IT firms need to seek productivity gains

IT firms need to seek productivity gains
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First Published: Wed, Jun 06 2007. 12 21 AM IST
Updated: Wed, Jun 06 2007. 12 21 AM IST
For India’s software exporters, there is a sombre message in the Plaza Accord of 1985. Following that agreement, the Japanese yen began a steep climb. It reached 121 to the US dollar in December 1987 from almost 263 in February 1985. Japan’s exporters, facing severe erosion in profitability, turned to their treasurers to create additional income by engaging in speculative trades.
Something similar is now happening in India. Buoyed by capital inflows, the rupee has strengthened 9.3% against the dollar since 2 March. It’s hovering close to a nine-year high.
Expectations are gaining ground that this may be the start of a multi-year currency appreciation driven by a return of the exchange rate to a level closer to its true purchasing power. This scenario—and it’s no more than that at present—is problematic for Indian software companies.
Immensely successful in the past few years in getting Fortune 500 companies to outsource their applications-support and network-maintenance work to India, these companies are now reaching that point where they must think hard about how they are going to live with a stronger currency.
And no, the solution doesn’t lie in forcing treasurers to take additional financial risk to make the quarterly profit guidance. Indian software companies have to stop being pure service providers and sell more products. From tools that allow mortgage banks to track defaults to applications that enable retailers to manage inventory, the scope is endless.
Mumbai-based Tata Consultancy Services Ltd (TCS) said on 31 May that its profit margin was shrinking because of rupee appreciation. On Monday, Credit Suisse Group cut its price target on Bangalore-based Infosys Technologies Ltd, citing a stronger rupee. It also changed its rating on Wipro Ltd, a smaller rival of Infosys, to “neutral” from “outperform.”
Shares of Infosys, Wipro and Tata have fallen during the 10% rally in the benchmark Bombay Stock Exchange Sensitive Index in the past three months. These companies are already highly efficient and investors doubt the rising currency, can be overcome by squeezing more out of workers or cutting costs. The three firms hire thousands of employees each quarter and utilize them so as to protect their 25-30% pretax profit margins even after routinely handing out annual 15% wage increases.
In this model, there isn’t much scope to get higher prices from clients without hiring more expensive resources. That might sacrifice profitability, rather than boost it: after all, a consulting company such as Hamilton, Bermuda-based Accenture Ltd has a pre-tax profit margin of less than 11%. Beating back the margin pressures from a rising currency requires a significant jump in revenue productivity per worker without an attendant increase in costs. It’s possible to do this by moving away from merely selling time to creating products. Last week, it announced the formation of TCS Financial Solutions, a product unit focused on banking and capital markets. “The idea is to grow our revenue disproportionate to the headcount,” says Krishnan Ramanujam, the Sydney-based chief operating officer of the new division.
TCS has, largely through acquisitions in Australia and Switzerland, come to own proprietary financial products that span everything from core banking to securities lending. Half of all banking transactions in South Korea and 45% in Taiwan are now processed using Tata’s products. With 2,500 employees, the unit had $170 million in sales in fiscal 2007. Its per-employee revenue of $68,000 is two-fifths higher than for TCS as a whole. This is the way forward for Indian software firms. They must utilize their robust cash flows to acquire products. Or else, they will remain efficiently run commodity producers. It’s bizarre that just when old industrial companies in India are scouring the world for leveraged-buyout targets, some new-age software-services firms are paying out more money as dividends than they are setting aside for investments.
Are they running out of ideas? Do they want to get acquired? It’s widely believed that the global market for outsourcing will continue to grow, and a lot of the new business will come to India simply because of demographics: no other nation between now and 2025 will add 273 million people to the workforce. But the stock market has already rewarded home-grown Indian software firms handsomely for their ability to execute outsourcing projects with efficiency. Now investors would like to see a blueprint for withstanding currency risk.
The rupee is at present trading at about 40.5 to the dollar. According to the University of Pennsylvania’s Penn World Table, Rs8 have the same purchasing power in India as $1 has in the US. It’s natural for developing-country currencies to remain undervalued relative to purchasing-power parity for a long time, though there usually is a process of convergence.
If the appreciation in the rupee turns out to be even half as rapid as it was in Japan, the exchange rate might climb to Rs30 to the dollar in three years. The assumption that the Indian central bank won’t allow the rupee to rise so quickly is no excuse for complacency. It shouldn’t stop Indian software firms from starting their search for productivity gains. Otherwise, the poor corporate treasurer will be forced to become a gambler. And that, if the experience of Japan is anything to go by, won’t be a good thing. (Bloomberg)
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First Published: Wed, Jun 06 2007. 12 21 AM IST
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