze Vandrevala, executive vice-president, TCS, Asia's biggest software company: "The Tier II and Tier III companies will find it difficult to leverage on volume and size. Unless they are niche players, they will find the going tough."

What is clear is that Indian IT companies will have to add more value to their work. Merely banking on access to the best professionals at lowest rates will not be enough. To be fair, Indian IT companies have already started working on these lines, but the progress has been slow, largely because of the US slowdown. "We are currently addressing only 3 per cent of the global IT services market. There is a huge market that India has not even begun looking at," says Arun Kumar, president and managing director, Hughes Software Systems.

Amidst falling margins Indian IT industry is also facing a social and legal backlash across the world. The arrest of the head of I-Flex's Dutch subsidiary in the Netherlands early this month, the rounding up of Indian software engineers in Malaysia in March, the imprisonment of Polaris Software CEO in December 2002 and legislation being prepared in a few US states banning transfer of work outside the country have haunted the IT industry. At stake for India are $10 billion (Rs 48,000 crore) annual IT exports and an estimated 1.5 lakh IT professionals currently working abroad.

The Indian IT industry is worried, if not panicky. "These incidents, though isolated, indicate some kind of a paranoia," says Kiran Karnik, president of nasscom, "It is something we have to watch out for." Some Indian companies foresaw the problems and took preventive measures like training their staff in handling the cultural change. "Indian IT companies should try to conform to the practices in various countries," says S. Mahalingam, chief financial officer, tcs. "They should strive to be better corporate citizens there."

Thankfully, the backlash so far has not abated the transfer of IT work to India. On April 7, BT signed a $160 million (Rs 768 crore) outsourcing deal with HCL Technologies. Given the huge cost advantage of working in India or with Indian companies the inflow of work will not peter out any time soon. What will remain under pressure though will be the profitability of that work.

-with Anil Padmanabhan, Stephen David, Malini Goyal and Ishara Bhasi