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Indian IT’s midlife crisis

With the help of cloud computing, termed also as a non-linear or non-headcount-related technology, companies such as Google, HP, Microsoft are more than nibbling at the IT outsourcing pie by increasingly hosting the IT infrastructure of enterprises in their own data centres, reducing the IT costs of their clients by 40%. Photo: Mint (Mint)Premium
With the help of cloud computing, termed also as a non-linear or non-headcount-related technology, companies such as Google, HP,
Microsoft are more than nibbling at the IT outsourcing pie by increasingly hosting the IT infrastructure of enterprises in their own data centres, reducing the IT costs of their clients by 40%. Photo: Mint

Manpower-linked linear growth models have left most Indian companies bloated, out of shape and with declining profitability. What’s the future?

Mumbai/Bangalore: On Friday, 12 April, Infosys Ltd, the company once considered the stock-market bellwether of India’s fabled information technology (IT) industry, declared its results for the last quarter of 2012-13.

The company’s performance had been slipping for some time, but it had turned around smartly (or so it seemed then) in the third quarter of 2012-13, which probably explains why no one was prepared for the poor results the company came up with on 12 April.

On 11 April, shares of Infosys closed 3.7% higher on BSE as analysts and investors anticipated improved revenue, coupled with better earnings guidance. They went terribly wrong and Infosys stumped the markets with yet another disappointing quarterly earnings announcement the following day.

While the Street expected Infosys to guide in the 12-13% US dollar revenue growth range, it forecast 6-10% revenue growth for fiscal 2014. Investors battered the stock, which fell 21% to close at 2,295.45 on 12 April on BSE.

Infosys reported a revenue of $1,938 million in the March quarter, up just 1.4% over the preceding quarter. Excluding Lodestone Holding AG—a global management consultancy firm headquartered in Zurich which Infosys acquired in September 2012—US dollar revenue grew by just 0.8% sequentially. The overall volume growth came in at 1.8% over the earlier quarter while overall pricing declined 0.7%. The Infosys management said the environment remains challenging and clients continue to delay IT spending.

TCS and HCL Technologies reported higher profit and revenue for the quarter ended March as they won more work from overseas clients. TCS said fourth quarter net profit rose 24.9% from a year earlier to Rs.3,615.64 crore in the three months on a 23.8% increase in revenue to Rs.16,430 crore. HCL Technologies’ net profit rose 72.6% in the March quarter to Rs.1,040 crore on a 23.2% increase in revenue to Rs.6,425 crore. The results, and the positive outlook of the companies’ management, pleased analysts and served to allay the disappointment delivered last week by Infosys Ltd, India’s second largest computer services firm, which failed to meet its fiscal 2013 revenue forecast.

India’s third largest software exporter Wipro Ltd, also reported better-than-expected March quarter net profit of Rs.1,729 crore, up 17% y-o-y. However, the company provided a weak forecast for the June quarter in the range of $1.57-1.61 billion, which would mean a much lower growth than what analysts had expected.

Nevertheless, while the other IT companies have not come up with as unpleasant a surprise as Bangalore-based Infosys, there is a larger story beyond the numbers.

It is the story of Indian IT’s midlife crisis.

For three decades now, India’s software exporters have raked in double-digit revenue growth figures based on conventional IT maintenance and development work and manpower-linked pricing models. Yet, if they want to stay relevant, they will have to recast this model to account for trends such as mobility, automation and the so-called Big Data or information deluge and disruptive technologies such as social media and cloud computing, say analysts.

The conventional model worked since over 80% of the clients, who are based in the US and the UK, outsourced and off-shored IT maintenance work to save money because labour in India was relatively cheaper; but that may no longer be the case with Indian IT workers getting 9-12% annual wage increases for years in a row.

Also, with the US and the UK economies seeing bad times, their governments are tightening work visa laws and want Indian IT firms to set up more local centres to create more jobs in their countries, which will increase labour and infrastructure costs.

Indeed, over the weekend of 13 and 14 April, The Washington Post reported that according to a new proposal pushed by some US senators, India’s outsourcing firms that use the maximum number of H1B work permits (such as TCS, Infosys, Wipro and HCL Tech) could be the biggest losers, while US technology firms, including Microsoft Corp., Cisco Systems Inc. and even Facebook Inc., would benefit.

Back office management, or so-called IT-enabled services, was the great white hope of the 2000s, but a lot of the voice-based commoditized business is moving to the Philippines, Vietnam, China and some Latin American countries.

And the rise of companies such as US-headquartered IPSoft Inc., which uses software humanoids to replace engineers to manage computer desktops, servers and communication networks of customers including Comcast Corp., is another cause for concern for Indian IT companies.

At the core of the challenge faced by such companies, however, is an interesting trend: with their employees working less on desktop personal computers and more on laptops and tablets, and even smartphones—the so-called bring your own device, or BYOD, phenomenon witnessed around the world—clients are increasingly demanding newer service delivery technologies that take account of trends such as mobility, social media and cloud computing—a method of delivery of IT services over a network, the Internet in many cases.

With the duration of IT contracts getting shorter, coupled with protectionism and regulatory hurdles, pure linear growth—or growing by just adding employees—will just not work. The top Indian IT firms, especially, are bursting at their seams with almost, or in some cases much more than, 100,000 employees each. India’s largest software exporter TCS alone has more than 250,000 employees.

Customers including Bank of America Corp. and Target Corp. are asking vendors to deliver services with fewer staff and bill them on a “pay as you go" model, and investors keep raising eyebrows at every percentage fall in profit margins—a metric that established the $108 billion industry as the most profitable software services business on earth.

“The India-centric model which made the country the back office of the world, is almost dead. With average pay hikes of 9-12% annually, our IT labour will no longer be cheap. This will force software exporters to look at global delivery models that comprise onsite, nearshore (closer to the client’s location) and some offshore work," said Sanjoy Sen, senior director, Deloitte Touche Tohmatsu India Pvt. Ltd.

For India’s top technology firms, seeking the next big thing beyond traditional people-based services, it’s a now-or-never situation, said R. Ray Wang, founder of enterprise research firm Constellation Research Inc., in a 21 January note. “IT services firms will have to move beyond volume-based, cost-competitive staff augmentation, testing, maintenance and advisory services. The classic time-and-materials, skilled body shop market has maxed out."

Research firm Gartner Inc., in a 19 March report, said IT service providers must bridge legacy offerings and new services based on new technologies, new delivery models and new architecture to remain relevant. Gartner forecast the overall IT services market to expand 5.2% in 2013 and continue strong growth through 2016. It added “growth will largely come from changes and opportunities brought on by what it calls a ‘nexus of forces’—cloud, social, mobile and information—and newer delivery models, although not exclusively in the consulting and implementation segments".

For instance, a decade ago, who could have imagined firms such as Google Inc. or Amazon Inc. would compete with Indian and multinational IT services providers in the outsourcing space? But with the help of cloud computing, termed also as a non-linear or non-headcount-related technology, companies such as Google, Amazon Web Services, Hewlett-Packard Co., Microsoft, VMWare and Salesforce Inc. are more than nibbling at the IT outsourcing pie by increasingly hosting the IT infrastructure of large enterprises and especially small- and medium-sized businesses (SMBs) in their own data centres, reducing the IT costs of their clients by 40%.

Cloud computing is just one non-linear technology that is threatening to change the future of traditional IT outsourcing with a pay-per-use or subscription model. Other non-headcount related initiatives include automation, templates to industry verticals that can be reused with minimal customization, reusing assets and codes, platform solutions and tools such as Six Sigma, and value-added services such as analytics and intellectual property (IPs), according to Sudin Apte, chief executive officer and research director, Offshore Insights.

“We are seeing the marginalization of me-too companies. Only the generalists that have scale and can serve across a wide range of services, and specialists—those offering niche services—will survive," said Apte.

Wang writes in his report that IT services firms that invest in intellectual property (IP)-based offerings will experience accelerated growth in the next 24-36 months, since most clients prefer “outcomes" rather than technologies or solutions from IT service providers. “The resulting demand-side dynamics of this preference will compel services firms to focus on IP versus vanilla offerings," the report said. Clients, according to Wang, have moved way beyond mere staff augmentation, infrastructure, testing and advice.

The 2012 Nasscom Strategic Review report, too, acknowledged that changing technology—such as automation and cannibalization of existing services due to new technologies (eg. software-as-a-service replacing production support)—presents a potent risk. It forecast that the future of the technology services industry would lie in a combination of services, solutions and platforms. For instance, it forecast public cloud services spending to outpace growth of the overall IT spend by about four times between 2012 and 2015. The cloud computing market in India, according to a study by Zinnov Management Consulting, is expected to touch $4.5 billion by 2015.

“The business architecture and revenue streams of IT services companies are built on a particular premise that is likely to undergo significant shifts in the decade ahead. The emergence of cloud computing, mobility play and Big Data, for example, holds the potential to disrupt the apple cart of IT services industry. While the traditional service lines will continue to grow into the foreseeable future, the gravity will shift to an IP-driven competitive ecosystem where services will be delivered in pay-per-use through the cloud. IT services firms have started addressing this paradigm only incrementally. The more challenging aspects entail shifts to a marketing- and product-driven business model, where IT services firms have no experience or marginal experience at best," said Alok Shende, founder-director and principal analyst, Ascentius Consulting.

Non-linear initiatives, according to Nasscom, pay dividends. The software testing services market, for instance, was forecast to generate $2.7 billion of revenue in fiscal 2013, growing at 19% over fiscal 2012. But analysts say IT services providers will have to increase their non-linear revenue to around 35-40% from the current figure that is less than 10%.

Multinational firms appear to be way ahead. Accenture Plc. has strengths in the consulting business. International Business Machines Corp.’s (IBM) global technology services (GTS) division is betting on concepts such as “Smarter Planet" which will involve sensors, chips and infrastructure as a long-term business. IBM has also moved from a labour-based to an asset-based model and created assets around each vertical. It reuses these assets even as it creates “industry templates" that serve as road maps in understanding verticals and the players within.

The results are there to see. TCS, with more employees than Accenture (261,000), is now the world’s second biggest IT services employer with nearly 264,000 people on its payroll, but with a revenue that is less than half of the Dublin-based technology and consulting firm. Moreover, while TCS’s revenue per employee is around $46,000, it’s $197,000 for IBM and about $107,000 for Accenture. This is because while Accenture sells more high-end consulting services as part of its offerings, IBM earns more by bundling hardware and software solutions as part of large deals.

IBM does not disclose the number of employees by businesses but employs around 400,000 people globally, making it the world’s No. 1 IT employer. To be fair, at least the bigger IT firms are getting their act together. Firms such as TCS, Infosys, Wipro and HCL Technologies are working to evolve and take advantage of their own capabilities in light of this change and are planning a host of non-linear initiatives.

TCS was the first to identify and invest in non-linear opportunities, namely, software products, platform BPO (business process outsourcing) and software as a service (SaaS), as well as focus on unit-priced contracts. A case in point is its deal with the Pearl Group in the UK, for which it developed a life and pensions (L&P) platform. The firm also has a cloud-based initiative for small and medium enterprises called iON, and a platform-based BPO. It has also sharpened its focus on mobility. Since June 2010, TCS has filed 20 patent applications in mobility alone, said TCS vice-president and mobility head Satya Ramaswamy.

On their part, firms such as Infosys have admitted that more of the same will not work. Infosys aims to have one-third of its total revenue come from newer areas, including mobility, products and software platforms, in three-five years. Infosys’s product efforts are focused on Finacle—its core banking solution.

When announcing its March quarter results on 11 April, Infosys committed to spending $100 million on developing products, platforms, and solutions.

Similarly, in the BPO space, Wipro offers transaction-based pricing (for processing, payment per invoice, and claims). HCL BPO, too, has moved to an outcome-based pricing model from an input-based model.

Francisco D’Souza of Cognizant Technology Solutions Corp., describing the trend as “the innovators dilemma", said in a February interview: “The challenge is you sometimes can lose focus on the next generation of services. What tends to happen is as you (are) thinking about longer term, you have to plant seeds. They start small, need lots of individual caring, need disproportionate amount of resource, management attention and that does not really necessarily fit into the management ecosystem of running large businesses and scaling."

But transitioning to a new mix of revenue is going to be a long, painful journey that could even hit the current volume of business. Firms such as Infosys are seeing their business volume growth drop as they steer through this transition. “We don’t know how fast this will happen, but definitely this will have an impact," Infosys co-chairman S. Gopalakrishnan said in a February interview. “The industry will have to prepare itself to provide services based on a very different model."

For instance, a PeopleSoft implementation would be undertaken as a project and by the time it was complete, Infosys would have got all its payments, although the client wouldn’t have started using the system. “But if the shift happens, we will get zero revenue till the implementation is over and clients start paying us on a pay-per-use basis, maybe for three years or five years. Imagine what will happen to our revenue profile and such. Till now, you got all your software revenue and suddenly you have to go to pay-per-use model," he explained.

Wang cautioned in his report that the simple adoption of new technologies alone will not drive growth and “to succeed in future, they (Indian IT firms) must adopt a software development culture" and “partner with vendors such as mega software vendors like Oracle, SAP, Microsoft, and IBM" to drive the ecosystem instead of being enslaved by the partner model.

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