As the year began though, things looked like they were going downhill further. The first quarter was terrible for most companies and billing pressure just did not seem to ease. That changed from the second quarter and most of the stability shown this year has come from Q3 onward.

The Top 20 software exporters had the best growth year since the downturn, growing at 28% compared to 16% and 22% in the previous two years. Unlike last year though, the growth was not skewed toward the Big Five alone. Within the Top 20 list, the bottom 10 players grew at a much faster rate of 35%.

Broadly, the four big stories of last year were-the offshoring debate; signs that billing rates were stabilizing even as margins remained under pressure; the building up of scale; the appreciating rupee.

But first, a few top line trends.

Breaking the Ceiling
Together the Top 20 companies contributed to a greater pie of total software exports, about 68% up from the 62% level in earlier years. The top five companies alone account for 45% of total exports (up from 42% and 36% in the two previous years). The next five companies account for 10% of total exports (up from 9% and 7% from the two previous years) while the next 10 now account for 12% of all exports.

That comes from deeper changes in the industry. While Infosys' and Wipro's over billion dollar revenues broke both a real and psychological barrier that has been much written about and celebrated, other quite changes have also been happening that have largely gone unnoticed.

There have been two traditional glass ceilings in this industry where companies have often stalled - Rs 500 crore and Rs 1,000 crore. This year Patni Computer systems broke through the Rs 1,000 crore ceiling to become only the sixth company on this list that has had only five members in the last two years. More dramatically, the number of companies with revenues between Rs 500 crore to Rs 1,000 crore doubled from five to 10 in just one year as Digital GlobalSoft, NIIT, Tata Infotech, iGate Global (formerly Mascot Systems) and Perot Systems TSI broke the Rs 500 crore ceiling.

In some ways, these are more important changes than the billion-dollar club is. They speak of an industry that might just be showing signs of a deeper recovery that extends to all steps on the ladder.

That this should have come in a year where the backlash to offshoring debate raged stronger than ever makes it even more interesting.

The Offshoring Debate
During the year, the US senate approved a measure that will bar government contractors from shifting work on federal contracts from US employees to staff in other countries.

Another Independent member of the US House of Representatives, Bernie Sanders proposed what he called the "Defending American Jobs Act" that would limit federal grants and loans to companies that replace US employees with foreign workers.

Some states have already passed legislation penalizing companies that send work offshore. Similar proposals to curb outsourcing are pending in at least two dozen other states. The level of angst on the issue is visible from, if nothing else, the names of these acts - Opportunity Indiana, the Keep Jobs in Colorado Act, and the American Jobs Act of Wisconsin among them.

Bottom line-US companies are feeling the heat from both politicians and their own employees.

While the BPO industry was more strongly impacted, the IT Services industry wasn't left entirely untouched. In September of 2003, the H1B quota was cut down from 195,000 to 65,000. During fiscal 2004, the visa cut down did not impact the industry much as it also uses a huge number of L1 visas. Wipro Technologies for instance has 60% of its overseas employee population on L1s instead of H1Bs. There is no annual cap on L1s, nor is there a required pay rate.

That however, could change this fiscal as federal lawmakers have called for further visa reforms, which could hit the industry. In February this year, a hearing of the House Committee on International Relations discussed what it called the "misuse of L1 and other guest worker visas". It expressed concerns over the L1 visa program being allegedly fraught with fraud and abuse and being allegedly used by IT services companies from India to circumvent H1B restrictions.

All told however, in fiscal 04, the rhetoric had a mixed affect on Indian IT Services companies.

And Free Publicity
Vivek Paul, president and vice chairman of Wipro told analysts at the year end press conference, "We are seeing our sales funnel growing as a result of the offshoring debate because the awareness that has been created is huge and people who weren't thinking about it, are saying, 'Oh my gosh, I need to be thinking about it'. However, sales cycles have remain unchanged. What is really getting affected in a few cases is the ramp ups. Particularly, deals that came on the back of US layoffs are generally being pushed out."

Nandan Nilekani, CEO of Infosys Technologies says, "The US Election and a jobless recovery are creating an atmosphere of backlash. This is not slowing down business but clients are a lot more careful about 'change management'." However, he says, the backlash also had unintended consequences. "It has actually served to enhance our profile in the West. Because everybody writes and talks about it, more and more people have heard of us. In a way, its kind of free publicity to outsourcing and to Infosys."

According to Nandan, while addressing the Global Leadership Summit of the London Business School, the kind of place where you meet the world's top CEOs, recently, "The kind of brand awareness of our business model and of Infosys that has come out of such meetings has been absolutely unprecedented."

In fact, while it wasn't all business as usual, some business fundamentals did return to the forefront.

Back to Business
While fiscal 2003 witnessed severe bargain hunting by customers, some of it began to ease up by the second quarter of fiscal 2004. As the US and European economies picked up, there was more than enough business to go around with Tier 1 as well as Tier 2 and 3 players benefiting.

This shows up almost across the board. During the last fiscal, only two of the top 20 companies saw revenue growth in the teens (compared to four the year before) and just one company showed single digit growth compared to four in the previous year. More importantly, none of the Top 20 showed negative growth.

In fact, in its forth quarter, Wipro Technologies' 11% Q-on-Q growth came from a 10% growth in volumes and a 3% increase in realization. Vivek Paul was quick to caution though that not all of the 3% increase was from the billing rates. "Roughly about 2.5% of it's really more revenue optimization, either from getting a better mix of business or fixed price over-runs. Only about 0.5% of its is apples to apples, prices going up, he says.

In fact, though there were still enterprise customers who were pushing for price-cuts, exporters were this time ready to push back a bit. At Wipro, R&D realizations were better than enterprise deals but Paul says it had more to do with the sales push from their side than the level of skill involved. Either way, in an industry that has become extraordinary cautious about optimistic over-statements, most were willing to go as far as: "pricing had stabilized and is not really likely to be a depressant in the coming year".

"Composite billing rates per hour have eased first because vendors compromised and later because the integrated rate (offshore plus onsite) went down. So, instead of negotiating hard on billing rates, customers are now asking for composite rates through fixed-rate contracts," says Ravindra Datar, principal analyst with Gartner India. Often, with sufficient efficiencies built in, this can work in favor of the vendor.

But the nub-operating margins continued to be under pressure. Some of this came because of extensive investments for growth that companies made, some because the billing pressure eased up too late in the year. At Infosys for instance, operating margins (OM) fell from 35% to 33%; at Wipro from 22% to 18.5%; at Satyam, from 31% to 27% and at HCL Technologies from 20% to 15%.

The Nuts and Bolts
Most of the IT spending growth that contributed to the growth of this sector came from stable spends from the BFSI segment (Banking, Financial Services and Insurance), a huge rebound from the Telecom segment, specially Telecom Equipment manufacturers which had skidded to a halt in FY03 and a large jump in the manufacturing sector's IT spends.

For instance, manufacturing grew 110% in fiscal 2004 as it drove Wipro's enterprise business to 33% of its exports revenues. It also contributed 32% of Satyam's and 15% of Infosys' software and services revenues in 2002-03. Telecom drove the growth at not only the broad services players but at smaller but niche companies like Sasken Technologies.

In addition, tier-2 companies in the US began to spend. Over the previous two fiscal years, capital spending by these companies had been depressed and R&D spends had almost totally disappeared. With R&D spends growing back again, top players in this segment including Wipro and HCL Technologies benefited.

More importantly, while fiscal 2002 and fiscal 2003 were largely driven by application maintenance work, fiscal 2004 saw the return of app build deals. Newer service lines like total product outsourcing, package implementation, engineering services etc all built up. At Infosys for example, 35% of all revenues during last fiscal came from new service lines introduced over the last four to five years. Most of all however, the big service line of the year was package implementation. At Infosys, Package Implemenation now accounts for 15% of the top line while it says 69% growth year-on-year at Wipro. In fact, according to Wipro, the company did three of the six large implementations around the world during the fiscal.

As a result of these new service lines however, onsite revenues continued to grow yet again (from 53% in FY03 to 56% in FY04) - one of the reasons that impacted margins. Similarly, revenues from the US grew again from 66% to 68% though the big news of the year was growing traction in Europe. While European revenues grew overall from 20% to 23%, by Q4 they had eaten into the American part of the pie in some companies. Japan, APAC and the Rest of the World also saw a lot of activity though given the small base of revenue from here, their share of the pie would continue to be fluid over the next few years.

Building Scale
However, if there is one single event of the year, that will impact this sector in the future, it is the building up of scale. Companies added people any which way they could -– either through some of the most aggressive hiring ever in the history of the industry, or through acquisitions. Wipro alone for instance grew from 12,358 people to 19,159. Including Spectramind, the company now has a good 30,000 people. Infosys grew from 15,000 to just over 23,000 people; HCL Tech from around 8700 to over 14700; TCS is now up to 27,000 people while Satyam now has a good 23,000 people up from 9700 in the last fiscal.

MNC IDCs: Ramping Up

From cost centers catering to the internal requirements of their parent companies, MNC India development centers (IDCs) are emerging as serious competition to Indian services vendors in their own backyard. Dataquest figures show that MNC centers contributed Rs 9,660 crores in fiscal 2004 and now account for 23% of total software services exports, up from 19% last year Reduced operational costs and a technical force, which comes cheap, remain India's USPs over countries like China, Israel, Ireland, Singapore, Malaysia and Russia. Often, the driving reason for companies like IBM, Texas Instruments and GE has not been cost, but the talent pool. Most of these firms have a strong consulting front-end, something which Indian players are in the process of acquiring. For example, database software maker Oracle does not restrict itself to recruiting developers, but takes on board consultants who have expertise in large scale ERP and CRM implementations. Thirty per cent of all software for Motorola's latest phones is written in India. With the share of offshore resource location on the rise, companies have ramped up confidently. Hughes Software's Noida development center added 406 employees more in fiscal 2004 to take its strength to over 700 personnel in India. With a strong emphasis on domain-specific skill sets, GE's 1,600-strong R&D employee workforce includes 1,100 technical experts. Of these, 31% are PhDs and 44% have master's degrees. Intel's worldwide R&D head count is more than 5,000, with about 1,000 in Bangalore, where it expects to add 1,200 employees by the end of 2005. Texas Instruments (India) was awarded 262 patents till March this year. Till December 2003, Indian units of various American technology companies filed more than 1,000 patent applications with the US Patent and Trademark office. From over 40,000 people last year, MNC development centers now employ over 48,000 personnel. Expert estimates see the headcount touching 80,000 in the next 18 months. n DQ estimates based on development costs of Rs 16 lakh per developer n Development costs include salaries, plus overheads, infrastructure and development expenses Ravi Menon in Bangalore

In addition, Infosys acquired Expert in Australia renaming in Infosys Australia and set up Infosys Consulting in the US. Wipro acquired Nervewire though, HCL Technologies took over HCL Infosystems, MphasiS BFL recently took over Anant Koppar's Kshema Technologies in a 21 million dollars stock, and cash deal.

Says Nandan Nilekani, "If there was one thing that has become clear this year, it is that scale is our forte."

It might well be. However, it comes with a flag. Going forward the only way out of the labor arbitrage proposition seems to be deep domain expertise. Acquisitions that were aimed at acquiring vertical specific expertise will show dividends in the future – case in point – Wipro's AMS, Ericcson (one R&D division) and Nervewire buyouts. However, scale built by merely adding vanilla skills could be a source of potential trouble. Even fiscal 2004 saw per person productivity and profitability go down in most companies. Meaning - each new head added is adding less and less to both the top line and the bottom line.

To add to this, appreciating rupee appeared as a new variable to deal with. At Infosys the 8.7% annual appreciation of the rupee had a major impact, negatively impacting the top line by about Rs 272 crore and the bottom line by Rs 111 crore. Hedging, however, is an art that most vendors still don't practice very aggressively. One of the most active in this respect was Wipro, which put in place a $900-million hedge fund to reduce the impact of the appreciating rupee. At Infosys, Nilekani said there had been a major impact of the rupee.

Going Forward
The ongoing fiscal comes with its own set of challenges. The rupee remains imponderable, while wage inflation is almost a given. Offshore wages have been going up as supply side pressures increase and are only expected to go up further. One of the contributing factors has been aggressive hiring by MNCs and the pressure on Indian IT Services companies to compete with them. According to Paul, "we continue to track how many people we lose to them (MNCs) and how many people we gain from them and there is a two way flow, although net-to-net we are a loser to them."

In fact, as most companies increase the number of freshers they hire, they're also seeing attrition rates in this experience group go up drastically. Paul told analysts that the company had done a wage hike last October and again in Q3 and yet, he said, "I think that we will not see any abatement on the compensation side. In the coming fiscal, we expect to see our overall average salary cost going up by about 14%."

In addition, onsite wages will come under pressure as salaries finally begin to rise in the US. Last fiscal, Infosys gave a 2-3% hike on onsite salaries, the first in four years. Wipro also saw onsite salary costs go up and as Indian talent in the US matures, there will be MNC driven supply side pressure even there. The only visible solution to this at the moment: tighter ships, better housekeeping and lower SG&A (sales, general and administration) expenses.

All told though, the coming year is most likely to be more of internal challenges than external ones. And no matter how tough, better the inner demon to fight, than the outer devil to grapple with.

Ravi Menon in Bangalore