A Downpour.... then, a Drizzle

Indian companies stood strong and firm, ready to service the gush of orders from abroad, and kept growing. And that growth was so fast that it overshadowed the dull phase that followed

IT was the best of times, it was the worst of times…. said Dickens in A Tale of Two Cities. Had he spoken this of Circa 2000-01, software exporters in India would have readily agreed. It was a year of unprecedented growth followed by a sudden and unexpected downturn that had exporters rethinking strategies, numbers and growth projections. It was a year in which it looked like nothing could go wrong. Yet, suddenly everything did.

First, the best of times—software exports became the dominant segment of the Indian IT industry. For the past few years, software exporters have dominated mindshare with big branding, huge market caps and extensive media coverage. In 2000-01, they dominated where it ultimately matters—share of revenue.

Except for the first big jump in 1996-97, it turned out to be the best year ever for software exports. Revenues, comprising those from services and packaged software, grew by a handsome 61% as against 47% in the previous year. At Rs 24,813 crore, they now account for half of Indian IT industry revenues. In 2000-01, more than 30 software companies in India have exported more than Rs 200 crore worth of software and services; altogether 75 companies have exported more than Rs 50 crore worth of software. In 2000-01, the number of software exporters increased to a record number of 3,000 companies.

Even more important, India has emerged as the preferred software-outsourcing destination of the world despite a growing IT workforce in China and strong competition from other outsourcing countries like Ireland and the Philippines. A combination of factors—direct as well as indirect—has contributed to this. While the Philippines competes well with India on both price and language, a chronic political instability makes it, at best, a second choice. Ireland has a reasonably mature, English speaking software industry, but has lost its cost advantage due to a steep rise in salaries. Billing rates in China are on an average 15% lower than India but this quasi-communist republic is a relatively new entrant—it suffers from industry immaturity and despite concentrated effort, an obvious language barrier. East European nations need to get their act together politically before they can pose a major threat.

Other factors played a role, but the single largest determinant in India’s outsourcing status was the industry’s investment in process certifications. Wipro was the first software services country in the world to attain Carnegie Mellon University’s SEI-CMM Level 5 certification. Today, India has the largest number of Level 5 certified companies. During the past year, the number of quality certified software companies from India increased to over 250. Twenty-seven Indian companies now have the unique distinction of being certified at the SEI-CMM Level 5 level. The reason is simple. As outsourcing clients hunt for vendors, they have limited means of ensuring a risk-free process. An analysis of the country’s language and cultural barriers and political situation, examination of the vendor’s previous projects, client referrals and on-site visits could be some factors vendors can check on. But there is no way of knowing if a software vendor will deliver what he promises to, when he promises to. Quality process certifications objectify the process. Clients know that a Level 5 certified company delivers over 90% of its projects on time without escalations in cost. For first-time clients, an assurance of this kind is critical. The Indian software industry realized this at an early stage, and last year this investment in process quality certifications began to pay-off. The motto of the year was: "If you think Indian software, don’t just think price. Think quality."

Last year, the domestic software market achieved a growth of over 47% mainly due to increased government computerization, increased Y2K spending, elimination of import duty on software; increased enforcement of anti-piracy laws as well as increased maturity in end-user organizations.

The Budget of 2000 had a positive impact with the removal of duty on a host of equipment for the telecom, IT, and the entertainment industries. In the Budget of 2000, the software industry had expected the finance minister to raise the limit for acquiring companies abroad to $100 million. Removal of tax incentives and non-enhancement of overseas acquisition limit for IT companies were longstanding demands as they would bring down software prices. This wasn’t done. The finance ministry’s silence on taxation of ESOPs at the time of sale of shares did not help. Furthermore, streamlining of Customs procedures by removing the bonding mechanism was not done. However, the easing of VC norms and hike in FII investment limit to 40 per cent were positive factors.

Budget 2001-02 has given a boost to the software industry by including onsite services in software exports for tax exemption and allowing change of ownership in public listed software companies located in EPZ, EOU and STP without depriving them of tax benefit.

In the Budget proposals, the income from on-site services by the software industry has been granted the benefit of tax exemption like other export earnings for all software development companies. Currently, on-site services contribute around 60% of the total software exports from India.

On the downside, the finance minister has taxed the domestic sale of software EOUs and units located in EPZs and STPs. These units currently enjoy tax exemption on 25% of their domestic sales. The Budget recommendations came as a major boost to the software sector. The industry had feared that software services and e-commerce might be borught into the tax net, but these sectors were left untouched.

Top 20 accounted for 63% revenues

The Top 20 software exporters accounted for 63% of total software export revenues, in line with the previous two years when the share had stood at 60% and 61%, respectively. This indicates that base-level exporters also grew at around the industry average.

Among the Top 20 software exporters, however, there were significant variations in growth terms. IBM and Infosys posted over 100% growth. Infosys has been on a steady rise for the past few years. It rose from No 4 in 1998-99 to No 3 the following year and is now at No 2. For IBM, on the other hand, last year was significant, especially in view of its dismal performance in 1999-00, when it grew at a mere 8% and fell in ranking from No 8 to No 12. Fiscal 2000-01 saw it climb a few rungs.

Wipro, Satyam Computers, Cognizant Technology Solutions and Patni Computer Services upped their revenue by 70-80%—all grew significantly higher than the industry average. Wipro, however, slid to the No 3 slot after holding the No 2 position for two years, largely because of Infosys’ unprecedented growth. Cognizant Technologies—largely into application management and e-business solutions—went up by one notch from No 7 to No 6. Patni Computer also scaled up the ladder, from 10 to 9.

What was really interesting, however, was the performance of the other two biggies—TCS and HCL. Despite below-industry growth rates, sheer size has ensured that TCS continues to reign supreme at number one. With export earnings of Rs 2,870 crore this year and a strong presence in the manufacturing vertical (billed to be the biggest growth area next year) TCS looks likely to remain at the top for a while. HCL Technologies, on the other hand, did not match up to its erstwhile impressive performance when it grew from a mere Rs 207 crore to over Rs 700 crore (a growth rate of 254%). Growth sobered down a little and though it stayed at the industry average of 60%, it found itself moving down from the fourth to the fifth position.

The two big surprises were Chennai-based Mascon Global and Mphasis BFL—both new entrants in the Top 20 exporters ranking. In 1999-00, Mascon had a total turnover of just Rs 59 crore and a DQ Top 20 ranking of 106. Two big projects this year however brought it more revenues in Q1 of 2000-01 than in the entire previous year. By the end of the FY 2000, the company’s export revenues alone had grown by nearly 500% to Rs 339 crore. Mphasis BFL too moved up from a ranking of 62 in 1999-00 to 17 last year.

The under-achievers (if such a term can be applied to companies in the Top 20) were Pentasoft and Pentamedia that grew at 40% and 35% respectively; i-Flex and Tata Infotech (51%) and MBT (59%). These are more than healthy growth rates by almost any standard. They paled only because of the meteoric growth that companies like Infosys, IBM and to an extent, Satyam and Wipro registered. The only company among the top 20 to have achieved a negative growth, of 2%, was NIIT, as export revenues fell from Rs 579 crore to Rs 570 crore. Overall, it was an exciting year for the Top 20 exporters, one in which companies with below 70% growth fell in the rankings, and in which growth rates of 58% were considered below the industry average.

The nuts and bolts

The overall composition of the export environment did not change significantly. In software services exports, customized software development and software maintenance remained the prime breadwinners with close to Rs 15,547 crore coming from here. In fact, notwithstanding analysts’ predictions of this being the slowest growing segment worldwide, Indian exports of customized software and maintenance services actually grew by 51%. Revenues from consulting and other services doubled, though in gross terms they were still low at Rs 6,774 crore. Growth in turnkey projects, though, remained disappointingly low at 24%.

The US continued to be the hot destination, with 63% revenues coming from there. But for the first time, the rest of the world brought in over a tenth of the revenues. Delivery modes changed slightly with products getting 11.5% of the revenues as compared to just 4.6% last year. Project revenues actually dropped marginally from 63 to 62%. Revenues from consulting services—the uppermost step of the value-ladder for software companies—also dropped significantly from 25% to 18%. Revenue models remained largely unchanged with fixed cost projects still accounting for a relatively small portion of revenues.

During the year, one of every four global giants outsourced their software requirements to India. The country exported software to 102 countries around the world, with almost 62% of exports to North America. In the applications segment, Web-based and e-commerce applications continued to draw in the big bucks. This can be attributed to the fact that the B2B sector has emerged unscathed through the dot-com bust. However, because of the dot-com debacle, the contribution of e-commerce applications to total revenues remained more or less the same—19%. Enterprise resource planning picked up a little as did datawarehousing, currently being termed the wave of the future. The latter’s share in total revenues grew from 1% to 5% and is expected to grow further this year. As far as verticals are concerned, Indian exporters have a large exposure to the banking and finance sector. This sector, as well as manufacturing and services (which includes insurance), also brought in significant revenues. Most of these figures, however, do not reflect the major changes that began by the end of the third quarter and were obvious by the fourth—the first tech-led US economic downturn and it’s fallout.

Bad times ahoy!

Just when things were going great, the US economic slowdown hit Indian shores. By Q4, sales cycles became longer, projects got cancelled and a price-competitive Indian industry found itself being bargained further down on costs. This had three major consequences: squeeze on margins, greater focus on offshore development and a new look at Europe. More than 260 of Fortune 1000 companies outsourced their mission critical software development to India in the year 2000.

Billing rates for Indian software programmers have traditionally been among the lowest in the world. Margins have increased over the years partly because India moved up the value chain and partly as a natural consequence of inflation. By the end of last year however, Indian software exporters found themselves facing severe margin pressure. Added to that were high rates of recruitment. As a result, companies like Infosys, DSQ, iFlex and Cognizant saw their operating margins plateau out or increase marginally by 1% or so. Some others like Mascot Systems actually saw a significant drop in margins. The only two companies that witnessed a notable rise in operating margin were the ones who have always been aggressive at price points—Tata Consultancy Services and Wipro. Tata Consultany Services’ operating margins rose from 27% to 48%, while Wipro’s margins also moved up from 26% to 34%. Longer sales cycles and a squeeze on margins had created an intensely competitive environment by the end of the year.

This meant that the greatest deal of competition to Indian exporters came from other Indian exporters. This phenomenon continues in FY 2001 and most companies will now be looking for their numbers in volumes than in margins.

Enter Europe

The US slowdown triggered a new trend; it prompted Indian companies to look at Europe. The US is and will remain the largest destination till 2004 at the least—at present, it accounts for 46% of worldwide software exports and projections. However, all companies, including exporters, will now be looking at increasing their revenues from Europe. By the end of the year, many companies, including Wipro and Infosys, had set up offices in the continent—mostly in France, Germany and the United Kingdom. These countries together account for 60% of the European market. Indian software export revenues from Europe moved up marginally—from 21% in 1999-00 to 22% in 2000-01. With the concerted moves by most of the top software and services players into this market, the number is likely to rise more steeply this year.

However, the slowdown in IT spend has spread to Europe. A survey of top companies on both continents reveal that 40 per cent of European companies were reducing spending and even important projects were being shunted. Top rung software services companies—TCS, Infosys, Wipro and Satyam—all have exposure to Europe, ranging from 7 to 30 per cent of their total revenues.

Out of the total software exports of Rs 28,350 crore during 2000-01, almost 62 per cent was to North America (U.S., and Canada); 24 per cent to Europe; 4 per cent to Japan; and 10 per cent to rest of the World. Unlike in the U.S., Europe has no language advantage and this results in slower market penetration. The onsite work is high and require local workforce (to combat language difficulties). This will negate the lower resource cost advantage that Indian companies have in the US. Moreover, in Europe, Indian companies will be competing against East European countries, which share a similar low-cost structure but do not have language constraints. In the fiscal year 2000-01 total Indian software exports to Europe was worth Rs 6,800 crore—a growth of 68 per cent over 1999-00 revenues of Rs 4,030 crore.

A few companies were even eyeing the APAC market, though with a marked lack of enthusiasm. The Asia-Pacific market is billed to be the fastest growing market in the world right now. However, for software services exporters there are several points of discomfort. One, it is a exceedingly fragmented market with numerous countries, cultures and languages. Moreover, margins are very low. The next best option then was Japan where most Indian exporters are increasing their presence. Wipro has set up a dedicated ODC for a Japanese Telecom firm in Hyderabad, Pentasoft already gets 17% of its revenues from there while others like Mascot Systems, iFlex, Pentamedia and DSQ are increasing their presence here.

Homeward bound

In the last few years, overseas travel expenses of software export companies had shown a steep rise as more and more work was done onsite. Of late, however, there has been a slight shift towards offshore development as confidence in Indian exporters has increased and remote management methods and global delivery models have been further refined. Barring those application areas where onsite presence is a must, the industry hoped the mix of on-site and offshore revenues to be increasingly skewed towards the latter.

Both vendors and clients are now experiencing a sense of urgency. For clients attempting to save money wherever they can, on-site development is viewed as an expensive affair. Offshore billing rates for low-level legacy work, for instance, are $15-20 per hour, but on-site rates for the same work goes up to $55-70 per hour. For middle-level work like CRM customer relationship management applications, offshore billing rates are $30-35 per hour, compared to on-site rates of $100 per hour. For high-end work in consulting and core technologies, the gap is even wider—from $30-120 per hour offshore to $300-350 per hour on-site. On the other hand, while revenues are higher in on-site work, so are the costs. Overall, offshore work tends to get more margins than on-site work does.

More and more vendors are, therefore, looking at larger offshore components. During the course of FY 2000, on-site development came down from 50% to 47% (it was over 54% in 1998-99), with a commensurate rise in offshore development from 49% to 52% (it was 44% in 1998-99). Improving infrastructure and business imperatives are likely to push that shift even further in the coming year. The downturn might precipitate outsourcing decisions (from India) much earlier, as the realization has dawned among US Fortune 500 and Fortune 1000 companies that their legacy-related costs need to be reduced. "The number of these (Fortune 500 companies) who have understood the Indian offshore model have swelled in number and they are the ones who are likely to ‘ramp up’ outsourcing from India.

At the same time, the opportunity landscape has also broadened as Indian software companies have made a successful transition from enterprise computing (client server) to collaborative computing (Internet open standards) environment. From this stage, the move towards "user-centric computing" involving mobile, broadband and personalization have just begun. "This presents a new wave of IT service opportunities and Indian companies which prepare themselves for this, will be in the best position to ride the wave."

Looking ahead

The problems that began by the end of Q4 remain the major challenges of this year. The software industry had hoped for a quick and painless move up the value chain. Worldwide, the big growth areas are billed to be IS consulting, systems integration, packaged software support and maintenance, network consulting and integration as well as network infrastructure management.

Last year, most companies had also planned to lay greater focus on business processes consulting and business services outsourcing along with e-biz consulting. These are the areas Indian software exporters need to concentrate on. Yet, much of this year will be spent on chasing volumes. Companies involved in core technology areas, Wipro Technologies and HCL, for instance, target the R&D budgets of vendors but even those are beginning to get squeezed.

This year’s sizzling tech-spaces are embedded systems, wireless applications, mobile commerce applications, communication software, and optical networking. They not only offer big market opportunities (if the products take off) but also the excitement of working on futuristic technologies. Historically, VC activity has been focused on either services or on Internet start-ups. Following the IT boom, in 2001, significant venture capital funding is expected to chase opportunities in the products and technology space as Indian companies move up the value chain.

OEMs globally were spending billions of dollars to scale and stay atop emerging technology. Also, the trend in global markets is outsourcing. "Companies/OEMs are concentrating on end-products. The potential for Indian companies to slot themselves in such niche spaces to build specific solutions in segments like embedded systems and wireless solutions is tremendous. However, with India leaping onto the products and specialised solutions bandwagon, the IT industry in India is shifting gear to get into the non-linear growth mode. While better workflow engines, global benchmarking standards and greater focus on productivity come into play, technology and products will hold the industry’s and consumers’ fancy for some time to come.

When will things begin to look up again? No one really has a handle on that yet. Perhaps by the fourth quarter of this calendar year…For now, a great year is over.