The last two trading sessions were the worst ever for infotech stocks. Shares of all technology companies fell sharply after infotech bellwether Infosys Technologies shocked the market with a downbeat earnings guidance for fiscal 2004.

Relentless selling by institutional investors and unwinding of speculative positions dragged tech stocks to their 52-week lows.

The BSE IT Index fell by 26.93 per cent as the 170 listed tech companies lost Rs 20,474 crore (Rs 204.74 billion) in market capitalisation. Infosys lost 37 per cent of its value in the selling stampede, and its share closed the week at Rs 2617.

Infosys is considered to be a benchmark for all domestic software services companies and its earnings guidance sets the tone for the sector in the forthcoming quarter. Obviously, its earnings guidance of 10-12 per cent for the fiscal has created a pandemonium on Dalal Street.

The issue, now, is not whether tech stocks will bounce-back in the near-term after the severe crash in prices -- it is almost certain, they will not do so by any significant measure--but what happens next.

Fund managers reckon that the fall in prices is essentially a re-rating, as market prices realign with the revised earnings forecast.

"Even if stocks recover a bit, the upmove will be short-lived," says Anup Maheshwari, equity fund manager, DSP Merrill Lynch Investment Managers.

The bigger questions, then, are:

• Is the Indian technology story over or is this only a temporary phenomenon influenced by the reccessionary trend in the US?
• Does this mean a structural shift in the infotech business and by implication, on tech stock valuations?

Analysts are still grappling with the numbers, trying to comprehend the full import of the Infosys guidance and interpreting every word uttered by the management in the analysts' conference called on Thursday.

Fund managers have dumped tech holdings, and are sitting on the sidelines waiting for a clearer picture to emerge. At this point, for most of them, tech is a strict no-no.

What has gone so awfully wrong? The Infosys management has indicated that the key assumption behind the guidance is that billing rates for FY04 will settle at levels prevailing in the fourth quarter of FY03 (January-March 2003).

This is based on the management's assessment that the US will continue to waddle in recessionary trends for the rest of the year, and large US companies will be conservative in their IT spends.

But some analysts are reading between the lines that the management's significantly lower-than-topline earnings guidance suggests that the company has taken a strategic decision to play on prices, something it has not done to date.

Infosys has not compromised on billing rates, keeping its premium image intact all these years. But increasing competition and worsening economic climate may have compelled the management to revisit its business strategy, some analysts suspect.

"The guidance is a clear indication of the company's pricing strategy given the tough business environment," says an IT analyst with a leading foreign brokerage who did not wish to be identified.

Domestic software companies have been facing stiff competition from multinational software services majors who have set shop in India to provide offshore services.

Global information technology heavyweights such as Accenture, IBM Global Services, EDS, Cap Gemini and Ernst & Young have been expanding operations in India prompted by the low labour costs.

For global service vendors, this is an effective way to cut their high cost structures as manhour rates in India are just about one-fourth of those prevailing in the US. Cons-equently, multinationals are raising their scale of operations by at least 40-50 per cent every year.

According to Nasscom data, out of total software sector exports of $7.7 billion (Rs 37,345 crore) in 2001-02, Indian companies captured an overall 73 per cent marketshare. Going forward, the global majors are expected to either ramp-up operations significantly, or acquire existing companies or subcontract to be able to offer competitive bids to cost-conscious clients.

This means the going will get tougher for domestic players who have so far enjoyed a good run. "Since large multinational companies may not mind bidding aggressively--even if it means some losses--to bag large orders, domestic companies' ability to do so may be limited," says Anil Sareen, tech fund manager, Birla Sunlife Mutual Fund.

While domestic biggies with global delivery models such as Infosys and Wipro have to reconcile to lower rates and dented profitability in the face of such cut-throat competition, for smaller companies it is a question of survival.

"For the smaller ones, even topline growth may be suspect," says Amit Khurana, senior research analyst, Birla Sunlife Securities. For domestic tech companies it is a double whammy.

On one hand pressure on billing rates has continued unabated (barring a brief period in late 2002 and early 2003 when it was benign), and on the other, there has been an escalation in costs.

Even as Indian software companies retain their competitive strengths and offer a strong value proposition in terms of prices and world-class delivery models, what has really seen a phenomenal change is the attitude of customers.

Ever since a recession hit the US economy, large customers have been hammering down the rates in order to bring their own costs lower. Elaborating on the pricing environment, the Infosys' management has pointed out that clients are now asking for bundling of projects and maintenance activities at lower, flat rates. That means a straight hit on profitability. It also leads to a cost push, primarily on account of two factors.

Firstly, there is a wage push effect. Despite the industry going through rough weather, the demand for software professionals still remains robust. Going forward, volume growth in business will only mean that companies will have to scale up their people strength.

"And if the software business becomes less exciting, the supply of new people will reduce," says Bharat Shah, partner and chief executive officer, ASK Raymond James.

Even if a company does not scale up at all, it will have to accommodate a 5-6 per cent inflation-related hike in wages. "This is unavoidable as the key raw material for the industry is human capital," adds Shah.

Secondly, companies have to incur high selling costs to get the same amount of business. Given that Indian companies are bidding for high-value strategic offshore contracts, sales and marketing expenses are set to rise. In that sense, the business has become more capital-intensive than ever before.

"The change in business environment is altering the very character of the business," says Shah. Longer lead times for the closure of deals coupled with the fact that the calibre of sales personnel has to be higher, will impact margins.

The rupee appreciation is another imponderable companies have to factor in. As against extra gains due to a depreciating rupee in the past, companies have to contend with a marginal loss on the currency front.

The continued appreciation in the rupee has impacted the margins adversely in the past two quarters. Analysts estimate that a one per cent rupee appreciation impacts the EBITDA margins by 30-40 bp, EBITDA by 1.2-1.5 per cent and net profits by 1.5-2.0 per cent.

Another latent fear among analysts is that the tax liability of software companies is likely to be aligned with the manufacturing sector sooner or later. That will also hurt shareholder earnings.

So where could the gains come from? An improvement in profit margins could only come though three factors - increase in the utilisation rate, a change in the business mix, or productivity gains.

Utilisation rates are already at optimal levels for top-rung companies. Though analysts foresee some change in the onsite and offshore mix, the gains could be limited since all projects require a critical minimum onsite activity.

Productivity gains are possible. But that will happen only gradually as companies gain more experience and learn to do business faster, cheaper and better. This means that the pressure on profit margins will stay for a while.

For smaller companies, the future looks grim. Being small is a disadvantage most of the time, however, they can succeed "if they have a niche focus or offer something unique," says DSP Merrill Lynch's Maheshwari.

Companies such as Geometric Software, for instance, operate in a niche segment of CAD/CAM in which there are not many established players. Besides, smaller companies will need to have "non-linear business models" says Shah.

"This is essentially because differential growth may not be possible without a non-linear model," he explains. For survival in the long haul, it will be imperative for companies to build robust business models and global execution capabilities.

So what does all this mean for valuations in the tech sector? One round of re-rating has already happened and prices have fallen between 25-50 per cent.

The high valuations rendered to tech companies were basically on account of the high growth rates in the range of 30-40 per cent and the superior returns on capital they were able to deliver.

With tough business conditions eating into extraordinary returns, companies may not be able to generate the same level of returns even if the US economy bounces back.

Analysts reckon that even though pressure on billing rates will ease if the economy gets back in shape, it is unlikely that customers will be willing to accept a hike in billing rates once they get to know the vendor's cost structure and get used to lower rates.

And, when earnings growth is affected because of price pessimism, the impact on margins is dramatic because any change in prices affects the bottomline directly.

"Given the lower earnings growth and the effect on overall return on capital, the re-rating of tech stocks is a structural shift," says Maheshwari.

"If Infosys commanded a price-earnings multiple of 25 to 30 times near-year forward earnings for the better part of last year, it will settle at around 15-18 times now," says Khurana.

After all, whatever be the business, it is ultimately the present value of future cash flows that determines the price one is willing to pay for a stock.

Based on the earnings growth projection of 10-15 per cent, an earnings multiple of 15 may be justified, accommodating the premium for the exceptional quality of the management and a healthy balance sheet.

Technology stocks, thus, will no longer qualify as a high-growth even though the sector may continue to grow in size because of the competitive advantage.

But some fund managers believe that the sector is still the richest business proposition in Indian equity markets.

"Infotech is still the only sector which can offer an ideal combination of growth plus high return on capital, and none of us can afford the luxury of ignoring this sector," says Birla Sunlife's Anil Sareen.

He explains it with a simple illustration. The cost of setting up a seat for rendering software service is Rs 400,000, and the working capital amounts to around Rs 200,000.

This can deliver a revenue of about Rs 20 lakh (Rs 2 million), and based on an operating margin of 20 per cent (a conservative estimate), the return on capital works out to a phenomenal 60 per cent. No other sector can match this rate.

The key here is the high capital-output ratio that the sector enjoys given the cost advantages of the Indian software industry. This means that there is an adequate margin of safety built into software companies.

But the real question is, how bad can it really get? It looks like the market has not got a fix on that yet.

As of now, the only good news for tech investors is that the sector may become less volatile. "The beta for the sector may actually drop because institutional ownership may come down drastically," says Maheshwari.

And when the dust settles down, investors can conveniently forget their acquisition prices to get peace of mind.