It has been an old adage in the IT industry—watch those PCs; they are a good indication of what’s up with the market. Almost three years ago, HP’s global PC sales slowed down. Within three months of HP’s results in October 2000, the more far-sighted CEOs of the Indian IT services industry knew the coming months would bring trouble. They did.

This October, HP specifically, and the worldwide PC market in general, have shown robust growth. The Palo Alto-based company’s PC business grew by 19% this quarter, while Dell’s grew by 22% (it’s expecting a 25% growth in the next quarter). Worldwide PC sales, in general, have been up 15.7% while the APAC region including India has soared. For the first time, this recovery looks like it has come to stay.

This time around though, what does it really mean for the Indian IT services industry? The answer is a little mixed. In the US, much has been written about the ‘jobless recovery’ where economic indicators have begun to look up but somehow, these have not led to more jobs being generated. Something similar seems to be happening here. Top line figures in the first half of fiscal 2003 indicate that a recovery may be on the way. Revenue growth at the large majors has remained steady while tier-2 companies like MphasiS and Digital GlobalSoft have actually seen growth rates increase. However, this is coming at a cost—margins pressures. If one were to draw a parallel, the jobless recovery of the US might be mirroring the ‘margin-less’ recovery in the software services sector in India. In short—the business is coming in and indeed, might be growing. But the pricing pressure is continuing, relentlessly.

Topline Growth
Toplines of most Indian software companies have grown at a robust rate in the first half of fiscal 2003. Infosys’ topline grew 35% (compared to 39% during the full fiscal 2002); Wipro’s 29% (steady at 29% in fiscal 2002); Digital Globalsoft’s 45% (up significantly from 27%); MphasiS 42% (up marginally from 37%). (See table 1). In fact, both Infosys and Wipro hope to join TCS in the exclusive league of Indian software companies that clock annual revenues of over a billion dollars.

"We expect our revenues for the financial year to exceed $1 billion. In 1999, the revenues of our company were $121 million, which means that in five years the revenues have grown from a little over $100 million to over a $1 billion," said Infosys CEO Nandan Nilekani, announcing the half yearly results of the industry bellwether. "Two years ago, our revenues were about half a billion dollars and have almost doubled since," he added.

Wipro too aims to join the club by the end of the financial year. "Translating second quarter’s IT revenues of $268 million on an annualized basis puts us into the billion-dollar league," said Wipro corporate executive V-P (finance) Suresh Senapathy at the half-yearly results announcement.

Part of this stupendous topline growth can be attributed to the fact that both outsourcing and offshoring have now become mainstream. More importantly, the international telecom industry—a key vertical for Indian services players—has begun to look up again after two years even as the banking and financial services industry continues to spend.

"In terms of verticals, we have recently seen an increased growth in the banking and financial services as well as in telecom. In telecom, this growth has come primarily from the service provider segment," says Infosys COO Kris Gopalakrishnan. That also showed up in the results of companies like Hughes Software, which gets a good chunk of its revenues from this vertical.

There is a caveat though. In companies like Wipro Technologies, the topline growth now includes its BPO business from Wipro Spectramind. This is significant since Spectramind has been a huge hirer during this half year and is likely to have significantly boosted the revenue growth figures. The same would apply to Digital GlobalSoft whose Digital Contact Center (DCC) has grown rapidly during the year.

That was the good news. The bad news is that other things haven’t changed. Three issues that had plagued the industry during fiscal 2002 continue to have a significant impact on companies’ finances—margins squeeze, an appreciating rupee, and the backlash against outsourcing.

The Big Squeeze
Analyze this: during the first half, Wipro’s topline grew by 29% even as profit before tax grew by a mere 6%. Digital Globalsoft’s topline grew by 45% while net profit grew by 27%. Satyam revenues were up 24% as compared to an 18% growth in net profits. Part of this is of course because of significant investments made during the year by some of these companies. Wipro Technologies bought over NerveWire while others like Satyam and Digital have invested in and expanded their BPO businesses.

However, that doesn’t explain it all. Adding to the squeeze is the fact that renegotiation of deals is continuing, especially from larger, older customers who have large volumes of business with any one company. "We have several hundred customers and only about 15 of them have actually renegotiated prices in the last six months. What happens though is that typically the renegotiations happen when the volume with the customer goes up. And because they tend to be larger customers, the impact is something that you feel," said Nilekani.

That’s the demand side pressure. Adding to supply side pressure is the very fact that offshoring has become mainstream. As a result, global services companies and systems integrators have continued to expand heavily in India, often hiring people at significantly higher salaries to get the momentum going quicker. Two of the big hirers of the year are, IBM Global Services that is now approximately 5,000-strong, and Accenture that has also been accused of pushing billing prices down over the last few months.

This has forced companies like Wipro and Infosys to hike salaries during the half-year under consideration, even though margins have not improved. How long the impact of this supply side pressure is likely to last is difficult to say at this point of time. While Wipro Technologies is acutely aware and chary, Infosys is aware but not yet worried. Says Infosys COO Gopalakrishnan, "In some instances, the global SIs are offering higher salaries… It doesn’t have a significant impact on Infosys right now. However, we are looking at how salaries will move over the years, and have increased salaries for our employees this year." That too, though, comes with a caveat. "By and large, we have made this hike a variable component of salary so that if the company does well, the employee gets more and if there is a downturn, then the company is also protected."

The Twin Pains
While the margin squeeze is a continuing saga, the other two issues have only exacerbated over the year. While presenting the half-yearly results in 2002, Nilekani had expressed worry on two main fronts—the possible effect of the appreciating rupee and the possible effect of a growing backlash to outsourcing. Both possibilities have since become realities. The rupee continues to appreciate steadily while not only have H1B quotas been cut down to 65,000 from 195,000 but the L1 visas have also come under closer scrutiny.

First the rupee. According to Infosys CFO Mohandas Pai, "The key issue is the impact of the appreciating rupee. Loss of revenues due to the rupee’s appreciation this quarter is about Rs 58 crore, and loss of revenues for the half year is about Rs 90 crore, assuming the same kind of average as you had the previous year." It boiled down to a negative impact of 5.1% on the topline and a negative impact of 0.75% on the operating margin.

For Bangalore-based Digital Globalsoft, the issue is of top priority because for every 1% appreciation in the value of the rupee, it’s a 0.5% hit on the bottomline. "One of the uncertainties is the rupee-dollar rate; so while everything else in under our control, at the moment, we have some quarter-to-quarter drive to manage the affect of the appreciation. Some of it is done by hedging and since some of the hedging happens against our expenses that are getting incurred in overseas currencies, the impact is significant. …The biggest uncertainty remains there," said Som Mittal, president and CEO of Digital Globalsoft, during the company’s results conference call.

Also, for an industry that was writing off the backlash against outsourcing as a media hype, the slashing of the H-1B quota has come as a bit of a shock. In October, the H-1B visa quota dropped to 65,000 and while the impact may not be immediately felt, this is something now being watched very closely. For one, one will need those extra visas if the recovery actually does happen and the business booms. More so because companies like TCS and Infosys have seen onsite revenues go up over the last couple of years due to change in service lines. Also because the H1B visa issue has led to closer scrutiny of the blanket L visas that all the big IT services companies have and use extensively. Infosys HR head Hema Ravichandar said, "On the H1 front, we currently have about 4,800 visas and 50% of those are utilized. We have a significant number in the pipeline as well… we don’t see it making a very significant impact right now, but going forward, we are looking at it very closely."

Going forward though, the key challenge will continue to be with margins. As MphasiS CEO Jerry Rao put it, "Our #1 concern is that we have to keep the trajectory of clawing back on the gross margins in software services. We had said that we had lost 5-6% points and we will claw it back over the next two-three quarters; if not all of it, at least some of it. We have clawed back 1.6% this quarter and we have to continue to do that." The rest of this fiscal should be interesting to watch.

TV Mahalingam

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