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The Top 5 get bigger, earning 42% of India’s software services revenue, compared to 40% in FY ’02 and 36% the year before
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Four Top 20 exporters showed single-digit growth, four just made it to double-digits, and one saw revenues decline
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The big software players added the highest number of people for the lowest growth in gross profit ever
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In tough times, there’s a trait in human beings and their endeavors that
makes them believe that hope lies just over the next mountain. Literature is
littered with metaphors to that affect—the cloud with the silver lining, the
night whose day will dawn. The IT services export industry and its watchers
believed fiscal 2002 was one such mountain—and that hope and dawn lay in
fiscal 2003.
Turned out, 2002-03 was yet another mountain to cross. If anything, things
just got tougher.
Two years ago, the Indian IT services sector thought it knew exactly where it
was headed. Average industry growth rate was 60%, operating margins were 40% or
above. As the industry perfected the global delivery model and got better at
what it was doing, things would only get better, one thought. Everyone spoke of
moving up the value chain and how it would mean a major paradigm shift. True,
Year 2002 wasn’t great—but that was to have been a blip that would soon
pass.
Turned out, that wasn’t so. Fiscal 2003 wasn’t about moving up the value
chain as it was meant to be. It was about burning tracks just to try and stay in
the same place. Sometimes successfully, more often not. Though some companies
like Infosys and HCL Technologies increased their performance by a percentage
point or two, overall industry growth fell further—for the first time into its
teens at 18%, compared to 22% the year before.
The saving grace of FY ’02 was that although the topline had got hit, the
bottomline had remained mostly intact. That changed last year as margin pressure
got excruciating. Gross profit growth halved and in some companies like Wipro
Technologies and Satyam, it fell into single digits.
In far too many ways, last year was an inflection point in the young history
of this industry.
The day the music died...
To be sure, at Rs 35,181 crore, the software services export sector still
accounts for 47% of the total Indian IT industry. But the inflection—for the
first time, this sector’s growth fell into the sub-20s and below the overall
industry growth rate. "We are entering an era of growth in the teens,"
Nasscom president Kiran Karnik warned in May. "This is a true inflection
point in this industry."
The big losers were companies like TCS, Satyam, IBM, Mahindra British Telecom
and Mascot Systems. At TCS, growth went down to half—from 37% to 15%. Satyam
Computer Services had grown by an admirable 43% in fiscal 2002, but that came
down to 18%. IBM showed no growth at all despite taking over PriceWaterhouse
Coopers and its 800-odd employees in January this year. HCL Perot showed a
growth of 1%, while NIIT—which had seen revenues slide by 15% in FY ’02—saw
that slide slow down a bit with only a 5% drop in revenues.
As many as eight of the Top 20 software exporters saw growth go down into the
teens or below. Four of these showed single-digit growth. One showed negative
growth.
A key consequence of this—there is glass ceiling in the industry today, the
Rs 500-crore mark that exporters have been finding impossible to cross over the
last two years. Since fiscal 2001, there’ve been only five Indian companies
with revenues above Rs 1,000 crore. Similarly, there have been only five
companies in the Rs 500 crore to Rs 1,000 crore range, accounting for another
10%. This isn’t even status quo. According to Nasscom estimates, there were
seven companies in the Rs 500 crore to Rs 1,000 crore range two years ago. That
number shrank to five in FY ’02 and has stayed there.
The second key inflection point—drastic profitability decline.
Wipro Technologies had the highest growth ever in billed man-months and the
lowest growth ever in profits at 3%. Infosys added the highest number of
employees ever for the lowest growth ever in gross profit. HCL Technologies
added 56% more developers for only a 13% growth in gross profit. Among the top
five exporters alone, productivity fell 2% to 15%, while profitability fell 6%
to 28% (see table).
Bottomline—each new body added less and less to both revenues and profits.
For the first time, a spurt in hiring in this sector was no longer a sign of
things looking up.
There were numerous reasons for this.
Pressure!
Ironically, some of the pressure came from the very thing the industry had
been hoping for—the fact that offshore has now become mainstream.
While that meant that companies—especially US companies—were more open to
sending work to India, it also meant that they got more savvy. Simply put, they
shopped around.
As Vivek Paul, vice-chairman of Wipro and CEO of Wipro Technologies put it—"Customers
became mercenary and stopped being so relationship-oriented." With larger
exporters, they threatened to go to Tier 2 and Tier 3 companies if billing rates
weren’t brought down. Said Paul—"They took the carrot-and-stick
approach. Threatening to withdraw future prospects if billing rates were not
brought down... and promising more business if they were." More often than
not, Tier 1 players gave in because their economies of scale allowed them to.
There were deals last year that are believed to have gone at rates below $10 an
hour—in what analysts have called "marketshare buying" strategies.
Basically, doing the first project at an extremely low cost in the hope that
more business would come their way from the same customer.
Tier 2 and Tier 3 players got squeezed from two sides—the customers and the
big Indian five who fiercely bid for deals they wouldn’t have bothered with a
couple of years ago. As one mid-tier company CEO put it—"We saw TCS,
Infosys and Wipro in the weirdest deals. They bid competitively and fought
fiercely for the smallest of deals. That really put the screws on us."
Look at the numbers. In 2001, the Top 5 accounted for 36% of all software
exports. That grew to 40% in fiscal 2002 and now stands at 42%. Similarly, the
next five accounted for only 7% of all software exports in fiscal ’01. That
grew to 9% in fiscal ’02 and now stands at 10%. ,However the overall Top 20
share of total exports, by and large, remains constant at 63%. Message—even
within the Top 20 exporters, the smaller ones are getting squeezed.
On their part, the smallest companies—those between Rs 25 crore and Rs 200
crore—had a peculiar year. Typically, companies graduate from being dependent
on a single project to a single client. And it is only then that they begin to
de-risk their client base for a more sustainable business model. The downturn of
the last two years made that difficult and most continued to remain heavily
dependent on one or two large customers. This year, they paid the price.
At Axes Technologies, for instance, revenues fell by close to 30% and profits
fell 57%, mostly because a single customer cut IT spend by 40%. At Aztec
Software, revenues were down 37% and the company posted a net loss because one
single, large customer walked out on them. Both these companies—and many
others like them—are now struggling for their very survival.
At no end of the ladder was life easy last fiscal.
The Big Boys come to town
Interestingly, there was a new element to the market dynamics this year—the
growing offshore presence and visibility of international services outsourcing
providers like IBM Global Services, CSC and Accenture. Though IBM Global has had
a presence in India for a while, others caught on to the advantages of an Indian
presence as offshore became more acceptable.
This brings its particular challenges. These providers have a well-known
international presence and branding with international customers. Quite often,
they also often have an existing relationship with their client. And if
anything, their economies of scale are better than that of Tier 1 Indian
players.
This is a trend that’ll only exacerbate in coming years. According to a
recent Giga report by Will Cappelli, "India’s offshoring industry will
undergo a crisis during the next two years as IGS, Accenture and other global
players attain quality/cost ratios similar to those achieved by TCS, Wipro et
al. Business process outsourcing is no salvation here, because the global
players will, of course, deliver that too."
Cappelli’s trends for this year include—US-based outsourcing firms like
IBM, CSC and EDS will undercut Indian vendors’ prices; companies too dependent
on India will increasingly look to diversify their risk; and large top-tier
outsourcing firms will continue to thrive while the smaller, newer Indian
vendors will struggle to survive.
Some of this is already happening. IGSI is getting extremely competitive in
international deals where it meets up with companies like Wipro, TCS and Infosys.
Accenture is making up for its late entry by a quick ramp-up and is already
getting a reputation for cut-throat pricing.
Indian companies are aware of this threat. Two years ago, Paul had dismissed
the threat from MNCs, saying they would find it difficult to master the global
delivery model that Indian companies had perfected. This time, during the
year-end analyst conference, he said—"Global companies like IGSI, KPMG,
Accenture and Cap Gemini Ernst & Young pose challenges from both sides—the
demand side and the supply side."
What he meant by supply side was as that as MNCs hire in droves—IGSI alone
has a good 4,000 people—Indian companies will have to offer competitive
salaries if they want to attract and retain the best developers. Paul,
therefore, told analysts that the company was seriously considering a
significant salary hike sometime during the year. On its part, Infosys made a
big deal of proposed salary hikes for its employees during the first quarter
results this July. After two years of no salary hikes or salary cuts, both
companies were eager to let it be known that better pay packages were on their
way.
But the catch—being forced to increase salaries even as margins go down is
not an enviable position to be in.
The nuts and bolts
All of this has been combined with a changes in the nuts and bolts of the
way this sector works. For one, the euphoria of some really large deals of
fiscal 2002 subsided. There were no large deals to be had for Indian companies
last year, even though internationally, some really large IT outsourcing deals
were signed by IBM and HP during the early part of the year. As deal sizes got
smaller, it meant more work, more sales dollars per deal, higher sales and
marketing costs and lower operating margins.
Secondly, there were fewer application build deals to go around. Put
together, custom application development and maintenance account for over 70% of
this sector’s revenues. The balance tilted sharply last year, however, toward
app maintenance instead of app build projects, which are typically low value and
therefore low margins.
This, however, was a continuing trend from last year. What really took off
was package implementation. But it wasn’t so much full package implementation
as nuts and bolts tinkering and customization.
The issue with both of these—app maintenance and package implementation—is
that they are heavier onsite plays. As a result, though offshore revenues
overall went up, some of the larger players actually saw onsite revenues
increase for the second year in a row. For instance, the onsite revenues of
Infosys went up from 51% to 54% while that at HCL Technologies from 46% to 53%
On the whole, while onsite may bill more, margins here are slimmer.
In addition, for the second year in a row, the industry’s attempt to
de-risk itself geographically didn’t work out—revenues from Europe continued
to fall in favor of the US, which now accounts for 68% of all exports. There are
of course internal challenges that the industry has in addressing the European
market— unfamiliarity with language, culture and business customs. But there
were external challenges that the industry could do little about—continuing
European unease with offshoring and economies that simply got worse and worse.
Frankly though, the growing dependence of Indian software services providers
on the US couldn’t have come at a worse time.
Resistance
Under pressure from an economy that showed no signs of looking up and a job
market that continued to shrink, there was increasingly vocal opposition to
anything that seemed to threaten Americans—either through jobs moving offshore
or immigrant workers coming into the US on H1B and L1 business visas. Some of it
was just frustration being vented on a growing number of sites on the Net
against H1B visas. Some of it took the form of protests by tech union workers
and bodies like the IEEE in the US and BT employees in the UK. But some
threatened to turn into into legislative restrictions.
For one, four US states introduced Bills to prevent state government bodies
to offshore work out of the country. The Bill that came closest to being passed
was the New Jersey bill, though it finally got held up for modifications at the
last moment. Whether these Bills, in fact, get passed or not is not particularly
important at the moment... for two different reasons. One—the US government
sector is not deeply penetrated by Indian IT services companies and, as such,
would not be a big loss. Two—irrespective of the passing of the Bill, in the
short term, the US government has already begun to get cagey about sending work
offshore. For example, with no help from legislative pressure, the New Jersey
Department of Human Services forced eFunds into scrapping the offshore component
of one of its projects in June.
The more immediately important issue, however, will be visa restrictions. Two
years ago, Bill Clinton had increased the H1B cap from 65,000 to 195,000. This
limit is up for review in September this year in an environment that is not
entirely pleasant. Made worse by Congressman Tom Tancredo’s latest salvo—the
proposal to scrap H1Bs altogether. Though that is hardly likely to happen, this
is a challenge that should see its culmination sometime during the current
fiscal.
Going Forward
While bodies like Nasscom and the Ministry of External Affairs deal with
those challenges, Indian companies have their own particular battle to fight.
One of these — the battle to define their identity.
Who will they be? Armies of programmers who as every year passes, add less
and less to the bottomline? Because that is one of the defining principles of
business – commodities only get cheaper, not more expensive. In addition, by
all accounts the current fiscal looks like it is going to be at least as tough
as the last year.
Or will they find the will and the foresight to transform themselves now into
something more?
Paul called it the choice between being "Indian factories" or
consultant-led truly global companies. This requires deep domain expertise, a
heavy investment in intellectual property and a business model that can compete
with the IBMs and CSCs of the world on more than just price. "The Empires
of the future," said Winston Churchill, "are Empires of the
Mind." In the end, that is what the next two years is going to be about –
the battle for the mind – their own, their employees’ and their customers.
Sarita Rani
The MNC IDCs: Ramping Up
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